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EX-32 - EXHIBIT 32 - SIERRA BANCORPv465183_ex32.htm
EX-31.2 - EXHIBIT 31.2 - SIERRA BANCORPv465183_ex31-2.htm
EX-31.1 - EXHIBIT 31.1 - SIERRA BANCORPv465183_ex31-1.htm

 

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES

EXCHANGE ACT OF 1934

 

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2017

Commission file number: 000-33063

 

Sierra Bancorp

(Exact name of Registrant as specified in its charter)

 

California 33-0937517
(State of Incorporation) (IRS Employer Identification No)

 

86 North Main Street, Porterville, California 93257

(Address of principal executive offices)       (Zip Code)

 

(559) 782-4900

(Registrant’s telephone number, including area code)

 

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

  

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.

Yes  þ                    No  ¨

 

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes  þ                    No  ¨

 

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.

Large accelerated filer ¨ Accelerated filer þ
Non-accelerated filer ¨ (Do not check if a smaller reporting company) Smaller Reporting Company ¨

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  ¨                    No  þ

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Common stock, no par value, 13,831,749 shares outstanding as of May 1, 2017

 

 

 

 

FORM 10-Q

 

Table of Contents

 

    Page
Part I - Financial Information   1
Item 1. Financial Statements (Unaudited)   1
Consolidated Balance Sheets   1
Consolidated Statements of Income   2
Consolidated Statements of Comprehensive Income   3
Consolidated Statements of Cash Flows   4
Notes to Consolidated Financial Statements (Unaudited)   5
     
Item 2. Management’s Discussion & Analysis of Financial Condition & Results of Operations   30
Forward-Looking Statements   30
Critical Accounting Policies   30
Overview of the Results of Operations and Financial Condition   31
Earnings Performance   32
Net Interest Income and Net Interest Margin   32
Provision for Loan and Lease Losses   35
Non-interest Income and Non-Interest Expense   36
Provision for Income Taxes   38
Balance Sheet Analysis   38
Earning Assets   38
Investments   39
Loan and Lease Portfolio   40
Nonperforming Assets   41
Allowance for Loan and Lease Losses   42
Off-Balance Sheet Arrangements   44
Other Assets   44
Deposits and Interest-Bearing Liabilities   45
Deposits   45
Other Interest-Bearing Liabilities   46
Non-Interest Bearing Liabilities   46
Liquidity and Market Risk Management   46
Capital Resources   49
     
Item 3. Qualitative & Quantitative Disclosures about Market Risk   50
     
Item 4. Controls and Procedures   50
     
Part II - Other Information   51
Item 1. - Legal Proceedings   51
Item 1A. - Risk Factors   51
Item 2. - Unregistered Sales of Equity Securities and Use of Proceeds   51
Item 3. - Defaults upon Senior Securities   51
Item 4. - (Removed and Reserved)   51
Item 5. - Other Information   51
Item 6. - Exhibits   52
     
Signatures   53

 

 

 

 

PART I - FINANCIAL INFORMATION

Item 1 – Financial Statements

 

SIERRA BANCORP

CONSOLIDATED BALANCE SHEETS

(dollars in thousands, unaudited)

 

   March 31, 2017   December 31, 2016 
   (unaudited)   (audited) 
ASSETS          
Cash and due from banks  $54,307   $79,087 
Interest-bearing deposits in banks   38,461    41,355 
Total cash & cash equivalents   92,768    120,442 
Securities available for sale   551,256    530,083 
Loans and leases:          
Gross loans and leases   1,235,897    1,262,531 
Allowance for loan and lease losses   (9,588)   (9,701)
Deferred loan and lease costs, net   2,869    2,924 
Net loans and leases   1,229,178    1,255,754 
Foreclosed assets   2,168    2,225 
Premises and equipment, net   29,018    28,893 
Goodwill   8,268    8,268 
Other intangible assets, net   2,696    2,803 
Company owned life insurance   44,379    43,706 
Other assets   39,994    40,699 
   $1,999,725   $2,032,873 
           
LIABILITIES AND SHAREHOLDERS' EQUITY          
Deposits:          
Non-interest bearing  $504,247   $524,552 
Interest bearing   1,216,174    1,170,919 
Total deposits   1,720,421    1,695,471 
Federal funds purchased and repurchase agreements   9,431    8,094 
Short-term borrowings   -    65,000 
Subordinated debentures, net   34,454    34,410 
Other liabilities   25,002    24,020 
Total Liabilities   1,789,308    1,826,995 
           
Commitments and contingent liabilities (Note 8)          
           
Shareholders' equity          
Common stock, no par value; 24,000,000 shares authorized; 13,829,649 and 13,776,589 shares issued and outstanding at March 31, 2017 and December 31, 2016, respectively   73,508    72,626 
Additional paid in capital   3,057    2,832 
Retained earnings   134,800    132,180 
Accumulated other comprehensive loss   (948)   (1,760)
Total shareholders' equity   210,417    205,878 
   $1,999,725   $2,032,873 

 

The accompanying notes are an integral part of these consolidated financial statements

 

 1 

 

 

CONSOLIDATED STATEMENTS OF INCOME

(dollars in thousands, except per share data, unaudited)

 

   For the Quarter Ended
March 31, 2017
   For the Quarter Ended
March 31, 2016
 
Interest and dividend income          
Loans and leases, including fees  $14,970   $13,092 
Taxable securities   2,008    2,147 
Tax-exempt securities   805    730 
Dividend income on securities   5    36 
Federal funds sold and other   114    28 
Total interest income   17,902    16,033 
Interest expense          
Deposits   689    491 
Short-term borrowings   10    25 
Subordinated debentures   320    202 
Total interest expense   1,019    718 
Net interest income   16,883    15,315 
Provision for loan losses   -    - 
Net interest income after provision for loan losses   16,883    15,315 
Non-interest income          
Service charges on deposits   2,571    2,371 
Net gains (losses) on sale of securities available-for-sale   8    (24)
Other income   2,554    1,947 
Total non-interest income   5,133    4,294 
Other operating expense          
Salaries and employee benefits   7,885    6,865 
Occupancy and equipment   2,320    1,750 
Other   5,496    4,864 
Total non-interest expenses   15,701    13,479 
Income before income taxes   6,315    6,130 
Provision for income taxes   1,764    2,094 
Net income  $4,551   $4,036 
           
PER SHARE DATA          
Book value  $15.21   $14.64 
Cash dividends  $0.14   $0.12 
Earnings per share basic  $0.33   $0.30 
Earnings per share diluted  $0.32   $0.30 
Average shares outstanding, basic   13,801,635    13,265,371 
Average shares outstanding, diluted   14,009,496    13,386,652 
           
Total shareholders' equity (in thousands)  $210,417   $194,347 
Shares outstanding   13,829,649    13,275,888 
Dividends paid (in thousands)  $1,931   $1,591 

 

The accompanying notes are an integral part of these consolidated financial statements

 

 2 

 

 

SIERRA BANCORP

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(dollars in thousands, unaudited)

 

   For the quarter ended
March 31, 2017
   For the quarter ended
March 31, 2016
 
         
Net income  $4,551   $4,036 
Other comprehensive income, before tax:          
Unrealized gains on securities:          
Unrealized holding gains arising during period   1,410    2,001 
Less: reclassification adjustment for (gains) losses included in net income (1)   (8)   24 
Other comprehensive income, before tax   1,402    2,025 
Income tax expense related to items of other comprehensive income   (590)   (830)
Other comprehensive income, net of tax   812    1,195 
           
Comprehensive income  $5,363   $5,231 

 

(1) Amounts are included in net gains on investment securities available-for-sale on the Consolidated Statements of Income in non-interest revenue. Income tax expense associated with the reclassification adjustment for the quarter ended March 31, 2017 and 2016 was $3 thousand and $10 thousand respectively.

 

The accompanying notes are an integral part of these consolidated financial statements

 

 3 

 

 

SIERRA BANCORP

CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands, unaudited)

 

   Three months ended March 31, 
   2017   2016 
Cash flows from operating activities:          
Net income  $4,551   $4,036 
Adjustments to reconcile net income to net cash provided by operating activities:          
(Gain) loss on investment of securities   (8)   24 
Loss on disposal of fixed assets   3    - 
Gain on sale on foreclosed assets   (13)   (46)
Writedown on foreclosed assets   98    122 
Share-based compensation expense   423    157 
Depreciation and amortization   719    598 
Net amortization on securities premiums and discounts   1,758    1,583 
(Accretion) amortization of discounts/premiums for loans acquired and deferred loan fees/costs   (13)   55 
(Increase) decrease in cash surrender value of life insurance policies   (673)   600 
Amortization of core deposit intangible   107    34 
Decrease in interest receivable and other assets   226    2,689 
Decrease (increase) in other liabilities   982    (4,613)
Deferred income tax (benefit) provision   (111)   310 
Deferred tax benefit from equity based compensation   -    (73)
Net cash provided by operating activities   8,049    5,476 
           
Cash flows from investing activities:          
Maturities of securities available for sale   -    30 
Proceeds from sales/calls of securities available for sale   12,905    2,575 
Purchases of securities available for sale   (59,511)   (38,673)
Principal pay downs on securities available for sale   25,086    21,496 
Net decrease in loans receivable, net   26,532    37,939 
Purchases of premises and equipment, net   (803)   (1,023)
Proceeds from sales of fixed assets   -    232 
Proceeds from sales of foreclosed assets   29    332 
Net cash provided by investing activities   4,238    22,908 
           
Cash flows from financing activities:          
Increase in deposits   24,950    23,458 
Decrease in borrowed funds   (65,000)   (54,500)
Increase (decrease) in repurchase agreements   1,337    (722)
Cash dividends paid   (1,931)   (1,592)
Stock options exercised   683    284 
Excess tax provision from equity based compensation   -    73 
Net cash used in financing activities   (39,961)   (32,999)
           
Decrease in cash and due from banks   (27,674)   (4,615)
           
Cash and cash equivalents          
Beginning of period   120,442    48,623 
End of period  $92,768   $44,008 

 

The accompanying notes are an integral part of these consolidated financial statements

 

 4 

 

 

Sierra Bancorp

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2017

(Unaudited)

 

Note 1 – The Business of Sierra Bancorp

 

Sierra Bancorp (the “Company”) is a California corporation headquartered in Porterville, California, and is a registered bank holding company under federal banking laws. The Company was formed to serve as the holding company for Bank of the Sierra (the “Bank”), and has been the Bank’s sole shareholder since August 2001. The Company exists primarily for the purpose of holding the stock of the Bank and of such other subsidiaries it may acquire or establish. As of March 31, 2017, the Company’s only other subsidiaries were Sierra Statutory Trust II, Sierra Capital Trust III, and Coast Bancorp Statutory Trust II, which exist solely to facilitate the issuance of capital trust pass-through securities (“TRUPS”). Pursuant to the Financial Accounting Standards Board (“FASB”) standard on the consolidation of variable interest entities, these trusts are not reflected on a consolidated basis in the Company’s financial statements. References herein to the “Company” include Sierra Bancorp and its consolidated subsidiary, the Bank, unless the context indicates otherwise.

 

Bank of the Sierra, a California state-chartered bank headquartered in Porterville, California, offers a full range of retail and commercial banking services in California’s South San Joaquin Valley and neighboring communities, the Central Coast, Ventura County, and Santa Clarita. The Bank was incorporated in September 1977, and opened for business in January 1978 as a one-branch bank with $1.5 million in capital. Our growth in the ensuing years has largely been organic in nature, but includes three whole-bank acquisitions: Sierra National Bank in 2000, Santa Clara Valley Bank in 2014, and Coast National Bank in July of 2016. The Bank now operates 34 full-service branches, a loan production office, and an online branch, and maintains ATMs at all branch locations and seven non-branch locations. Our most recent branching activity occurred in the first quarter of 2017, with a de novo branch opened on California Avenue in Bakersfield and our Paso Robles branch relocated to a superior site in reasonably close proximity to the previous location. The Company plans to expand even further in 2017 with the acquisition of OCB Bancorp, the holding company for Ojai Community Bank (see Note 13 to the financial statements, Recent Developments, for more details on the proposed acquisition), and we have also received regulatory approvals for a de novo branch in Pismo Beach, California, although the timing for that branch opening remains uncertain. In addition to our stand-alone offices the Bank has specialized lending units which include a real estate industries center, an agricultural credit center, and an SBA lending unit. We were $2.0 billion in total assets as of March 31, 2017, and for the past several years have claimed the distinction of being the largest bank headquartered in the South San Joaquin Valley. The Bank’s deposit accounts, which totaled over $1.7 billion at March 31, 2017, are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to maximum insurable amounts.

 

Note 2 – Basis of Presentation

 

The accompanying unaudited consolidated financial statements have been prepared in a condensed format, and therefore do not include all of the information and footnotes required by U.S. generally accepted accounting principles (“GAAP”) for complete financial statements. The information furnished in these interim statements reflects all adjustments that are, in the opinion of Management, necessary for a fair statement of the results for such periods. Such adjustments can generally be considered as normal and recurring unless otherwise disclosed in this Form 10-Q. In preparing the accompanying financial statements, Management has taken subsequent events into consideration and recognized them where appropriate. The results of operations in the interim statements are not necessarily indicative of the results that may be expected for any other quarter, or for the full year. Certain amounts reported for 2016 have been reclassified to be consistent with the reporting for 2017. The interim financial information should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2016, as filed with the Securities and Exchange Commission (the “SEC”).

 

 5 

 

 

Note 3 – Current Accounting Developments

 

In May 2014, the FASB issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606). This ASU is the result of a joint project initiated by the FASB and the International Accounting Standards Board (IASB) to clarify the principles for recognizing revenue, and to develop common revenue standards and disclosure requirements that would: (1) remove inconsistencies and weaknesses in revenue requirements; (2) provide a more robust framework for addressing revenue issues; (3) improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets; (4) provide more useful information to users of financial statements through improved disclosures; and (5) simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer. The guidance affects any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets. The core principle is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance provides steps to follow to achieve the core principle. An entity should disclose sufficient information to enable users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. Qualitative and quantitative information is required with regard to contracts with customers, significant judgments and changes in judgments, and assets recognized from the costs to obtain or fulfill a contract. This ASU is effective for annual reporting periods beginning after December 15, 2017, including interim periods therein, with early adoption permitted for reporting periods beginning after December 15, 2016. The Company plans to adopt ASU 2014-09 on January 1, 2018 utilizing the modified retrospective approach. Since the guidance does not apply to revenue associated with financial instruments such as loans and investments, which are accounted for under other provisions of GAAP, we do not expect it to impact interest income, our largest component of income. The Company is currently performing an overall assessment of revenue streams potentially affected by the ASU, including certain deposit related fees and interchange fees, to determine the potential impact of this guidance on our consolidated financial statements.

 

In January 2016 the FASB issued ASU 2016-01, Financial Instruments–Overall: Recognition and Measurement of Financial Assets and Financial Liabilities. This guidance primarily affects the accounting for equity securities with readily determinable fair values, by requiring that the changes in fair value for such securities will be reflected in earnings rather than in other comprehensive income. The accounting for other financial instruments such as loans, debt securities, and financial liabilities is largely unchanged. ASU 2016-01 also changes the presentation and disclosure requirements for financial instruments, including a requirement that public business entities use exit pricing when estimating fair values for financial instruments measured at amortized cost for disclosure purposes. ASU 2016-01 is generally effective for public business entities in fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company has evaluated the provisions of ASU 2016-01, and based on this preliminary evaluation we do not expect it to have a material impact on our consolidated financial statements.

 

In February 2016 the FASB issued ASU 2016-02, Leases (Topic 842). The intention of this standard is to increase the transparency and comparability around lease obligations. Previously unrecorded off-balance sheet obligations will now be brought more prominently to light by presenting lease liabilities on the face of the balance sheet, accompanied by enhanced qualitative and quantitative disclosures in the notes to the financial statements. ASU 2016-02 is generally effective for public business entities in fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company has leases on 17 branch locations, a loan production office, and an administrative office, which are considered operating leases and are not currently reflected in our financial statements. We expect that these lease agreements will be recognized on our consolidated statements of condition as right-of-use assets and corresponding lease liabilities subsequent to implementing ASU 2016-02, but we are still evaluating the extent to which this will impact our consolidated financial statements.

 

In March 2016 the FASB issued ASU 2016-09, Compensation–Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, as part of its simplification initiative. Currently, as they relate to share-based payments, tax benefits in excess of compensation costs (“windfalls”) are recorded in equity, and tax deficiencies (“shortfalls”) are recorded in equity to the extent of previous windfalls, and then to the income statement. ASU 2016-09 will reduce some of the administrative complexities by eliminating the need to track a windfall “pool,” but could increase the volatility of income tax expense. This change is required to be applied prospectively to all excess tax benefits and tax deficiencies resulting from settlements after the date of adoption. ASU 2016-09 also removes the requirement to delay recognition of a windfall tax benefit until it reduces current taxes payable. Under the new guidance, the benefit will be recorded when it arises, subject to normal valuation allowance considerations. This change is required to be applied on a modified retrospective basis, with a cumulative-effect adjustment to opening retained earnings. Furthermore, all tax-related cash flows resulting from share-based payments are to be reported as operating activities on the statement of cash flows, a change from the current requirement to present windfall tax benefits as an inflow from financing activities and an outflow from operating activities. However, cash paid by an employer when directly withholding shares for tax withholding purposes should be classified as a financing activity. Under the new guidance, entities are also permitted to make an accounting policy election for the impact of forfeitures on expense recognition for share-based payment awards. Forfeitures can be estimated in advance, as required today, or recognized as they occur. Estimates will still be required in certain circumstances, such as at the time of modification of an award or issuance of a replacement award in a business combination. If elected, the change to recognize forfeitures when they occur needs to be adopted using a modified retrospective approach, with a cumulative effect adjustment recorded to opening retained earnings. ASU 2016-09 is effective for public business entities for annual reporting periods beginning after December 15, 2016, and interim periods within that reporting period. The Company adopted ASU 2016-09 effective January 1, 2017. We did not elect to recognize forfeitures as they occur, but rather to continue with current GAAP and estimate potential forfeitures in advance, but we expect that the adoption of other provisions of ASU 2016-09 will result in increased volatility to our reported income tax expense going forward.

 

 6 

 

 

In June 2016 the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which eliminates the probable initial recognition threshold for credit losses in current U.S. GAAP, and instead requires an organization to record a current estimate of all expected credit losses over the contractual term for financial assets carried at amortized cost. This is commonly referred to as the current expected credit losses (“CECL”) methodology. Expected credit losses for financial assets held at the reporting date will be measured based on historical experience, current conditions, and reasonable and supportable forecasts. Another change from existing U.S. GAAP involves the treatment of purchased credit deteriorated assets, which are more broadly defined than purchased credit impaired assets in current accounting standards. When such assets are purchased, institutions will estimate and record an allowance for credit losses that is added to the purchase price rather than being reported as a credit loss expense. Furthermore, ASU 2016-13 updates the measurement of credit losses on available-for-sale debt securities, by mandating that institutions record credit losses on available-for-sale debt securities through an allowance for credit losses rather than the current practice of writing down securities for other-than-temporary impairment. ASU 2016-13 will also require the enhancement of financial statement disclosures regarding estimates used in calculating credit losses. ASU 2016-13 does not change the existing write-off principle in U.S. GAAP or current nonaccrual practices, nor does it change accounting requirements for loans held for sale or certain other financial assets which are measured at the lower of amortized cost or fair value. As a public business entity that is an SEC filer, ASU 2016-13 becomes effective for the Company on January 1, 2020, although early application is permitted for 2019. On the effective date, institutions will apply the new accounting standard as follows: for financial assets carried at amortized cost, a cumulative-effect adjustment will be recognized on the balance sheet for any change in the related allowance for loan and lease losses generated by the adoption of the new standard; financial assets classified as purchased credit impaired assets prior to the effective date will be reclassified as purchased credit deteriorated assets as of the effective date, and will be grossed up for the related allowance for expected credit losses created as of the effective date; and, debt securities on which other-than-temporary impairment had been recognized prior to the effective date will transition to the new guidance prospectively with no change in their amortized cost basis. The Company has commenced its transition efforts by establishing an implementation team chaired by the Company’s Chief Credit Officer, and comprised of members of the Company’s credit administration and finance departments. The Company’s preliminary evaluation indicates that the provisions of ASU 2016-13 will impact our consolidated financial statements, in particular the level of our reserve for credit losses and shareholders’ equity. However, we continue to evaluate the potential extent of that impact.

 

In January 2017 the FASB issued ASU 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business. Currently, Topic 805 specifies three elements of a business – inputs, processes, and outputs. While an integrated set of assets and activities (collectively referred to as a “set”) that is a business usually has outputs, outputs are not required. In addition, all the inputs and processes that a seller uses in operating a set are not required if market participants can acquire the set and continue to produce outputs, for example, by integrating the acquired set with their own inputs and processes. This led many transactions to be accounted for as business combinations rather than asset purchases under legacy GAAP. The primary goal of ASU 2017-01 is to narrow the definition of a business, and the guidance in this update provides a screen to determine when a set is not a business. The screen requires that when substantially all of the fair value of the gross assets acquired (or disposed of) is concentrated in a single identifiable asset or a group of similar identifiable assets, the set is not a business. This screen reduces the number of transactions that need to be further evaluated. The amendments in this update are effective for public business entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The amendments in this update should be applied prospectively on or after the effective date. The Company is currently evaluating this ASU to determine the impact on its consolidated financial position, results of operations and cash flows.

 

 7 

 

 

In January 2017 the FASB issued ASU 2017-04, Intangibles – Goodwill and Other (Topic 350): Simplifying the Accounting for Goodwill Impairment. This guidance removes Step 2 of the goodwill impairment test, which requires a hypothetical purchase price allocation, and goodwill impairment will simply be the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. All other goodwill impairment guidance will remain largely unchanged. Entities will continue to have the option to perform a qualitative assessment to determine if a quantitative impairment test is necessary. The same one-step impairment test will be applied to goodwill at all reporting units, even those with zero or negative carrying amounts. Entities will be required to disclose the amount of goodwill at reporting units with zero or negative carrying amounts. The amendments in this update are effective for public business entities for fiscal years beginning after December 15, 2019. We have not been required to record any goodwill impairment to date, and after a preliminary review do not expect that this guidance would require us to do so given current circumstances. Nevertheless, we will continue to evaluate ASU 2017-04 to more definitely determine its potential impact on the Company’s consolidated financial position, results of operations and cash flows.

 

Note 4 – Supplemental Disclosure of Cash Flow Information

 

During the three months ended March 31, 2017 and 2016, cash paid for interest due on interest-bearing liabilities was $1.070 million and $697,000, respectively. There was no cash paid for income taxes during the three months ended March 31, 2017, and $1.400 million in cash paid for income taxes for the three months ended March 31, 2016. Assets totaling $94,000 and $330,000 were acquired in settlement of loans for the three months ended March 31, 2017 and March 31, 2016, respectively. We received $29,000 in cash from the sale of foreclosed assets during the first three months of 2017 relative to $332,000 during the first three months of 2016, which represents sales proceeds less loans (if any) extended to finance such sales.

 

Note 5 – Share Based Compensation

 

On March 16, 2017 the Company’s Board of Directors approved and adopted the 2017 Stock Incentive Plan (the “2017 Plan”), which becomes effective May 24, 2017 subject to the approval of the Company’s shareholders. The 2017 Plan will replace the Company’s 2007 Stock Incentive Plan (the “2007 Plan”), which expired by its own terms on March 15, 2017. Options to purchase 503,020 shares that were granted under the 2007 Plan were still outstanding as of March 31, 2017, and remain unaffected by that plan’s expiration. The new 2017 Plan provides for the issuance of both “incentive” and “nonqualified” stock options to officers and employees, and of “nonqualified” stock options to non-employee directors and consultants of the Company. The 2017 Plan also provides for the issuance of restricted stock awards to these same classes of eligible participants, although no restricted stock awards have ever been issued by the Company. The total number of shares of the Company’s authorized but unissued stock reserved for issuance pursuant to awards under the 2017 Plan is 850,000 shares. The dilutive impact of stock options outstanding is discussed below in Note 6, Earnings per Share.

 

Pursuant to FASB’s standards on stock compensation, the value of each stock option granted is reflected in our income statement as employee compensation or directors’ expense by amortizing its grant date fair value over the vesting period for options with graded vesting, or by expensing its fair value as of the grant date in the case of immediately vested options. The Company is utilizing the Black-Scholes model to value stock options, and the “multiple option” approach is used to allocate the resulting valuation to actual expense. Under the multiple option approach an employee’s options for each vesting period are separately valued and amortized, which appears to be the preferred method for option grants with graded vesting. A pre-tax charge of $423,000 was reflected in the Company’s income statement during the first quarter of 2017 and $157,000 was charged during the first quarter of 2016, as expense related to stock options.

 

Note 6 – Earnings per Share

 

The computation of earnings per share, as presented in the Consolidated Statements of Income, is based on the weighted average number of shares outstanding during each period. There were 13,801,635 weighted average shares outstanding during the first quarter of 2017, and 13,265,371 during the first quarter of 2016.

 

Diluted earnings per share include the effect of the potential issuance of common shares, which for the Company is limited to shares that would be issued on the exercise of “in-the-money” stock options. For the first quarter of 2017, calculations under the treasury stock method resulted in the equivalent of 207,861 shares being added to basic weighted average shares outstanding for purposes of determining diluted earnings per share, while a weighted average of 90,000 stock options were excluded from the calculation because they were underwater and thus anti-dilutive. For the first quarter of 2016 the equivalent of 121,281 shares were added in calculating diluted earnings per share, while 216,100 anti-dilutive stock options were excluded.

 

Note 7 – Comprehensive Income

 

As presented in the Consolidated Statements of Comprehensive Income, comprehensive income includes net income and other comprehensive income. The Company’s only source of other comprehensive income is unrealized gains and losses on available-for-sale investment securities. Gains or losses on investment securities that were realized and reflected in net income of the current period, which had previously been included in other comprehensive income as unrealized holding gains or losses in the period in which they arose, are considered to be reclassification adjustments that are excluded from other comprehensive income in the current period.

 

 8 

 

 

Note 8 – Financial Instruments with Off-Balance-Sheet Risk

 

The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business. Those financial instruments currently consist of unused commitments to extend credit and standby letters of credit. They involve, to varying degrees, elements of risk in excess of the amount recognized in the balance sheet. The Company’s exposure to credit loss in the event of nonperformance by counterparties for commitments to extend credit and letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and issuing letters of credit as it does for originating loans included on the balance sheet. The following financial instruments represent off-balance-sheet credit risk (dollars in thousands):

 

   March 31, 2017   December 31, 2016 
Commitments to extend credit  $577,980   $463,923 
Standby letters of credit  $8,482   $8,582 

 

Commitments to extend credit consist primarily of the unused or unfunded portions of the following: home equity lines of credit; commercial real estate construction loans, where disbursements are made over the course of construction; commercial revolving lines of credit; mortgage warehouse lines of credit; unsecured personal lines of credit; and formalized (disclosed) deposit account overdraft lines. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many commitments are expected to expire without being drawn upon, the unused portions of committed amounts do not necessarily represent future cash requirements. Standby letters of credit are generally unsecured and are issued by the Company to guarantee the performance of a customer to a third party, and the credit risk involved in issuing letters of credit is essentially the same as the risk involved in extending loans to customers.

 

At March 31, 2017, the Company was also utilizing a letter of credit in the amount of $97 million issued by the Federal Home Loan Bank on the Company’s behalf as security for certain deposits and to facilitate certain credit arrangements with the Company’s customers. That letter of credit is backed by loans which are pledged to the FHLB by the Company.

 

Note 9 – Fair Value Disclosures and Reporting, the Fair Value Option and Fair Value Measurements

 

FASB’s standards on financial instruments, and on fair value measurements and disclosures, require all entities to disclose in their financial statement footnotes the estimated fair values of financial instruments for which it is practicable to estimate fair values. In addition to disclosure requirements, FASB’s standard on investments requires that our debt securities which are classified as available for sale and our equity securities that have readily determinable fair values be measured and reported at fair value in our statement of financial position. Certain impaired loans are also reported at fair value, as explained in greater detail below, and foreclosed assets are carried at the lower of cost or fair value. FASB’s standard on financial instruments permits companies to report certain other financial assets and liabilities at fair value, but we have not elected the fair value option for any of those financial instruments.

 

Fair value measurement and disclosure standards also establish a framework for measuring fair values. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability, in an orderly transaction between market participants on the measurement date. Further, the standards establish a fair value hierarchy that encourages an entity to maximize the use of observable inputs and limit the use of unobservable inputs when measuring fair values. The standards describe three levels of inputs that may be used to measure fair values:

 

·Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

 

·Level 2: Significant observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.

 

 9 

 

 

·Level 3: Significant unobservable inputs that reflect a company’s own assumptions about the factors that market participants would likely consider in pricing an asset or liability.

 

Fair value estimates are made at a specific point in time based on relevant market data and information about the financial instruments. The estimates do not reflect any premium or discount that could result from offering the Company’s entire holdings of a particular financial instrument for sale at one time, nor do they attempt to estimate the value of anticipated future business related to the instruments. In addition, the tax ramifications related to realized gains and losses could have a significant effect on fair value estimates but have not been considered in those estimates. Because no active market exists for a significant portion of our financial instruments, fair value disclosures are based on judgments regarding current economic conditions, risk characteristics of various financial instruments and other factors. The estimates are subjective and involve uncertainties and matters of significant judgment, and therefore cannot be determined with precision. Changes in assumptions could significantly alter the fair values presented. The following methods and assumptions were used by the Company to estimate its financial instrument fair values disclosed at March 31, 2017 and December 31, 2016:

 

·Cash and cash equivalents and fed funds sold: The carrying amount is estimated to be fair value.

 

·Investment securities: Fair values are determined by obtaining quoted prices on nationally recognized securities exchanges or by matrix pricing, which is a mathematical technique used widely in the industry to value debt securities by relying on their relationship to other benchmark quoted securities when quoted prices for specific securities are not readily available.

 

·Loans and leases: For variable-rate loans and leases that re-price frequently with no significant changes in credit risk or interest rate spreads relative to current market pricing, fair values are based on carrying values. Fair values for other loans and leases are estimated by discounting projected cash flows at interest rates being offered at each reporting date for loans and leases with similar terms, to borrowers of comparable creditworthiness. The carrying amount of accrued interest receivable approximates its fair value.

 

·Loans held for sale: Since loans designated by the Company as available-for-sale are typically sold shortly after making the decision to sell them, realized gains or losses are usually recognized within the same period and fluctuations in fair values are not relevant for reporting purposes. If available-for-sale loans are on our books for an extended period of time, the fair value of those loans is determined using quoted secondary-market prices.

 

·Collateral-dependent impaired loans: Collateral-dependent impaired loans are carried at fair value when it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the original loan agreement and the loan has been written down to the fair value of its underlying collateral, net of expected disposition costs where applicable.

 

·Cash surrender value of life insurance policies: Fair values are based on net cash surrender values at each reporting date.

 

·Other investments: Certain investments for which no secondary market exists are carried at cost and the carrying amount for those investments typically approximates their estimated fair value, unless an impairment analysis indicates the need for adjustments.

 

·Deposits: Fair values for non-maturity deposits are equal to the amount payable on demand at the reporting date, which is the carrying amount. Fair values for fixed-rate certificates of deposit are estimated using a cash flow analysis, discounted at interest rates being offered at each reporting date by the Bank for certificates with similar remaining maturities. The carrying amount of accrued interest payable approximates its fair value.

 

·Short-term borrowings: Current carrying amounts are used as an approximation of fair values for federal funds purchased, overnight advances from the Federal Home Loan Bank (“FHLB”), borrowings under repurchase agreements, and other short-term borrowings maturing within ninety days of the reporting dates. Fair values of other short-term borrowings are estimated by discounting projected cash flows at the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

 

·Long-term borrowings: Fair values are estimated using projected cash flows discounted at the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

 

·Subordinated debentures: Fair values are determined based on the current market value for like instruments of a similar maturity and structure.

 

 10 

 

 

·Commitments to extend credit and letters of credit: If funded, the carrying amounts for currently unused commitments would provide an equivalent measure of fair values for the newly created financial assets at the funding date. However, because of the high degree of uncertainty with regard to whether or not those commitments will ultimately be funded, fair values for loan commitments and letters of credit in their current undisbursed state cannot reasonably be estimated, and only notional values are disclosed in the table below.

 

 11 

 

 

Estimated fair values for the Company’s financial instruments are as follows, as of the dates noted:

 

Fair Value of Financial Instruments                
(dollars in thousands, unaudited)  March 31, 2017 
       Estimated Fair Value 
  

Carrying

Amount

  

Quoted Prices in

Active Markets for

Identical Assets

(Level 1)

  

Significant

Observable

Inputs

(Level 2)

  

Significant

Unobservable

Inputs

(Level 3)

   Total 
Financial assets:                         
Cash and cash equivalents  $92,768   $92,768   $-   $-   $92,768 
Securities available for sale   551,256    1,645    549,611    -    551,256 
Loans and leases, net held for investment   1,228,731    -    1,240,991    -    1,240,991 
Collateral dependent impaired loans   447    -    447    -    447 
Cash surrender value of life insurance policies   44,379    -    44,379    -    44,379 
Other investments   8,506    -    8,506    -    8,506 
Accrued interest receivable   5,997    -    5,997    -    5,997 
                          
Financial liabilities:                         
Deposits:                         
Non-interest-bearing  $504,247   $504,247   $-   $-   $504,247 
Interest-bearing   1,216,174    -    1,216,510    -    1,216,510 
Fed funds purchased and repurchase agreements   9,431    -    9,431    -    9,431 
Short-term borrowings   -    -    -    -    - 
Subordinated debentures   34,454    -    22,744    -    22,744 
Accrued interest payable   137    -    137    -    137 
                          
   Notional Amount                     
Off-balance-sheet financial instruments:                         
Commitments to extend credit  $577,980                     
Standby letters of credit   8,482                     

 

   December 31, 2016 
       Estimated Fair Value 
  

Carrying

Amount

  

Quoted Prices in

Active Markets for

Identical Assets

(Level 1)

  

Significant

Observable

Inputs

(Level 2)

  

Significant

Unobservable

Inputs

(Level 3)

   Total 
Financial assets:                         
Cash and cash equivalents  $120,442   $120,442   $-   $-   $120,442 
Securities available for sale   530,083    1,546    528,537    -    530,083 
Loans and leases, net held for investment   1,255,348    -    1,266,447    -    1,266,447 
Collateral dependent impaired loans   406    -    406    -    406 
Cash surrender value of life insurance policies   43,706    -    43,706    -    43,706 
Other investments   8,506    -    8,506    -    8,506 
Accrued interest receivable   6,354    -    6,354    -    6,354 
                          
Financial liabilities:                         
Deposits:                         
Non-interest-bearing  $524,552   $524,552   $-   $-   $524,552 
Interest-bearing   1,170,919    -    1,171,188    -    1,171,188 
Fed funds purchased and repurchase agreements   8,094    -    8,094    -    8,094 
Short-term borrowings   65,000    -    65,000    -    65,000 
Subordinated debentures   34,410    -    22,633    -    22,633 
Accrued interest payable   188    -    188    -    188 
                          
   Notional Amount                     
Off-balance-sheet financial instruments:                         
Commitments to extend credit  $463,923                     
Standby letters of credit   8,582                     

 

 12 

 

 

For financial asset categories that were actually reported at fair value as of March 31, 2017 and December 31, 2016, the Company used the following methods and significant assumptions:

 

·Investment securities: Fair values are determined by obtaining quoted prices on nationally recognized securities exchanges or by matrix pricing, which is a mathematical technique used widely in the industry to value debt securities by relying on their relationship to other benchmark quoted securities.

 

·Collateral-dependent impaired loans: Collateral-dependent impaired loans are carried at fair value when it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the original loan agreement and the loan has been written down to the fair value of its underlying collateral, net of expected disposition costs where applicable.

 

·Foreclosed assets: Repossessed real estate (known as other real estate owned, or “OREO”) and other foreclosed assets are carried at the lower of cost or fair value. Fair value is the appraised value less expected selling costs for OREO and some other assets such as mobile homes, and fair values for any other foreclosed assets are represented by estimated sales proceeds as determined using reasonably available sources. Foreclosed assets for which appraisals can be feasibly obtained are periodically measured for impairment using updated appraisals. Fair values for other foreclosed assets are adjusted as necessary, subsequent to a periodic re-evaluation of expected cash flows and the timing of resolution. If impairment is determined to exist, the book value of a foreclosed asset is immediately written down to its estimated impaired value through the income statement, thus the carrying amount is equal to the fair value and there is no valuation allowance.

 

Assets reported at fair value on a recurring basis are summarized below:

 

Fair Value Measurements - Recurring                    
(dollars in thousands, unaudited)                    
   Fair Value Measurements at March 31, 2017, using     
   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
   Significant
Observable
Inputs
(Level 2)
   Significant
Unobservable
Inputs
(Level 3)
   Total   Realized
Gain/(Loss)
 
Securities:                         
US Government agencies  $-   $25,220   $-   $25,220   $- 
Mortgage-backed securities   -    406,817    -    406,817    - 
State and poltical subdivisions   -    117,574    -    117,574    - 
Equity securities   1,645    -    -    1,645    - 
                          
Total available-for-sale securities  $1,645   $549,611   $-   $551,256   $- 
                          
   Fair Value Measurements at December 31, 2016, using     
   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
   Significant
Observable
Inputs
(Level 2)
   Significant
Unobservable
Inputs
(Level 3)
   Total   Realized
Gain/(Loss)
 
Securities:                         
US Government agencies  $-   $26,468   $-   $26,468   $- 
Mortgage-backed securities   -    387,876    -    387,876    - 
State and poltical subdivisions   -    114,193    -    114,193    - 
Equity securities   1,546    -    -    1,546    - 
                          
Total available-for-sale securities  $1,546   $528,537   $-   $530,083   $- 

 

 13 

 

 

Assets reported at fair value on a nonrecurring basis are summarized below:

 

Fair Value Measurements - Nonrecurring                
(dollars in thousands, unaudited)                
   Fair Value Measurements at March 31, 2017, using 
   Quoted Prices in Active
Markets for
Identical Assets
(Level 1)
   Significant
Observable
Inputs
(Level 2)
   Significant
Unobservable
Inputs
(Level 3)
   Total 
Impaired loans                    
Real Estate:                    
1-4 family residential construction  $-   $-   $-   $- 
Other construction/land   -    -    -    - 
1-4 family - closed-end   -    -    -    - 
Equity lines   -    15    -    15 
Multi-family residential   -    -    -    - 
Commercial real estate - owner occupied   -    402    -    402 
Commercial real estate-non-owner occupied   -    -    -    - 
Farmland   -    -    -    - 
Total real estate   -    417    -    417 
Agriculture   -    -    -    - 
Commercial and industrial   -    -    -    - 
Consumer loans   -    30    -    30 
Total impaired loans   -    447    -    447 
Foreclosed assets  $-   $2,168   $-   $2,168 
Total assets measured on a norecurring basis  $-   $2,615   $-   $2,615 
                     
   Fair Value Measurements at December 31, 2016, using 
   Quoted Prices in Active
Markets for
Identical Assets
(Level 1)
   Significant
Observable
Inputs
(Level 2)
   Significant
Unobservable
Inputs
(Level 3)
   Total 
Impaired loans                    
Real Estate:                    
1-4 family residential construction  $-   $-   $-   $- 
Other construction/land   -    -    -    - 
1-4 family - closed-end   -    -    -    - 
Equity lines   -    -    -    - 
Multi-family residential   -    -    -    - 
Commercial real estate - owner occupied   -    281    -    281 
Commercial real estate-non-owner occupied   -    67    -    67 
Farmland   -    -    -    - 
Total real estate   -    348    -    348 
Agriculture   -    -    -    - 
Commercial and industrial   -    -    -    - 
Consumer loans   -    58    -    58 
Total impaired loans   -    406    -    406 
Foreclosed assets  $-   $2,225   $-   $2,225 
Total assets measured on a norecurring basis  $-   $2,631   $-   $2,631 

 

The table above includes collateral-dependent impaired loan balances for which a specific reserve has been established or on which a write-down has been taken. Information on the Company’s total impaired loan balances and specific loss reserves associated with those balances is included in Note 11 below, and in Management’s Discussion and Analysis of Financial Condition and Results of Operation in the “Nonperforming Assets” and “Allowance for Loan and Lease Losses” sections.

 

 14 

 

 

The unobservable inputs are based on Management’s best estimates of appropriate discounts in arriving at fair market value. Increases or decreases in any of those inputs could result in a significantly lower or higher fair value measurement. For example, an increase or decrease in actual loss rates would create a directionally opposite change in the fair value of unsecured impaired loans.

 

Note 10 – Investments

 

Investment Securities

 

Although the Company currently has the intent and the ability to hold the securities in its investment portfolio to maturity, the securities are all marketable and are classified as “available for sale” to allow maximum flexibility with regard to interest rate risk and liquidity management. Pursuant to FASB’s guidance on accounting for debt and equity securities, available for sale securities are carried on the Company’s financial statements at their estimated fair market values, with monthly tax-effected “mark-to-market” adjustments made vis-à-vis accumulated other comprehensive income in shareholders’ equity.

 

The amortized cost and estimated fair value of investment securities available-for-sale are as follows:

 

Amortized Cost And Estimated Fair Value

(dollars in thousands, unaudited)

 

   March 31, 2017 
   Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Estimated Fair
Value
 
                 
U.S Government agencies  $25,601   $53   $(434)  $25,220 
Mortgage-backed securities   409,681    1,431    (4,295)   406,817 
State and poltical subdivisions   117,109    1,698    (1,233)   117,574 
Equity securities   500    1,145    -    1,645 
Total investment securities  $552,891   $4,327   $(5,962)  $551,256 

 

   December 31, 2016 
   Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Estimated Fair
Value
 
                 
U.S Government agencies  $26,926   $48   $(506)  $26,468 
Mortgage-backed securities   391,555    1,492    (5,171)   387,876 
State and political subdivisons   114,140    1,519    (1,466)   114,193 
Equity securities   500    1,046    -    1,546 
Total investment securities  $533,121   $4,105   $(7,143)  $530,083 

 

 15 

 

 

At March 31, 2017 and December 31, 2016, the Company had 408 securities and 431 securities, respectively, with gross unrealized losses. Management has evaluated those securities as of the respective dates, and does not believe that any of the unrealized losses are other than temporary. Gross unrealized losses on our investment securities as of the indicated dates are disclosed in the table below, categorized by investment type and by the duration of time that loss positions on individual securities have continuously existed (over or under twelve months).

 

Investment Portfolio - Unrealized Losses                
(dollars in thousands, unaudited)  March 31, 2017 
   Less than twelve months   Twelve months or more 
   Gross
Unrealized
Losses
   Fair Value   Gross
Unrealized
Losses
   Fair Value 
                 
US Government agencies  $(365)  $17,665   $(69)  $2,356 
Mortgage-backed securities   (3,518)   270,610    (777)   45,667 
State and political subdivisions   (1,231)   46,773    (2)   265 
Other securities   -    -    -    - 
Total  $(5,114)  $335,048   $(848)  $48,288 

 

   December 31, 2016 
   Less than twelve months   Twelve months or more 
   Gross
Unrealized
Losses
   Fair Value   Gross
Unrealized
Losses
   Fair Value 
                 
US Government agencies  $(500)  $21,056   $(6)  $711 
Mortgage-backed securities   (4,303)   271,276    (868)   43,570 
State and political subdivisions   (1,466)   49,195    -    - 
Other securities   -    -    -    - 
Total  $(6,269)  $341,527   $(874)  $44,281 

 

The table below summarizes the Company’s gross realized gains and losses as well as gross proceeds from the sales of securities, for the periods indicated:

 

Investment Portfolio - Realized Gains/(Losses)        
(dollars in thousands, unaudited)        
         
   Three months ended March 31, 
   2017   2016 
Proceeds from sales and calls of securities available for sale  $12,905   $2,575 
Gross gains on sales and calls of securities available for sale  $43   $14 
Gross losses on sales and calls of securities available for sale   (35)   (38)
Net gains (losses) on sale of securities available for sale  $8   $(24)

 

 16 

 

 

The amortized cost and estimated fair value of investment securities available-for-sale at March 31, 2017 and December 31, 2016 are shown below, grouped by the remaining time to contractual maturity dates. The expected life of investment securities may not be consistent with contractual maturity dates, since the issuers of the securities could have the right to call or prepay obligations with or without penalties.

 

Estimated Fair Value of Contractual Maturities        
(dollars in thousands, unaudited)  March 31, 2017 
   Amortized
Cost
   Fair Value 
         
Maturing within one year  $6,286   $6,344 
Maturing after one year through five years   221,003    221,297 
Maturing after five years through ten years   83,477    83,230 
Maturing after ten years   59,159    58,403 
           
Investment securities not due at a single maturity date:          
U.S Government agencies collateralized by mortgage obligations   182,466    180,337 
Other securities   500    1,645 
   $552,891   $551,256 

 

   December 31, 2016 
   Amortized
Cost
   Fair Value 
         
Maturing within one year  $8,488   $8,573 
Maturing after one year through five years   260,387    259,535 
Maturing after five years through ten years   50,823    50,687 
Maturing after ten years   47,132    46,190 
           
Investment securities not due at a single maturity date:          
U.S Government agencies collateralized by mortgage obligations   165,791    163,552 
Other securities   500    1,546 
   $533,121   $530,083 

 

At March 31, 2017, the Company’s investment portfolio included securities issued by 311 different government municipalities and agencies located within 30 states with a fair value of $117.6 million. The largest exposure to any single municipality or agency was a $1.146 million (fair value) bond issued by Inyo County, California, to be repaid by property taxes.

 

The Company’s investments in bonds issued by states, municipalities and political subdivisions are evaluated in accordance with Supervision and Regulation Letter 12-15 issued by the Board of Governors of the Federal Reserve System, “Investing in Securities without Reliance on Nationally Recognized Statistical Rating Organization Ratings,” and other regulatory guidance. Credit ratings are considered in our analysis only as a guide to the historical default rate associated with similarly-rated bonds. There have been no significant differences in our internal analyses compared with the ratings assigned by the third party credit rating agencies.

 

 17 

 

 

The following table summarizes the amortized cost and fair values of general obligation and revenue bonds in the Company’s investment securities portfolio at the indicated dates, identifying the state in which the issuing municipality or agency operates for our largest geographic concentrations:

 

Revenue and General Obligation Bonds by Location            
(dollars in thousands, unaudited)  March 31, 2017   December 31, 2016 
   Amortized   Fair Market   Amortized   Fair Market 
General obligation bonds  Cost   Value   Cost   Value 
State of issuance                    
California  $24,880   $25,318   $25,457   $25,799 
Texas   24,415    24,192    20,170    19,875 
Ohio   9,393    9,329    9,412    9,324 
Illinois   7,984    8,029    9,873    9,871 
Washington   6,138    6,203    5,928    5,970 
Utah   948    963    949    957 
Other (19 states)   22,915    23,034    21,688    21,741 
Total General Obligation Bonds   96,673    97,068    93,477    93,537 
                     
Revenue bonds                    
State of issuance                    
Texas   6,733    6,727    5,727    5,702 
Utah   5,005    4,977    5,286    5,236 
Washington   1,841    1,855    1,302    1,299 
California   1,030    1,035    1,283    1,298 
Ohio   260    261    261    261 
Other (11 states)   5,567    5,651    6,804    6,860 
Total Revenue Bonds   20,436    20,506    20,663    20,656 
                     
Total Obligations of States and Political Subdivisions  $117,109   $117,574   $114,140   $114,193 

 

The revenue bonds in the Company’s investment securities portfolios were issued by government municipalities and agencies to fund public services such as utilities (water, sewer, and power), educational facilities, and general public and economic improvements. The primary sources of revenue for these bonds are delineated in the table below, which shows the amortized cost and fair market values for the largest revenue concentrations as of the indicated dates.

 

 18 

 

 

Revenue Bonds by Type        
(dollars in thousands, unaudited)  March 31, 2017   December 31, 2016 
         
   Amortized   Fair Market   Amortized   Fair Market 
Revenue bonds  Cost   Value   Cost   Value 
Revenue source:                    
Water  $6,732   $6,669   $4,788   $4,722 
College & University   2,633    2,713    3,401    3,472 
Sales Tax   2,975    2,936    2,981    2,927 
Lease   2,328    2,342    3,119    3,123 
Electric & Power   1,033    1,035    940    935 
Other (11 sources)   4,735    4,811    5,434    5,477 
Total Revenue Bonds  $20,436   $20,506   $20,663   $20,656 

 

Low-Income Housing Tax Credit (“LIHTC”) Fund Investments

 

The Company has the ability to invest in limited partnerships which own housing projects that qualify for federal and/or California state tax credits, by mandating a specified percentage of low-income tenants for each project. The tax credits flow through to investors, supplementing any returns that might be derived from an increase in property values. Because rent levels are lower than standard market rents and the projects are generally highly leveraged, each project also typically generates tax-deductible operating losses that are allocated to the limited partners.

 

The Company invested in seven LIHTC fund limited partnerships from 2001 through 2007, and in the second quarter of 2016 we committed $3 million to another such fund. Our investments to date have all been in California-focused funds which help the Company meet its obligations under the Community Reinvestment Act. We utilize the cost method of accounting for our LIHTC fund investments, under which we initially record on our balance sheet an asset that represents the total cash expected to be invested over the life of the partnership. Any commitments or contingent commitments for future investment are reflected as a liability. The income statement treatment reflects tax credits and any other tax benefits from these investments “below the line” within our income tax provision, while the initial book value of the investment is amortized on a straight-line basis as an offset to non-interest income, over the time period in which the tax credits and tax benefits are expected to be received.

 

As of March 31, 2017 our total LIHTC investment book balance was $6.6 million, which includes $1.5 million in remaining commitments for additional capital contributions. There were $172,000 in tax credits derived from our LIHTC investments that were recognized during the three months ended March 31, 2017, and amortization expense of $237,000 associated with those investments was included in pre-tax income for the same time period. Our LIHTC investments are evaluated annually for potential impairment, and we have concluded that the carrying value of the investments is stated fairly and is not impaired.

 

Note 11 – Credit Quality and Nonperforming Assets

 

Credit Quality Classifications

 

The Company monitors the credit quality of loans on a continuous basis using the regulatory and accounting classifications of pass, special mention, substandard and impaired to characterize the associated credit risk. Balances classified as “loss” are immediately charged off. The Company conforms to the following definitions for risk classifications utilized:

 

·Pass: Larger non-homogeneous loans not meeting the risk rating definitions below, and smaller homogeneous loans that are not assessed on an individual basis.

 

·Special mention: Loans which have potential issues that deserve the close attention of Management. If left uncorrected, those potential weaknesses could eventually diminish the prospects for full repayment of principal and interest according to the contractual terms of the loan agreement, or could result in deterioration of the Company’s credit position at some future date.

 

 19 

 

 

·Substandard: Loans that have at least one clear and well-defined weakness that could jeopardize the ultimate recoverability of all principal and interest, such as a borrower displaying a highly leveraged position, unfavorable financial operating results and/or trends, uncertain repayment sources or a deteriorated financial condition.

 

·Impaired: A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans include all nonperforming loans and restructured troubled debt (“TDRs”). A TDR may be nonperforming or performing, depending on its accrual status and the demonstrated ability of the borrower to comply with restructured terms (see “Troubled Debt Restructurings” section below for additional information on TDRs).

 

Credit quality classifications for the Company’s loan balances were as follows, as of the dates indicated:

 

 

Credit Quality Classifications                    
(dollars in thousands, unaudited)                    
   March 31, 2017 
   Pass   Special
Mention
   Substandard   Impaired   Total 
             
Real Estate:                         
1-4 family residential construction  $33,756   $-   $-   $-   $33,756 
Other construction/land   41,198    878    389    595    43,060 
1-4 family - closed end   136,870    647    263    5,871    143,651 
Equity lines   32,480    3,256    698    4,640    41,074 
Multi-family residential   31,511    -    -    568    32,079 
Commercial real estate - owner occupied   246,979    4,572    2,857    2,170    256,578 
Commercial real estate - non-owner occupied   253,416    4,087    3,198    1,708    262,409 
Farmland   143,077    1,014    1,246    38    145,375 
Total real estate   919,287    14,454    8,651    15,590    957,982 
                          
Agricultural   48,828    757    -    22    49,607 
Commercial and industrial   106,016    10,713    659    2,720    120,108 
Mortgage Warehouse   96,974    -    -    -    96,974 
Consumer loans   9,421    240    16    1,549    11,226 
Total gross loans and leases  $1,180,526   $26,164   $9,326   $19,881   $1,235,897 

 

   December 31, 2016 
   Pass   Special
Mention
   Substandard   Impaired   Total 
             
Real Estate:                         
1-4 family residential construction  $32,417   $-   $-   $-   $32,417 
Other construction/land   38,699    888    -    1,063    40,650 
1-4 family - closed end   129,726    624    403    6,390    137,143 
Equity lines   35,159    3,165    698    4,421    43,443 
Multi-family residential   31,058    -    -    573    31,631 
Commercial real estate - owner occupied   243,366    4,991    2,892    2,286    253,535 
Commercial real estate - non-owner occupied   233,584    5,597    3,220    1,797    244,198 
Farmland   132,613    1,020    808    39    134,480 
Total real estate   876,622    16,285    8,021    16,569    917,497 
                          
Agricultural   45,249    891    -    89    46,229 
Commercial and industrial   107,404    13,186    732    2,273    123,595 
Mortgage Warehouse   163,045    -    -    -    163,045 
Consumer loans   10,303    191    9    1,662    12,165 
Total gross loans and leases  $1,202,623   $30,553   $8,762   $20,593   $1,262,531 

 

 20 

 

 

Past Due and Nonperforming Assets

 

Nonperforming assets are comprised of loans for which the Company is no longer accruing interest, and foreclosed assets, including mobile homes and OREO. OREO consists of real properties acquired by foreclosure or similar means, which the Company is offering or will offer for sale. Nonperforming loans and leases result when reasonable doubt surfaces with regard to the ability of the Company to collect all principal and interest. At that point, we stop accruing interest on the loan or lease in question and reverse any previously-recognized interest to the extent that it is uncollected or associated with interest-reserve loans. Any asset for which principal or interest has been in default for 90 days or more is also placed on non-accrual status even if interest is still being received, unless the asset is both well secured and in the process of collection. An aging of the Company’s loan balances is presented in the following tables, by number of days past due as of the indicated dates:

 

Loan Portfolio Aging

(dollars in thousands, unaudited)

 

   March 31, 2017 
   30-59 Days
Past Due
   60-89 Days Past
Due
   90 Days Or More
Past Due(1)
   Total Past Due   Current   Total Financing
Receivables
   Non-Accrual
Loans(2)
 
Real Estate:                                   
1-4 family residential construction  $-   $-   $-   $-   $33,756   $33,756   $- 
Other construction/land   5,630    -    -    5,630    37,430    43,060    148 
1-4 family - closed end   33    -    555    588    143,063    143,651    932 
Equity lines   468    125    94    687    40,387    41,074    1,754 
Multi-family residential   -    -    -    -    32,079    32,079    - 
Commercial real estate - owner occupied   1,170    192    244    1,606    254,972    256,578    1,462 
Commercial real estate - non-owner occupied   -    -    -    -    262,409    262,409    - 
Farmland   -    106    -    106    145,269    145,375    38 
Total real estate   7,301    423    893    8,617    949,365    957,982    4,334 
                                    
Agricultural   -    -    22    22    49,585    49,607    22 
Commercial and industrial   165    -    789    954    119,154    120,108    1,135 
Mortgage warehouse lines   -    -    -    -    96,974    96,974    - 
Consumer loans   198    12    23    233    10,993    11,226    434 
Total gross loans and leases  $7,664   $435   $1,727   $9,826   $1,226,071   $1,235,897   $5,925 

 

(1) As of March 31, 2017 there were no loans over 90 days past due and still acrruing.

(2) Included in total financing receivables

 

   December 31, 2016 
   30-59 Days Past
Due
   60-89 Days Past
Due
   90 Days Or More
Past Due(1)
   Total Past Due   Current   Total Financing
Receivables
   Non-Accrual
Loans(2)
 
Real Estate:                                   
1-4 family residential construction  $-   $-   $-   $-   $32,417   $32,417   $- 
Other construction/land   -    -    -    -    40,650    40,650    558 
1-4 family - closed end   99    23    575    697    136,446    137,143    963 
Equity lines   397    -    320    717    42,726    43,443    1,926 
Multi-family residential   -    -    -    -    31,631    31,631    - 
Commercial real estate - owner occupied   338    -    28    366    253,169    253,535    1,572 
Commercial real estate - non-owner occupied   -    -    -    -    244,198    244,198    67 
Farmland   -    -    -    -    134,480    134,480    39 
Total real estate   834    23    923    1,780    915,717    917,497    5,125 
                                    
Agricultural   -    -    89    89    46,140    46,229    89 
Commercial and industrial   168    3    292    463    123,132    123,595    692 
Mortgage warehouse lines   -    -    -    -    163,045    163,045    - 
Consumer loans   94    9    52    155    12,010    12,165    459 
Total gross loans and leases  $1,096   $35   $1,356   $2,487   $1,260,044   $1,262,531   $6,365 

 

(1) As of December 31, 2016 there were no loans over 90 days past due and still accruing.

(2) Included in total financing receivables

 

 21 

 

 

Troubled Debt Restructurings

 

A loan that is modified for a borrower who is experiencing financial difficulty is classified as a troubled debt restructuring if the modification constitutes a concession. At March 31, 2017, the Company had a total of $16.4 million in TDRs, including $2.4 million in TDRs that were on non-accrual status. Generally, a non-accrual loan that has been modified as a TDR remains on non-accrual status for a period of at least six months to demonstrate the borrower’s ability to comply with the modified terms. However, performance prior to the modification, or significant events that coincide with the modification, could result in a loan’s return to accrual status after a shorter performance period or even at the time of loan modification. Regardless of the period of time that has elapsed, if the borrower’s ability to meet the revised payment schedule is uncertain then the loan will be kept on non-accrual status. Moreover, a TDR is generally considered to be in default when it appears that the customer will not likely be able to repay all principal and interest pursuant to restructured terms.

 

The Company may agree to different types of concessions when modifying a loan or lease. The tables below summarize TDRs which were modified during the noted periods, by type of concession:

 

Troubled Debt Restructurings, by Type of Loan Modification

(dollars in thousands, unaudited)

 

   Three months ended March 31, 2017 
   Rate
Modification
   Term
Modification
   Rate & Term
Modification
   Term &
Interest Only
Modification
   Total 
                     
Real estate:                         
Other construction/land  $-   $-   $-   $-   $- 
1-4 family - closed-end   -    -    47    -    47 
Equity lines   -    281    -    -    281 
Multi-family residential   -    -    -    -    - 
Commercial real estate - owner occupied   -    -    -    -    - 
Commercial real estate - non-owner occupied   -    -    -    -    - 
Total real estate loans   -    281    47    -    328 
                          
Agricultural   -    -    -    -    - 
Commercial and industrial   -    -    -    -    - 
Consumer loans   -    -    -    -    - 
   $-   $281   $47   $-   $328 

 

   Three months ended March 31, 2016 
   Rate
Modification
   Term
Modification
   Rate & Term
Modification
   Term &
Interest Only
Modification
   Total 
                     
Real Estate:                         
Other construction/land  $-   $17   $-   $-   $17 
1-4 family - closed-end   -    -    -    -    - 
Equity lines   -    229    -    -    229 
Multi-family residential   -    -    -    -    - 
Commercial real estate - owner occupied   -    -    266    -    266 
Commercial real estate - non-owner occupied   -    -    -    -    - 
Total real estate loans   -    246    266    -    512 
                          
Agricultural   -    -    -    -    - 
Commercial and industrial   -    -    -    -    - 
Consumer loans   -    20    50    -    70 
   $-   $266   $316   $-   $582 

 

 22 

 

 

The following tables present, by class, additional details related to loans classified as TDRs during the referenced periods, including the recorded investment in the loan both before and after modification and balances that were modified during the period:

 

Troubled Debt Restructurings

(dollars in thousands, unaudited)

 

   Three months ended March 31, 2017 
                     
   Number of
Loans
   Pre-
Modification
Outstanding
Recorded
Investment
   Post-
Modification
Outstanding
Recorded
Investment
   Reserve
Difference(1)
   Reserve 
Real Estate:                        
Other construction/land  0   $-   $-   $-   $- 
1-4 family - closed-end  1    47    47    2    2 
Equity lines  2    281    281    4    14 
Multi-family residential  0    -    -    -    - 
Commercial real estate owner occupied  0    -    -    -    - 
Commercial real estate non-owner occupied  0    -    -    -    - 
Total real estate loans       328    328    6    16 
                         
Agricultural  0    -    -    -    - 
Commercial and industrial  0    -    -    -    - 
Consumer loans  0    -    -    -    - 
       $328   $328   $6   $16 

 

(1) This represents the change in the ALLL reserve for these credits measured as the difference between the specific post-modification impairment reserve and the pre-modification reserve calculated under our general allowance for loan loss methodology.

 

   Three months ended March 31, 2016 
                     
   Number of
Loans
   Pre-
Modification
Outstanding
Recorded
Investment
   Post-
Modification
Outstanding
Recorded
Investment
   Reserve
Difference(1)
   Reserve 
Real Estate:                        
Other construction/land  1   $17   $17   $-   $2 
1-4 family - closed-end  0    -    -    -    - 
Equity lines  2    229    229    (43)   9 
Multi-family residential  0    -    -    -    - 
Commercial real estate owner occupied  1    266    266    -    4 
Commercial real estate non-owner occupied  0    -    -    -    - 
Total real estate loans       512    512    (43)   15 
                         
Agricultural  0    -    -    -    - 
Commercial and industrial  0    -    -    -    - 
Consumer loans  1    70    70    1    2 
       $582   $582   $(42)  $17 

 

(1) This represents the change in the ALLL reserve for these credits measured as the difference between the specific post-modification impairment reserve and the pre-modification reserve calculated under our general allowance for loan loss methodology.

 

The company had no finance receivables modified as TDRs within the previous twelve months that defaulted or were charged off during the three month periods ended March 31, 2017 and 2016 respectively.

 

 23 

 

 

Purchased Credit Impaired Loans

 

The Company may acquire loans which show evidence of credit deterioration since origination. These purchased credit impaired (“PCI”) loans are recorded at the amount paid, since there is no carryover of the seller’s allowance for loan losses. Potential losses on PCI loans subsequent to acquisition are recognized by an increase in the allowance for loan losses. PCI loans are accounted for individually or are aggregated into pools of loans based on common risk characteristics. The Company estimates the amount and timing of expected cash flows, and expected cash receipts in excess of the amount paid for the loan(s) are recorded as interest income over the remaining life of the loan or pool of loans (accretable yield). The excess of contractual principal and interest over expected cash flows is not recorded (nonaccretable difference). Expected cash flows are periodically re-evaluated throughout the life of the loan or pool of loans. If the present value of the expected cash flows is determined at any time to be less than the carrying amount, a reserve is recorded. If the present value of the expected cash flows is greater than the carrying amount, it is recognized as part of future interest income.

 

Our acquisitions of Santa Clara Valley Bank in the fourth quarter of 2014 and Coast Bancorp in the third quarter of 2016 included certain loans which have shown evidence of credit deterioration since origination, and for which it was probable at acquisition that all contractually required payments would not be collected. The carrying amount and unpaid principal balance of those PCI loans was as follows, as of the dates indicated:

 

Purchased Credit Impaired Loans:

(dollars in thousands, unaudited)

 

   March 31, 2017 
         
   Unpaid Principal Balance   Carrying Value 
         
Real estate secured  $708   $41 
Commercial and industrial   -    5 
Total purchased credit impaired loans  $708   $46 

 

   December 31, 2016 
         
   Unpaid Principal Balance   Carrying Value 
         
Real estate secured  $712   $47 
Commercial and industrial   23    - 
Total purchased credit impaired loans  $735   $47 

 

An allowance for loan losses totaling $30,000 was allocated for PCI loans as of March 31, 2017, as compared to $58,000 at December 31, 2016. We also recorded approximately $4,000 in discount accretion on PCI loans during the three months ended March 31, 2017.

 

Note 12 – Allowance for Loan and Lease Losses

 

The Company’s allowance for loan and lease losses, a contra-asset, is established through a provision for loan and lease losses. The allowance is maintained at a level that is considered adequate to absorb probable losses on certain specifically identified loans, as well as probable incurred losses inherent in the remaining loan portfolio. Specifically identifiable and quantifiable losses are immediately charged off against the allowance; recoveries are generally recorded only when cash payments are received subsequent to the charge off. We employ a systematic methodology, consistent with FASB guidelines on loss contingencies and impaired loans, for determining the appropriate level of the allowance for loan and lease losses and adjusting it at least quarterly. Pursuant to that methodology, impaired loans and leases are individually analyzed and a criticized asset action plan is completed specifying the financial status of the borrower and, if applicable, the characteristics and condition of collateral and any associated liquidation plan. A specific loss allowance is created for each impaired loan, if necessary.

 

 24 

 

 

The following tables disclose the unpaid principal balance, recorded investment, average recorded investment, and interest income recognized for impaired loans on our books as of the dates indicated. Balances are shown by loan type, and are further broken out by those that required an allowance and those that did not, with the associated allowance disclosed for those that required such. Included in the valuation allowance for impaired loans shown in the tables below are specific reserves allocated to TDRs, totaling $1.100 million at March 31, 2017 and $1.048 million at December 31, 2016.

 

Impaired Loans
(dollars in thousands, unaudited)

 

   March 31, 2017 
   Unpaid Principal
Balance(1)
   Recorded
Investment(2)
   Related
Allowance
   Average
Recorded
Investment
   Interest Income
Recognized(3)
 
With an allowance recorded                         
Real Estate:                         
1-4 family residential construction  $-   $-   $-   $-   $- 
Other construction/land   389    234    13    448    3 
1-4 Family - closed-end   7,256    5,301    130    7,865    112 
Equity lines   4,299    4,214    338    4,392    27 
Multi-family residential   568    568    45    582    9 
Commercial real estate- owner occupied   1,314    1,234    44    3,244    19 
Commercial real estate- non-owner occupied   1,855    1,708    35    1,924    32 
Farmland   -    -    -    -    - 
Total real estate   15,681    13,259    605    18,455    202 
Agricultural   22    22    22    22    - 
Commercial and industrial   2,671    2,671    572    2,832    22 
Consumer loans   1,459    1,459    288    1,635    22 
    19,833    17,411    1,487    22,944    246 
With no related allowance recorded                         
Real estate:                         
1-4 family residential construction  $-   $-   $-   $-   $- 
Other construction/land   361    361    -    366    6 
1-4 family - closed-end   570    570    -    638    1 
Equity lines   426    426    -    500    - 
Multi-family residential   -    -    -    -    - 
Commercial real estate- owner occupied   936    936    -    104    20 
Commercial real estate- non-owner occupied   -    -    -    49    - 
Farmland   38    38    -    49    - 
Total real estate   2,331    2,331    -    1,706    27 
Agricultural   -    -    -    -    - 
Commercial and industrial   49    49    -    175    - 
Consumer loans   116    90    -    283    - 
    2,496    2,470    -    2,164    27 
Total  $22,329   $19,881   $1,487   $25,108   $273 

 

(1)Contractual principal balance due from customer.

(2)Principal balance on Company's books, less any direct charge offs.

(3)Interest income is recognized on performing balances on a regular accrual basis.

 

 25 

 

 

   December 31, 2016 
   Unpaid Principal
Balance(1)
   Recorded
Investment(2)
   Related
Allowance
   Average
Recorded
Investment
   Interest Income
Recognized(3)
 
With an allowance recorded                         
Real estate:                         
Other construction/land  $854   $699   $20   $624   $14 
1-4 family - closed-end   7,730    5,783    163    8,008    462 
Equity lines   3,991    3,906    214    4,110    49 
Multifamily residential   573    573    7    588    50 
Commercial real estate- owner occupied   1,287    1,287    49    1,641    14 
Commercial real estate- non-owner occupied   1,877    1,730    35    1,969    131 
Farmland   -    -    -    -    - 
Total real estate   16,312    13,978    488    16,940    720 
Agricultural   24    24    24    24    - 
Commercial and industrial   2,211    2,211    608    2,652    99 
Consumer loans   1,633    1,633    287    1,847    94 
    20,180    17,846    1,407    21,463    913 
With no related allowance recorded                         
Real estate:                         
1-4 family residential construction  $-   $-   $-   $-   $- 
Other construction/land   364    364    -    374    27 
1-4 family - closed-end   666    607    -    685    3 
Equity lines   544    515    -    550    - 
Multifamily residential   -    -    -    -    - 
Commercial real estate- owner occupied   999    999    -    1,773    98 
Commercial real estate- non-owner occupied   77    67    -    85    - 
Farmland   39    39    -    50    - 
Total real estate   2,689    2,591    -    3,517    128 
Agricultural   65    65         65    - 
Commercial and industrial   62    62    -    277    - 
Consumer loans   148    29    -    238    - 
    2,964    2,747    -    4,097    128 
Total  $23,144   $20,593   $1,407   $25,560   $1,041 

 

(1)Contractual principal balance due from customer.

(2)Principal balance on Company's books, less any direct charge offs.

(3)Interest income is recognized on performing balances on a regular accrual basis.

 

The specific loss allowance for an impaired loan generally represents the difference between the book value of the loan and either the fair value of underlying collateral less estimated disposition costs, or the loan’s net present value as determined by a discounted cash flow analysis. The discounted cash flow approach is typically used to measure impairment on loans for which it is anticipated that repayment will be provided from cash flows other than those generated solely by the disposition or operation of underlying collateral. However, historical loss rates may be used to determine a specific loss allowance if they indicate a higher potential reserve need than the discounted cash flow analysis. Any change in impairment attributable to the passage of time is accommodated by adjusting the loss allowance accordingly.

 

For loans where repayment is expected to be provided by the disposition or operation of the underlying collateral, impairment is measured using the fair value of the collateral. If the collateral value, net of the expected costs of disposition where applicable, is less than the loan balance, then a specific loss reserve is established for the shortfall in collateral coverage. If the discounted collateral value is greater than or equal to the loan balance, no specific loss reserve is required. At the time a collateral-dependent loan is designated as nonperforming, a new appraisal is ordered and typically received within 30 to 60 days if a recent appraisal is not already available. We generally use external appraisals to determine the fair value of the underlying collateral for nonperforming real estate loans, although the Company’s licensed staff appraisers may update older appraisals based on current market conditions and property value trends. Until an updated appraisal is received, the Company uses the existing appraisal to determine the amount of the specific loss allowance that may be required. The specific loss allowance is adjusted, as necessary, once a new appraisal is received. Updated appraisals are generally ordered at least annually for collateral-dependent loans that remain impaired. Current appraisals were available or in process for 89% of the Company’s impaired real estate loan balances at March 31, 2017. Furthermore, the Company analyzes collateral-dependent loans on at least a quarterly basis, to determine if any portion of the recorded investment in such loans can be identified as uncollectible and would therefore constitute a confirmed loss. All amounts deemed to be uncollectible are promptly charged off against the Company’s allowance for loan and lease losses, with the loan then carried at the fair value of the collateral, as appraised, less estimated costs of disposition if applicable. Once a charge-off or write-down is recorded, it will not be restored to the loan balance on the Company’s accounting books.

 

 26 

 

 

Our methodology also provides for the establishment of a “general” allowance for probable incurred losses inherent in loans and leases that are not impaired. Unimpaired loan balances are segregated by credit quality, and are then evaluated in pools with common characteristics. At the present time, pools are based on the same segmentation of loan types presented in our regulatory filings. While this methodology utilizes historical loss data and other measurable information, the credit classification of loans and the establishment of the allowance for loan and lease losses are both to some extent based on Management’s judgment and experience. Our methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan and lease losses that Management believes is appropriate at each reporting date. Quantitative information includes our historical loss experience, delinquency and charge-off trends, and current collateral values. Qualitative factors include the general economic environment in our markets and, in particular, the condition of the agricultural industry and other key industries. Lending policies and procedures (including underwriting standards), the experience and abilities of lending staff, the quality of loan review, credit concentrations (by geography, loan type, industry and collateral type), the rate of loan portfolio growth, and changes in legal or regulatory requirements are additional factors that are considered. The total general reserve established for probable incurred losses on unimpaired loans was $8.101 million at March 31, 2017.

 

There were no material changes to the methodology used to determine our allowance for loan and lease losses during the three months ended March 31, 2017, although in recognition of relatively low loan loss rates in recent periods upward adjustments were made to qualitative factor multipliers. As we add new products and expand our geographic coverage, and as the economic environment changes, we expect to enhance our methodology to keep pace with the size and complexity of the loan and lease portfolio and respond to pressures created by external forces. We engage outside firms on a regular basis to assess our methodology and perform independent credit reviews of our loan and lease portfolio. In addition, the Company’s external auditors, the FDIC, and the California DBO review the allowance for loan and lease losses as an integral part of their audit and examination processes. Management believes that the current methodology is appropriate given our size and level of complexity.

 

 27 

 

 

The tables that follow detail the activity in the allowance for loan and lease losses for the periods noted:

 

Allowance for Credit Losses and Recorded Investment in Financing Receivables

(dollars in thousands, unaudited)

 

   For the quarter ended March 31, 2017 
   Real Estate   Agricultural   Commercial and
Industrial (1)
   Consumer   Unallocated   Total 
                         
Allowance for credit losses:                              
Beginning balance  $3,548   $209   $4,279   $1,208   $457   $9,701 
Charge-offs   (87)   -    (29)   (515)   -    (631)
Recoveries   104    2    161    251    -    518 
Provision   547    31    (904)   267    59    - 
                               
Ending Balance  $4,112   $242   $3,507   $1,211   $516   $9,588 
                               
Reserves:                              
Specific  $605   $22   $572   $288   $-   $1,487 
General   3,507    220    2,935    923    516    8,101 
                               
Ending balance  $4,112   $242   $3,507   $1,211   $516   $9,588 
                               
Loans evaluated for impairment:                              
Individually  $15,590   $22   $2,720   $1,549   $-   $19,881 
Collectively   942,392    49,585    214,362    9,677    -    1,216,016 
                               
Ending balance  $957,982   $49,607   $217,082   $11,226   $-   $1,235,897 

 

(1) Includes mortgage warehouse lines

 

   For the year ended December 31, 2016 
   Real Estate   Agricultural   Commercial and
Industrial (1)
   Consumer   Unallocated   Total 
Allowance for credit losses:                              
Beginning Balance  $4,783   $722   $2,533   $1,263   $1,122   $10,423 
Charge-offs   (962)   -    (344)   (1,905)   -    (3,211)
Recoveries   983    14    477    1,015    -    2,489 
Provision   (1,256)   (527)   1,613    835    (665)   - 
                               
Ending balance  $3,548   $209   $4,279   $1,208   $457   $9,701 
                               
Reserves:                              
Specific  $488   $24   $608   $287   $-   $1,407 
General   3,060    185    3,671    921    457    8,294 
                               
Ending balance  $3,548   $209   $4,279   $1,208   $457   $9,701 
                               
Loans evaluated for impairment:                              
Individually  $16,569   $89   $2,273   $1,662   $-   $20,593 
Collectively   900,928    46,140    284,367    10,503    -    1,241,938 
                               
Ending balance  $917,497   $46,229   $286,640   $12,165   $-   $1,262,531 

 

(1) Includes mortgage warehouse lines

 

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Note 13 – Recent Developments

 

On April 24, 2017, the Company entered into a definitive agreement to acquire OCB Bancorp (“Ojai”), the holding company for Ojai Community Bank. Transaction consideration will consist of Sierra Bancorp stock in an amount equivalent to $14 per share of OCB Bancorp stock, subject to certain adjustments as outlined in the definitive agreement. The mechanics of the transaction are described in greater detail in the definitive agreement, which was included as an attachment to the Form 8-K announcing the acquisition that was filed with the SEC on April 24, 2017. We expect the transaction to be completed in October 2017, subject to customary closing conditions including the receipt of required regulatory approvals and the consent of OCB Bancorp shareholders. Immediately following the acquisition, Ojai Community Bank will be merged with and into Bank of the Sierra. Ojai Community Bank has its main office in Ojai, California, and also maintains branch offices in Ventura, Santa Paula, and Santa Barbara, conducting business in those communities as Ventura Community Bank, Santa Paula Community Bank, and Santa Barbara Community Bank, respectively. Ojai had $257 million in consolidated assets, $209 million in loans, and $208 million in deposits as of December 31, 2016. One-time acquisition costs are expected to add $2.5 million to $3.0 million to the Company’s pre-tax non-interest expense in 2017.

 

The Company acquired Coast Bancorp (“Coast”), the holding company for Coast National Bank, on July 8, 2016, and immediately following the acquisition Coast National Bank was merged with and into Bank of the Sierra. Coast National Bank was a community bank with branch offices in San Luis Obispo, Paso Robles, and Arroyo Grande, and a loan production office in Atascadero, California. Shortly after transaction closing, the Atascadero location was converted into a full-service branch office. At the acquisition date, the fair value of Coast’s loans totaled $94 million and deposits totaled $129 million. The acquisition also involved $7 million in trust preferred securities, which were booked by the Company at their fair value of $3.4 million. This acquisition had, and will continue to have, a material impact on comparative 2017 and 2016 average balances and associated income and expense. Furthermore, one-time acquisition costs added over $2.4 million to the Company’s pre-tax non-interest expense in the latter half of 2016.

 

 29 

 

 

PART I - FINANCIAL INFORMATION

 

ITEM 2

 

MANAGEMENT’S DISCUSSION AND

ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

 

FORWARD-LOOKING STATEMENTS

 

This Form 10-Q includes forward-looking statements that involve inherent risks and uncertainties. Words such as “expects”, “anticipates”, “believes”, “projects”, and “estimates” or variations of such words and similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed, forecast in, or implied by such forward-looking statements.

 

A variety of factors could have a material adverse impact on the Company’s financial condition or results of operations, and should be considered when evaluating the Company’s potential future financial performance. They include, but are not limited to, the risk of unfavorable economic conditions in the Company’s market areas; risks associated with fluctuations in interest rates; liquidity risks; increases in nonperforming assets and credit losses that could occur, particularly in times of weak economic conditions or rising interest rates; reductions in the market value of available-for-sale securities that could result if interest rates increase substantially or an issuer has real or perceived financial difficulties; the Company’s ability to attract and retain skilled employees; the Company’s ability to successfully deploy new technology; the success of acquisitions or branch expansion; and risks associated with the multitude of current and prospective laws and regulations to which the Company is and will be subject. Risk factors that could cause actual results to differ materially from results that might be implied by forward-looking statements include the risk factors disclosed in the Company’s Form 10-K for the fiscal year ended December 31, 2016.

 

CRITICAL ACCOUNTING POLICIES

 

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The financial information and disclosures contained within those statements are significantly impacted by Management’s estimates and judgments, which are based on historical experience and incorporate various assumptions that are believed to be reasonable under current circumstances. Actual results may differ from those estimates under divergent conditions.

 

Critical accounting policies are those that involve the most complex and subjective decisions and assessments, and have the greatest potential impact on the Company’s stated results of operations. In Management’s opinion, the Company’s critical accounting policies deal with the following areas: the establishment of the allowance for loan and lease losses, as explained in detail in Note 12 to the consolidated financial statements and in the “Provision for Loan and Lease Losses” and “Allowance for Loan and Lease Losses” sections of this discussion and analysis; the valuation of impaired loans and foreclosed assets, as discussed in Note 11 to the consolidated financial statements; income taxes and deferred tax assets and liabilities, especially with regard to the ability of the Company to recover deferred tax assets as discussed in the “Provision for Income Taxes” and “Other Assets” sections of this discussion and analysis; and goodwill and other intangible assets, which are evaluated annually for impairment and for which we have determined that no impairment exists, as discussed in the “Other Assets” section of this discussion and analysis. Critical accounting areas are evaluated on an ongoing basis to ensure that the Company’s financial statements incorporate our most recent expectations with regard to those areas.

 

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OVERVIEW OF THE RESULTS OF OPERATIONS

AND FINANCIAL CONDITION

 

results of operations Summary

 

First Quarter 2017 compared to First Quarter 2016

 

Net income for the quarter ended March 31, 2017 was $4.551 million, representing an increase of $515,000, or 13%, relative to net income of $4.036 million for the quarter ended March 31, 2016. Basic and diluted earnings per share for the first quarter of 2017 were $0.33 and $0.32, respectively, compared to $0.30 basic and diluted earnings per share for the first quarter of 2016. The Company’s annualized return on average equity was 8.85% and annualized return on average assets was 0.94% for the quarter ended March 31, 2017, compared to 8.41% and 0.93%, respectively, for the quarter ended March 31, 2016. The primary drivers behind the variance in first quarter net income are as follows:

 

·Net interest income was up by $1.568 million, or 10%, due to growth in average interest-earning assets totaling $205 million, or 13%, net of the impact of a six basis point decline in our net interest margin. There was no loan loss provision recorded in either quarter.

 

·Total non-interest income increased by $839,000, or 20%, due to a $200,000 increase in service charges on deposits, a $243,000 increase in bank-owned life insurance (BOLI) income resulting primarily from higher income on BOLI associated with deferred compensation plans, and a $396,000 increase in other non-interest income due mainly to higher non-deposit service charges and fees, and dividends on restricted stock.

 

·Total non-interest expense reflects an increase of $2.222 million, or 16%, due in large part to ongoing costs stemming from our acquisition of Coast Bancorp (“Coast”) in July of 2016, and recent de novo branch openings.

 

·The Company’s provision for income taxes was 28% of pre-tax income in the first quarter of 2017 compared to 34% in the first quarter of 2016. The lower tax accrual rate is primarily the result of our adoption of FASB’s Accounting Standards Update 2016-09 effective January 1, 2017, and the subsequent change in accounting methodology associated with the disqualifying disposition of Company shares issued pursuant to the exercise of incentive stock options (ISOs). Without consideration of ISO exercises, our tax accrual rate for the first quarter of 2017 would have been approximately 32%.

 

Financial Condition Summary

 

March 31, 2017 relative to December 31, 2016

 

The Company’s assets totaled $2.000 billion at March 31, 2017, relative to total assets of $2.033 billion at December 31, 2016. Total liabilities were $1.789 billion at March 31, 2017 compared to $1.827 billion at the end of 2016, and shareholders’ equity totaled $210 million at March 31, 2017 compared to $206 million at December 31, 2016. The following provides a summary of key balance sheet changes during the first three months of 2017:

 

·Cash balances were down $28 million, or 23%, including a $25 million reduction in non-earning balances due in large part to a lower level of cash items in process of collection.

 

·Investment securities were up $21 million, or 4%, due in part to the longer-term investment of some of the liquidity created by loan runoff, primarily in mortgage-backed securities.

 

·Despite strong organic growth in real estate loans and agricultural production loans, gross loans were down $27 million, or 2%, due to lower utilization on mortgage warehouse lines. There was a $66 million reduction in outstanding balances on mortgage warehouse lines, as the utilization rate on those lines dropped to 26% at March 31, 2017 from 48% at December 31, 2016, due in part to lower residential refinancing and purchase activity.

 

·Total nonperforming assets, namely non-accrual loans and foreclosed assets, were reduced by $497,000, or 6%. The Company’s ratio of nonperforming assets to total loans plus foreclosed assets was 0.65% at March 31, 2017, compared to 0.68% at December 31, 2016 and 0.97% at March 31, 2016.

 

·Deposit balances reflect net growth of $25 million, or 1%, due in large part to continued organic growth in core non-maturity deposits.

 

·Junior subordinated debentures increased slightly from the accretion of the discount on trust-preferred securities acquired from Coast, but other borrowings were reduced by $64 million, or 87%.

 

 31 

 

 

·Total capital reflects an increase of almost $5 million, or 2%, due to the addition of income, the impact of stock options exercised and a lower accumulated other comprehensive loss, net of dividends paid. Our consolidated total risk-based capital ratio increased to 17.86% at March 31, 2017 from 17.25% at year-end 2016, due in large part to the reduction in risk-adjusted assets, and our regulatory capital ratios remain very strong relative to peer banks.

 

EARNINGS PERFORMANCE

 

The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on deposits and other borrowed money. The second is non-interest income, which primarily consists of customer service charges and fees but also comes from non-customer sources such as bank-owned life insurance. The majority of the Company’s non-interest expense is comprised of operating costs that facilitate offering a full range of banking services to our customers.

 

Net interest income AND NET INTEREST MARGIN

 

Net interest income increased by $1.568 million, or 10%, for the first quarter of 2017 relative to the first quarter of 2016. The level of net interest income we recognize in any given period depends on a combination of factors including the average volume and yield for interest-earning assets, the average volume and cost of interest-bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other interest-bearing liabilities. Net interest income is also impacted by the reversal of interest for loans placed on non-accrual status during the reporting period, and the recovery of interest on loans that had been on non-accrual and were paid off, sold or returned to accrual status.

 

The following table shows average balances for significant balance sheet categories and the amount of interest income or interest expense associated with each category for the noted periods. The table also displays the calculated yields on each major component of the Company’s investment and loan portfolios, the average rates paid on each key segment of the Company’s interest-bearing liabilities, and our net interest margin for the noted periods.

 

 32 

 

 

Average Balances and Rates  For the three months ended   For the three months ended 
(dollars in thousands, unaudited)  March 31, 2017   March 31, 2016 
   Average Balance   Income/   Average   Average Balance   Income/   Average 
   (1)   Expense   Rate/Yield (2)   (1)   Expense   Rate/Yield (2) 
Assets                              
Investments:                              
Federal funds sold/due from time  $56,658   $114    0.80%  $19,947   $28    0.56%
Taxable   424,763    2,008    1.89%   408,968    2,147    2.08%
Non-taxable   116,049    805    4.27%   101,973    730    4.36%
Equity   1,605    5    1.25%   1,253    36    11.37%
Total investments   599,075    2,932    2.25%   532,141    2,941    2.48%
                               
Loans and Leases:(3)                              
Real estate   927,531    11,608    5.08%   774,324    9,789    5.08%
Agricultural   47,508    556    4.75%   45,824    502    4.41%
Commercial   118,720    1,481    5.06%   106,837    1,226    4.62%
Consumer   12,095    347    11.64%   14,819    402    10.91%
Mortgage warehouse lines   90,030    917    4.13%   117,068    1,119    3.84%
Direct financing leases   1,355    18    5.39%   1,618    21    5.22%
Other   2,979    43    5.85%   2,026    33    6.55%
Total loans and leases   1,200,218    14,970    5.06%   1,062,516    13,092    4.96%
Total interest earning assets (4)   1,799,293    17,902    4.13%   1,594,657    16,033    4.14%
Other earning assets   8,506              7,546           
Non-earning assets   155,246              134,639           
Total assets  $1,963,045             $1,736,842           
                               
Liabilities and shareholders’ equity                              
Interest bearing deposits:                              
Demand deposits  $134,717   $101    0.30%  $126,972   $95    0.30%
NOW   368,612    102    0.11%   307,614    89    0.12%
Savings accounts   221,449    63    0.12%   196,914    54    0.11%
Money market   120,367    23    0.08%   99,230    16    0.06%
CDAR's   128    -    -    12,070    2    0.07%
Certificates of deposit, under $100,000   74,704    58    0.31%   74,579    57    0.31%
Certificates of deposit, $100,000 or more    267,885    342    0.52%   219,423    178    0.33%
Total interest bearing deposits   1,187,862    689    0.24%   1,036,802    491    0.19%
Borrowed Funds:                              
Federal funds purchased   3    -    -    1    -    - 
Repurchase agreements   8,157    8    0.40%   8,937    9    0.41%
Short term borrowings   1,648    2    0.49%   16,007    16    0.40%
Long term borrowings   -    -    -    1,231    -    - 
TRUPS   34,428    320    3.77%   30,928    202    2.63%
Total borrowed funds   44,236    330    3.03%   57,104    227    1.60%
Total interest bearing liabilities   1,232,098    1,019    0.34%   1,093,906    718    0.26%
Demand deposits - non-interest bearing   495,656              435,563           
Other liabilities   26,817              14,399           
Shareholders' equity   208,474              192,974           
Total liabilities and shareholders’ equity  $1,963,045             $1,736,842           
                               
Interest income/interest earning assets             4.13%             4.14%
Interest expense/interest earning assets             0.23%             0.18%
Net interest income and margin(5)       $16,883    3.90%       $15,315    3.96%

 

(1)Average balances are obtained from the best available daily or monthly data and are net of deferred fees and related direct costs.
(2)Yields and net interest margin have been computed on a tax equivalent basis utilizing a 35% effective tax rate.
(3)Loans are gross the allowance for possible loan losses. Net loan fees have been included in the calculation of interest income. Net loan fees and loan acquisition FMV amortization were $13 thousand and $(55) thousand for the quarters ended March 31, 2016 and 2015.
(4)Non-accrual loans are slotted by loan type and have been included in total loans for purposes of total earning assets.
(5)Net interest margin represents net interest income as a percentage of average interest-earning assets.

 

 33 

 

 

The Volume and Rate Variances table below sets forth the dollar difference for the comparative periods in interest earned or paid for each major category of interest-earning assets and interest-bearing liabilities, and the amount of such change attributable to fluctuations in average balances (volume) or differences in average interest rates. Volume variances are equal to the increase or decrease in average balances multiplied by prior period rates, and rate variances are equal to the change in rates multiplied by prior period average balances. Variances attributable to both rate and volume changes, calculated by multiplying the change in rates by the change in average balances, have been allocated to the rate variance.

 

Volume & Rate Variances  Quarter ended March 31, 
(dollars in thousands, unaudited)  2017 over 2016 
   Increase(decrease) due to 
   Volume   Rate   Net 
Assets:               
Investments:               
Federal funds sold / Due from time  $52   $34   $86 
Taxable   82    (221)   (139)
Non-taxable(1)   100    (25)   75 
Equity   9    (40)   (31)
Total Investments   243    (252)   (9)
Loans and Leases:               
Real Estate   1,936    (117)   1,819 
Agricultural   19    35    54 
Commercial   137    118    255 
Consumer   (73)   18    (55)
Mortgage Warehouse Lines   (258)   56    (202)
Direct Financing Leases   (3)   -    (3)
Other   15    (5)   10 
Total Loans and Leases   1,773    105    1,878 
Total Interest Earning Assets  $2,016   $(147)  $1,869 
Liabilities               
Interest Bearing Deposits:               
Demand Deposits  $6   $-   $6 
NOW   18    (5)   13 
Savings Accounts   7    2    9 
Money Market   3    4    7 
CDAR's   (2)   -    (2)
Certificates of Deposit, under $100,000   -    1    1 
Certificates of Deposit, $100,000 or more   39    125    164 
Total Interest Bearing Deposits   71    127    198 
Borrowed Funds:               
Repurchase Agreements   (1)   -    (1)
Short Term Borrowings   (14)   -    (14)
TRUPS   23    95    118 
Total Borrowed Funds   8    95    103 
Total Interest Bearing Liabilities  $79   $222   $301 
Net Interest Income  $1,937   $(369)  $1,568 

 

(1) Yields on tax exempt income have not been computed on a tax equivalent basis.

 

The volume variance calculated for the first quarter of 2017 relative to the first quarter of 2016 was a favorable $1.937 million, due to an increase of $205 million, or 13%, in the average balance of interest-earning assets resulting from growth in loans and investments, including the impact of the Coast acquisition. The rate variance for the first quarter comparison was an unfavorable $369,000. Our yield on investments dropped by 23 basis points for the comparative quarters, due to the reinvestment of cash flows in a historically low interest rate environment and a disproportionate increase in lower-yielding balances maintained at the Federal Reserve Bank. Our weighted average yield on loans was up 10 basis points, however, in response to the impact of higher short-term interest rates on our variable-rate loans, discount accretion on loans from the Coast acquisition, and an increase in non-recurring interest income. Nonrecurring interest income, primarily in the form of interest recovered on non-accrual loans net of interest reversed on loans placed on non-accrual status, totaled $136,000 in the first quarter of 2017 relative to $42,000 in the first quarter of 2016. Our weighted average cost of interest-bearing liabilities increased by eight basis points primarily because of higher interest rates paid on trust-preferred securities (“TRUPS”), short-term borrowings and large time deposits. The unfavorable rate variance includes the allocation of an unfavorable variance of $59,000 attributable to both rate and volume changes, as per the calculations noted above.

 

The Company’s net interest margin, which is tax-equivalent net interest income as a percentage of average interest-earning assets, was affected by the same factors discussed above relative to rate and volume variances. Our net interest margin was 3.90% in the first quarter of 2017, down six basis points relative to the first quarter of 2016 primarily as the result of lower investment yields and higher borrowing costs.

 

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Provision for loan and LEASE losses

 

Credit risk is inherent in the business of making loans. The Company sets aside an allowance for loan and lease losses, a contra-asset account, through periodic charges to earnings which are reflected in the income statement as the provision for loan and lease losses. A loan loss provision has not been necessary thus far in 2017, nor was a provision recorded in 2016. Specifically identifiable and quantifiable loan losses are immediately charged off against the allowance. The Company recorded $113,000 in net loan balances charged off in the first quarter of 2017 relative to $393,000 in net loans charged off in the first quarter of 2016.

 

Even without a loan loss provision in recent periods we have been able to maintain our allowance for loan and lease losses at a level that, in Management’s judgment, is adequate to absorb probable loan losses related to specifically-identified impaired loans as well as probable incurred losses in the remaining loan portfolio. A loan loss provision has not been recorded due to the following factors: all of our acquired loans were booked at their fair values on the acquisition date, and thus did not initially require a loan loss allowance; loan charge-offs have primarily been recorded against pre-established reserves, which alleviated what otherwise might have been a need for reserve replenishment; organic growth in our performing loan portfolio has been concentrated in loan types with low historical loss rates, thus having a positive impact on general reserves for performing loans; and, new loans booked during and since the great recession have been underwritten using tighter credit standards than was the case for many legacy loans.

 

The Company’s policies for monitoring the adequacy of the allowance and determining loan amounts that should be charged off, and other detailed information with regard to changes in the allowance, are discussed in note 12 to the consolidated financial statements and below under “Allowance for Loan and Lease Losses.” The process utilized to establish an appropriate allowance for loan and lease losses can result in a high degree of variability in the Company’s loan loss provision, and consequently in our net earnings.

 

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NON-INTEREST INCOME and NON-INTEREST expense

 

The following table provides details on the Company’s non-interest income and non-interest expense for the three-month periods ended March 31, 2017 and 2016:

 

Non Interest Income/Expense                
(dollars in thousands, unaudited)    
   For the quarter ended March 31, 
   2017   % of Total   2016   % of Total 
NON-INTEREST INCOME:                    
Service charges on deposit accounts  $2,571    50.09%  $2,371    55.22%
Other service charges, commissions & fees   2,062    40.17%   1,810    42.15%
Gain (loss) on sale of securities   8    0.15%   (24)   -0.56%
Bank owned life insurance   453    8.83%   210    4.89%
Other   39    0.76%   (73)   -1.70%
Total non-interest income  $5,133    100.00%  $4,294    100.00%
As a % of average interest-earning assets (1)        1.16%        1.08%
                     
OTHER OPERATING EXPENSE:                    
Salaries and employee benefits  $7,885    50.22%  $6,865    50.93%
Occupancy costs                    
Furniture & equipment   685    4.36%   566    4.20%
Premises   1,635    10.41%   1,184    8.78%
Advertising and marketing costs   518    3.30%   489    3.63%
Data processing costs   938    5.97%   766    5.68%
Deposit services costs   933    5.94%   861    6.39%
Loan services costs                    
Loan processing   250    1.59%   167    1.24%
Foreclosed assets   141    0.90%   132    0.98%
Other operating costs                    
Telephone & data communications   422    2.69%   383    2.84%
Postage & mail   258    1.64%   227    1.68%
Other   250    1.60%   156    1.16%
Professional services costs                    
Legal & accounting   423    2.69%   425    3.15%
Other professional services   878    5.60%   594    4.41%
Stationery & supply costs   328    2.09%   419    3.11%
Sundry & tellers   157    1.00%   245    1.82%
Total other operating expense  $15,701    100.00%  $13,479    100.00%
As a % of average interest-earning assets (1)        3.54%        3.40%
Efficiency Ratio (2)   69.21%        66.93%     

 

(1) Annualized

(2) Tax equivalent

 

Total non-interest income increased by $839,000, or 20%, for the first quarter of 2017 over the first quarter of 2016. As detailed below, the increase in non-interest income includes higher service charges on deposits, an increase in bank-owned life insurance (BOLI) income, additional non-deposit service charges and fees, and higher dividends on restricted stock. Total non-interest income was an annualized 1.16% of average interest-earning assets in the first quarter of 2017 relative to 1.08% in the first quarter of 2016.

 

Service charge income on deposits increased by $200,000, or 8%, for the first quarter comparison due primarily to fees earned from accounts added over the past year, including those in the Coast acquisition, but the increase also includes higher revenue-generating activity on certain commercial accounts. Other service charges, commissions, and fees increased by $252,000, or 14%, for the first quarter, including higher levels of debit card interchange fees and an increase in fees related to commercial customer activities. Gains realized on the sale of investment securities totaled $8,000 in the first quarter of 2017 relative to a loss of $24,000 in the first quarter of 2016, for an absolute increase of $32,000.

 

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BOLI income is derived from two types of policies owned by the Company: “separate account” life insurance policies associated with deferred compensation plans, and “general account” life insurance. BOLI income increased by $243,000, or 116%, in the first quarter of 2017 over the first quarter of 2016 due primarily to higher income on separate account BOLI. At March 31, 2017, the Company’s books reflect a $38.6 million net cash surrender value for general account BOLI. General account BOLI generates income that is used to help offset expenses associated with executive salary continuation plans, director retirement plans and other employee benefits. Interest credit rates on general account BOLI do not change frequently and the income has typically been fairly consistent, but rate reductions and an increase in the cost of insurance for certain policies have led to an overall downward trend in income over the past few years. The Company also had $5.8 million invested in separate account BOLI at March 31, 2017, which produces income that helps offset expense accruals for deferred compensation accounts the Company maintains on behalf of certain directors and senior officers. Those accounts have returns pegged to participant-directed investment allocations that can include equity, bond, or real estate indices, and are thus subject to gains or losses which often contribute to significant fluctuations in income (and associated expense accruals). There was a gain on separate account BOLI totaling $205,000 in the first quarter of 2017 relative to a loss of $24,000 in the first quarter of 2016, for an absolute difference of $229,000. As noted, gains and losses on separate account BOLI are related to expense accruals or reversals associated with participant gains and losses on deferred compensation balances, thus their net impact on taxable income tends to be minimal.

 

The “Other” category under non-interest income reflects a favorable swing of $112,000 for the quarter. This line item includes gains and losses on the disposition of assets other than OREO, rent on bank-owned property other than OREO, dividends on restricted stock, and other miscellaneous income. Amortization expense associated with our investments in low-income housing tax credit funds and other limited partnership investments are netted against this category. The favorable variance in “Other” non-interest income is primarily the result of higher dividends on restricted stock in the first quarter of 2017, including dividends on our equity investment in the Federal Home Loan Bank.

 

Total non-interest expense increased by $2.222 million, or 16%, in the first quarter of 2017 relative to the first quarter of 2016. As detailed below there were several significant fluctuations within non-interest expense, including items of a non-recurring nature. Because of the increase in total non-interest expense, it rose to an annualized 3.54% of average interest-earning assets in the first quarter of 2017 from 3.40% in the first quarter of 2016.

 

The largest component of non-interest expense, salaries and employee benefits, increased by $1.020 million, or 15%, for the first quarter of 2017 over the first quarter of 2016. Salaries and benefits for the first quarter of 2017 include expenses for former Coast employees retained subsequent to the acquisition in July of 2016, as well as staffing costs for our Sanger branch which opened in May of 2016 and our newest Bakersfield branch that commenced operations in March 2017. The quarterly increase also reflects salary adjustments in the normal course of business, higher staffing levels as vacant positions were filled, and an $89,000 increase in equity incentive compensation costs due primarily to a higher stock option grant date fair value, and thus a greater level of expense, for stock options that were granted in February 2017. Those increases were partially offset by a higher level of deferred salaries directly related to successful loan originations, which are an offset to current period expense and which increased by $236,000 in the first quarter. Total salaries and benefits dropped slightly as a percentage of total non-interest expense for the comparative quarters.

 

Occupancy expense was up $570,000, or 33%, for the quarter due to occupancy costs associated with the former Coast National Bank branches and our Sanger branch, higher rent and depreciation expense in other locations, and roughly $100,000 in non-recurring expenses associated with opening our newest Bakersfield branch in the first quarter of 2017.

 

Marketing costs were up by $29,000, or 6%, for the first quarter of 2017 due primarily to marketing efforts targeting our expanded geography. Data processing costs increased by $172,000, or 22%, for the first quarter, largely due to ongoing expenses related to the Coast acquisition and our new branches but including costs associated with an online lending platform that was implemented at the beginning of 2017. Total deposit services costs increased by $72,000, or 8%, for the quarterly comparison due primarily to amortization expense on the core deposit intangible created via the Coast acquisition.

 

Loan processing costs increased by $83,000, or 50%, for the comparative quarters as the result of certain non-recurring adjustments. Net costs associated with foreclosed assets increased by only $9,000 in the first quarter of 2017 relative to the first quarter of 2016.

 

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Telecommunications expense increased by $39,000, or 10%, in the first quarter of 2017 relative to the first quarter of 2016 due to the Coast acquisition and branch expansion. Postage costs also increased by $31,000, or 14%, due primarily to growth in our customer base. The “Other” category under other operating costs increased by $94,000, or 60%, for the first quarter, due to higher training and education costs and an increase in corporate travel expenses.

 

Under professional services costs, legal and accounting expenses were at roughly the same level in the first quarters of 2017 and 2016. The cost of other professional services increased by $284,000, or 48%, however, primarily for the following reasons: directors’ deferred compensation expense rose by $198,000 for the first quarter in conjunction with the aforementioned increase in separate account BOLI income; equity incentive compensation costs for stock options issued to our directors was $177,000 higher, due to three additional directors as well as a higher stock option grant date fair value for stock options issued in February 2017; director retirement plan expense accruals were higher due to a non-recurring expense reversal of $173,000 in director retirement plan accruals in the first quarter of 2016, subsequent to the death of a former director; and, directors fees increased due to the expansion of our Board in September 2016. The increases within other professional services costs were partially offset by a $219,000 reduction in non-recurring acquisition costs, and an $87,000 drop in FDIC assessments.

 

Stationery and supply costs were reduced by $91,000, or 22%, for the first quarter of 2017, due to prior-year costs associated with the issuance of new debit cards incorporating EMV technology. Sundry and teller losses were also reduced by $88,000, or 36%, due to lower operations-related losses within our branch system.

 

Because of the increase in total overhead expense, the Company’s tax-equivalent overhead efficiency ratio increased to 69.21% in the first quarter of 2017 from 66.93% in the first quarter of 2016. The overhead efficiency ratio represents total non-interest expense divided by the sum of fully tax-equivalent net interest and non-interest income, with the provision for loan losses and investment gains/losses excluded from the equation.

 

PROVISION FOR INCOME TAXES

 

The Company sets aside a provision for income taxes on a monthly basis. The amount of that provision is determined by first applying the Company’s statutory income tax rates to estimated taxable income, which is pre-tax book income adjusted for permanent differences, and then subtracting available tax credits. Permanent differences include but are not limited to tax-exempt interest income, BOLI income, and certain book expenses that are not allowed as tax deductions. Our tax credits consist primarily of those generated by investments in low-income housing tax credit funds, and California state employment tax credits.

 

The Company’s provision for income taxes was 28% of pre-tax income in the first quarter of 2017 relative to 34% in the first quarter of 2016. While a higher level of non-taxable BOLI income had an impact, the lower tax accrual rate for the first quarter of 2017 is primarily the result of our adoption of ASU 2016-09 effective January 1, 2017, and the subsequent change in accounting methodology associated with the disqualifying disposition of Company shares issued pursuant to the exercise of incentive stock options (ISOs). A disqualifying disposition is an employee’s sale, transfer, or exchange of ISO shares within two years of the date of grant or within one year of the option exercise leading to the issuance of such shares. Prior to January 1, 2017, the favorable tax impact of disqualifying dispositions was recorded directly to equity, whereas it now runs through the income statement as an adjustment to our income tax provision. There were a relatively large number of ISO exercises in the first quarter of 2017, and without consideration of disqualifying transactions our tax accrual rate would have been approximately 32% for the quarter. The adoption of ASU 2016-09 will lead to volatility in our tax provision in future periods as the level of disqualifying dispositions fluctuates from quarter to quarter.

 

balance sheet analysis

 

EARNING ASSETS

 

The Company’s interest-earning assets are comprised of investments and loans, and the composition, growth characteristics, and credit quality of both of those components are significant determinants of the Company’s financial condition. Investments are analyzed in the section immediately below, while the loan and lease portfolio and other factors affecting earning assets are discussed in the sections following investments.

 

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INVESTMENTS

 

The Company’s investments can at any given time consist of debt securities and marketable equity securities (together, the “investment portfolio”), investments in the time deposits of other banks, surplus interest-earning balances in our Federal Reserve Bank (“FRB”) account, and overnight fed funds sold. Surplus FRB balances and fed funds sold to correspondent banks represent the temporary investment of excess liquidity. The Company’s investments serve several purposes: 1) they provide liquidity to even out cash flows from the loan and deposit activities of customers; 2) they provide a source of pledged assets for securing public deposits, bankruptcy deposits and certain borrowed funds which require collateral; 3) they constitute a large base of assets with maturity and interest rate characteristics that can be changed more readily than the loan portfolio, to better match changes in the deposit base and other funding sources of the Company; 4) they are another interest-earning option for surplus funds when loan demand is light; and 5) they can provide partially tax exempt income. Aggregate investments totaled $590 million, or 29% of total assets at March 31, 2017, compared to $571 million, or 28% of total assets at December 31, 2016.

 

We had no fed funds sold at the end of the reporting periods, and interest-bearing balances at other banks declined to $38 million at March 31, 2017 from $41 million at December 31, 2016. The Company’s investment portfolio had a book balance of $551 million at March 31, 2017, reflecting an increase of $21 million, or 4%, for the first three months of 2017 due to the longer-term investment of some of the liquidity created by loan runoff. The Company carries investments at their fair market values. We currently have the intent and ability to hold our investment securities to maturity, but the securities are all marketable and are classified as “available for sale” to allow maximum flexibility with regard to interest rate risk and liquidity management. The expected average life for bonds in our investment portfolio was 4.1 years and their average effective duration was 3.1 years at March 31, 2017, up from 3.9 years and 2.6 years, respectively, relative to year-end 2016 due to the addition of longer-term bonds.

 

The following table sets forth the amortized cost and fair market value of Company’s investment portfolio by investment type as of the dates noted:

 

Investment Portfolio        
(dollars in thousands, unaudited)  March 31, 2017   December 31, 2016 
         
   Amortized   Fair Market   Amortized   Fair Market 
   Cost   Value   Cost   Value 
Available for Sale                    
U.S Government agencies & corporations  $25,601   $25,220   $26,926   $26,468 
Mortgage-backed securities   409,681    406,817    391,555    387,876 
State & political subdivisions   117,109    117,574    114,140    114,193 
Equity securities   500    1,645    500    1,546 
Total securities  $552,891   $551,256   $533,121   $530,083 

 

The net unrealized loss on our investment portfolio, or the difference between the fair market value and amortized cost, was $1.6 million at March 31, 2017, down from $3.0 million at December 31, 2016 due primarily to a slight drop in long-term interest rates. The balance of US Government agency securities declined by $1 million, or 5%, during the first three months of 2017 due primarily to bond maturities. Mortgage-backed securities increased by $19 million, or 5%, due to bond purchases and higher market valuations, net of prepayments in the portfolio. Municipal bond balances were also up by over $3 million, or 3%, due to bond purchases and increases in market valuations. All municipal bonds purchased in recent periods have strong underlying ratings, and all municipal bonds in our portfolio are evaluated quarterly for potential impairment. The balance of other securities increased by $99,000, or 6%, due to a higher market value for our marketable equity securities.

 

Investment securities that were pledged as collateral for Federal Home Loan Bank borrowings, repurchase agreements, public deposits and other purposes as required or permitted by law totaled $194 million at both March 31, 2017 and December 31, 2016, leaving $356 million in unpledged debt securities at March 31, 2017 and $335 million at December 31, 2016. Securities that were pledged in excess of actual pledging needs and were thus available for liquidity purposes, if needed, totaled $49 million at March 31, 2017 and $51 million at December 31, 2016.

 

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Loan AND LEASE Portfolio

 

Despite strong organic growth in real estate loans and agricultural production loans during the first quarter of 2017, total loans and leases, gross of the associated allowance for losses and deferred fees and origination costs, declined to $1.236 billion at March 31, 2017 from $1.263 billion at December 31, 2016. This represents a drop of $27 million, or 2%, due to lower utilization on mortgage warehouse lines. A distribution of the Company’s loans showing the balance and percentage of loans by type is presented for the noted periods in the table below. The balances shown are before deferred or unamortized loan origination, extension, or commitment fees, and deferred origination costs. While not reflected in the loan totals and not currently comprising a material segment of our lending activities, the Company also occasionally originates and sells, or participates out portions of, loans to non-affiliated investors.

 

Loan and Lease Distribution        
(dollars in thousands, unaudited)        
   March 31, 2017   December 31, 2016 
Real Estate:          
1-4 family residential construction  $33,756   $32,417 
Other construction/land   43,060    40,650 
1-4 family - closed-end   143,651    137,143 
Equity lines   41,074    43,443 
Multi-family residential   32,079    31,631 
Commercial real estate- owner occupied   256,578    253,535 
Commercial real estate- non-owner occupied   262,409    244,198 
Farmland   145,375    134,480 
Total real estate   957,982    917,497 
Agricultural   49,607    46,229 
Commercial and industrial   120,108    123,595 
Mortgage warehouse lines   96,974    163,045 
Consumer loans   11,226    12,165 
Total loans and leases  $1,235,897   $1,262,531 
Percentage of Total Loans and Leases          
Real Estate:          
1-4 family residential construction   2.73%   2.57%
Other construction/land   3.48%   3.22%
1-4 family - closed-end   11.62%   10.86%
Equity lines   3.32%   3.44%
Multi-family residential   2.60%   2.51%
Commercial real estate- owner occupied   20.76%   20.08%
Commercial real estate- non-owner occupied   21.23%   19.34%
Farmland   11.76%   10.65%
Total real estate   77.50%   72.67%
Agricultural   4.01%   3.66%
Commercial and industrial   9.72%   9.79%
Mortgage warehouse lines   7.86%   12.92%
Consumer loans   0.91%   0.96%
Total loans and leases   100.00%   100.00%

 

For the first three months of 2017, total real estate loans increased by $40 million, or 4%, due to growth in loans secured by commercial real estate, farmland, and residential properties. Agricultural production loans were also up by over $3 million, or 7%. As noted, outstanding balances on mortgage warehouse lines were down $66 million, or 41%, due to a market-driven drop in utilization on those lines, to 26% at March 31, 2017 from 48% at December 31, 2016. Commercial loan balances reflect a net decline of $3 million, or 3%, due to paydowns in the portfolio, although we are hopeful that our recent implementation of an online lending platform will have a positive impact on commercial loan volume going forward. Consumer loans declined by close to $1 million, or 8%, but this segment of the portfolio could also eventually be favorably affected by our new online lending solution. The Company’s balance of loan participations purchased was down slightly for the quarter, to $39 million at March 31, 2017 from $41 million at December 31, 2016, although we continue to actively seek quality loan participations to supplement organic growth.

 

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Management remains focused on loan growth, which combined with stronger economic activity in some of our markets has led to increases in our pipeline of loans in process of approval in recent periods. However, mortgage warehouse lending is highly correlated with changes in interest rates and refinancing activity and has historically been subject to significant fluctuations, thus no assurance can be provided with regard to future growth in aggregate loan balances.

 

NONPERFORMING ASSETS

 

Nonperforming assets are comprised of loans for which the Company is no longer accruing interest, and foreclosed assets including mobile homes and OREO. If the Company grants a concession to a borrower in financial difficulty, the loan falls into the category of a troubled debt restructuring (“TDR”). TDRs may be classified as either nonperforming or performing loans depending on their accrual status. The following table presents comparative data for the Company’s nonperforming assets and performing TDRs as of the dates noted:

 

Nonperforming Assets and Performing Troubled Debt Restructurings
(dollars in thousands, unaudited)  March 31, 2017   December 31, 2016   March 31, 2016 
NON-ACCRUAL LOANS:               
Real Estate:               
1-4 family residential construction  $-   $-   $- 
Other construction/land   148    558    294 
1-4 family - closed-end   932    963    590 
Equity lines   1,754    1,926    1,614 
Multi-family residential   -    -    1,035 
Commercial real estate- owner occupied   1,462    1,572    2,384 
Commercial real estate- non-owner occupied   -    67    244 
Farmland   38    39    101 
TOTAL REAL ESTATE   4,334    5,125    6,262 
Agricultural   22    89    64 
Commercial and industrial   1,135    692    612 
Direct finance leases   -    -    - 
Consumer loans   434    459    555 
TOTAL NONPERFORMING LOANS   5,925    6,365    7,493 
                
Foreclosed assets   2,168    2,225    3,115 
Total nonperforming assets  $8,093   $8,590   $10,608 
Performing TDR's (1)  $13,814   $14,182   $13,455 
Nonperforming loans as a % of total gross loans and leases   0.48%   0.50%   0.68%
Nonperforming assets as a % of total gross loans and leases and foreclosed assets   0.65%   0.68%   0.97%

 

(1) Performing TDRs are not included in nonperforming loans above, nor are they included in the numerators used to calculate the ratios disclosed in this table.

 

Total nonperforming assets were reduced by $497,000, or 6%, during the first three months of 2017. Nonperforming loans decreased by $440,000, or 7%, while foreclosed assets were down $57,000, or 3%. The balance of nonperforming loans at March 31, 2017 includes $3.4 million in TDRs and other loans that were paying as agreed, but which met the technical definition of nonperforming and were classified as such. As shown in the table, we also had $13.8 million in loans classified as performing TDRs for which we were still accruing interest as of March 31, 2017, a reduction of $368,000, or 3%, relative to December 31, 2016.

 

Non-accruing loan balances secured by real estate comprised $4.3 million of total nonperforming loans at March 31, 2017, down $791,000, or 15%, since December 31, 2016 due primarily to principal pay-downs and balances returned to accrual status.

 

As noted above, foreclosed assets were reduced by $57,000, or 3%, during the first three months of 2017 due to the sale of certain properties and $98,000 in write-downs on OREO, partially offset by additions totaling $94,000. The balance of foreclosed assets had a carrying value of slightly less than $2.2 million at March 31, 2017, and was comprised of 12 properties classified as OREO and two mobile homes. At the end of 2016 foreclosed assets totaled just over $2.2 million, consisting of 11 properties classified as OREO and two mobile homes. All foreclosed assets are periodically evaluated and written down to their fair value less expected disposition costs, if lower than the then-current carrying value.

 

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Total nonperforming assets were 0.65% of gross loans and leases plus foreclosed assets at March 31, 2017, down from 0.68% at December 31, 2016 and 0.97% at March 31, 2016. An action plan is in place for each of our non-accruing loans and foreclosed assets and they are all being actively managed. Collection efforts are continuously pursued for all nonperforming loans, but we cannot provide assurance that they will be resolved in a timely manner or that nonperforming balances will not increase.

 

Allowance for loan and lease Losses

 

The allowance for loan and lease losses, a contra-asset, is established through a provision for loan and lease losses. It is maintained at a level that is considered adequate to absorb probable losses on specifically identified impaired loans, as well as probable incurred losses inherent in the remaining loan portfolio. Specifically identifiable and quantifiable losses are immediately charged off against the allowance; recoveries are generally recorded only when sufficient cash payments are received subsequent to the charge off.

 

The Company’s allowance for loan and lease losses was $9.6 million, or 0.78% of gross loans at March 31, 2017, relative to $9.7 million, or 0.77% of gross loans at December 31, 2016. The decline in the dollar amount of the allowance in the first three months of 2017 was due to the fact that the majority of loan charge-offs during the period were charged against specific loss reserves established in previous periods and therefore did not lead to the need for reserve replenishment. Moreover, our need for loss reserves has been favorably impacted in recent periods by loan growth in portfolio segments with relatively low historical loss rates, by continued credit quality improvement in the performing loan portfolio in general as loans booked or renewed during or since the great recession have been underwritten using tighter credit criteria, and by acquired loans that were booked at their fair values and thus initially did not necessarily require loss reserves. The ratio of the allowance to nonperforming loans was 161.83% at March 31, 2017, relative to 152.41% at December 31, 2016 and 133.86% at March 31, 2016. A separate allowance of $344,000 for potential losses inherent in unused commitments is included in other liabilities at March 31, 2017.

 

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The table that follows summarizes the activity in the allowance for loan and lease losses for the noted periods:

 

Allowance for Loan and Lease Losses            
(dollars in thousands, unaudited)  For the Quarter   For the Year   For the Quarter 
   Ended March 31,   Ended December 31,   Ended March 31, 
   2017   2016   2016 
Balances:               
Average gross loans and leases outstanding during period (1)  $1,200,218   $1,153,240   $1,062,516 
Gross loans and leases outstanding at end of period  $1,235,897   $1,262,531   $1,093,870 
                
Allowance for Loan and Lease Losses:               
Balance at beginning of period  $9,701   $10,423   $10,423 
Provision charged to expense   -    -    - 
Charge-offs               
Real Estate               
1-4 family residential construction   -    -    - 
Other construction/land   -    144    - 
1-4 family - closed-end   7    97    97 
Equity lines   -    94    80 
Multi-family residential   -    50    - 
Commercial real estate- owner occupied   80    108    22 
Commercial real estate- non-owner occupied   -    469    9 
Farmland   -    -    - 
TOTAL REAL ESTATE   87    962    208 
Agricultural   -    -    - 
Commercial & industrial   29    344    109 
Mortgage warehouse lines   -    -    - 
Consumer   515    1,905    491 
Total   631    3,211    808 
Recoveries               
Real Estate               
1-4 family residential construction   -    -    - 
Other construction/land   5    467    - 
1-4 family - closed-end   3    15    1 
Equity lines   2    17    3 
Multi-family residential   -    -    - 
Commercial real estate- owner occupied   -    35    34 
Commercial real estate- non-owner occupied   94    449    23 
Farmland   -    -    - 
TOTAL REAL ESTATE   104    983    61 
Agricultural   2    14    2 
Commercial and industrial   161    477    120 
Mortgage warehouse lines   -    -    - 
Consumer   251    1,015    232 
Total   518    2,489    415 
Net loan charge offs (recoveries)   113    722    393 
Balance at end of period  $9,588   $9,701   $10,030 
                
RATIOS               
Net charge-offs to average loans and leases (annualized)   0.04%   0.06%   0.15%
Allowance for loan losses to Gross loans and leases at end of period   0.78%   0.77%   0.92%
Allowance for loan losses to Non-performing loans   161.83%   152.41%   133.86%
Net loan charge-offs to allowance for loan losses at end of period   1.18%   7.44%   3.92%
Net loan charge-offs to Provision for loan losses   -    -    - 

 

(1) Average balances are obtained from the best available daily or monthly data and are net of deferred fees and related direct costs.

 

As shown in the table above, the Company did not record a provision for loan and lease losses in the first three months of 2017, nor was a provision recorded during 2016. There were $113,000 in net loan balances charged off during the first quarter of 2017 relative to $393,000 in net loans charged off in the first quarter of 2016, representing a decline of $280,000. Any shortfall in the allowance identified pursuant to our analysis of remaining probable losses is covered by quarter-end. Our allowance for probable losses on specifically identified impaired loans was increased by $125,000, or 9%, during the three months ended March 31, 2017, due to reserves required for certain loans that were downgraded to non-performing status during that period net of the charge-off of losses against the allowance. The allowance for probable losses inherent in non-impaired loans was reduced by $238,000, or 3%, during the first three months of 2017, primarily from the impact of loan runoff on required reserves. The “Provision for Loan and Lease Losses” section above includes additional details on our provision and its relationship to actual charge-offs.

 

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The Company’s allowance for loan and lease losses at March 31, 2017 represents Management’s best estimate of probable losses in the loan portfolio as of that date, but no assurance can be given that the Company will not experience substantial losses relative to the size of the allowance. Furthermore, fluctuations in credit quality, changes in economic conditions, updated accounting or regulatory requirements, and/or other factors could induce us to augment or reduce the allowance.

 

OFF-BALANCE SHEET ARRANGEMENTS

 

The Company maintains commitments to extend credit in the normal course of business, as long as there are no violations of conditions established in the outstanding contractual arrangements. Unused commitments to extend credit totaled $578 million at March 31, 2017 and $464 million at December 31, 2016, although it is not likely that all of those commitments will ultimately be drawn down. Unused commitments represented approximately 47% of gross loans outstanding at March 31, 2017 and 37% at December 31, 2016, with the increase due primarily to lower utilization on mortgage warehouse lines and an increase in commercial construction loan commitments. The Company also had undrawn letters of credit issued to customers totaling $8 million at March 31, 2017 and $9 million at December 31, 2016. The effect on the Company’s revenues, expenses, cash flows and liquidity from the unused portion of the commitments to provide credit cannot be reasonably predicted because there is no guarantee that the lines of credit will ever be used. However, the “Liquidity” section in this Form 10-Q outlines resources available to draw upon should we be required to fund a significant portion of unused commitments.

 

In addition to unused commitments to provide credit, the Company is utilizing a $97 million letter of credit issued by the Federal Home Loan Bank on the Company’s behalf as security for certain deposits and to facilitate certain credit arrangements with the Company’s customers. That letter of credit is backed by loans which are pledged to the FHLB by the Company. For more information regarding the Company’s off-balance sheet arrangements, see Note 8 to the financial statements located elsewhere herein.

 

OTHER ASSETS

 

The balance of cash and due from banks depends on the timing of collection of outstanding cash items (checks), the level of cash maintained on hand at our branches, and our reserve requirement among other things, and is subject to significant fluctuation in the normal course of business. While cash flows are normally predictable within limits, those limits are fairly broad and the Company manages its short-term cash position through the utilization of overnight loans to and borrowings from correspondent banks, including the Federal Reserve Bank and the Federal Home Loan Bank. Should a large “short” overnight position persist for any length of time, the Company typically raises money through focused retail deposit gathering efforts or by adding brokered time deposits. If a “long” position is prevalent, the Company will let brokered deposits or other wholesale borrowings roll off as they mature, or might invest excess liquidity in higher-yielding, longer-term bonds. The Company’s balance of non-interest earning cash and due from banks was $54 million at March 31, 2017 and $79 million at December 31, 2016, with the drop due primarily to a lower level of cash items in process of collection. The average balance for the first three months of 2017 was $47 million, relative to an average balance of $42 million for the first three months of 2016. The increase in the average balance in 2017 is largely a function of cash required for the former Coast branches, and for our newer de novo branches.

 

Net premises and equipment changed only minimally during the first three months of 2017. Foreclosed assets are discussed above, in the section titled “Nonperforming Assets.” Company owned life insurance, with a balance of $44 million at March 31, 2017, is also discussed above in the “Non-Interest Income and Non-Interest Expense” section. Goodwill was $8 million at March 31, 2017, unchanged for the first quarter. Other intangible assets were down $107,000, or 4%, during the first three months, due to amortization on core deposit intangibles. The Company’s goodwill and other intangible assets are evaluated annually for potential impairment, and pursuant to that analysis Management has concluded that no impairment exists as of March 31, 2017.

 

The aggregate balance of “Other assets” was $40.0 million at March 31, 2017, down $705,000, or 2%, for the first three months due in part to a lower deferred tax asset, lower accrued interest receivable and certain other reductions, partially offset by a $2.0 million increase in our capital commitment to a small business investment corporation. At March 31, 2017, the balance of other assets included as its largest components a net deferred tax asset of $9.0 million, an $8.5 million investment in restricted stock, a $6.6 million investment in low-income housing tax credit funds, accrued interest receivable totaling $6.0 million, and a $3.3 million investment in a small business investment corporation. Restricted stock is comprised primarily of Federal Home Loan Bank of San Francisco stock held in conjunction with our FHLB borrowings, and is not deemed to be marketable or liquid. Our net deferred tax asset is evaluated as of every reporting date pursuant to FASB guidance, and we have determined that no impairment exists.

 

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DEPOSITS AND INTEREST BEARING LIABILITIES

 

DEPOSITS

 

Deposits are another key balance sheet component impacting the Company’s net interest margin and other profitability metrics. Deposits provide liquidity to fund growth in earning assets, and the Company’s net interest margin is improved to the extent that growth in deposits is concentrated in less volatile and typically less costly non-maturity deposits such as demand deposit accounts, NOW accounts, savings accounts, and money market demand accounts. Information concerning average balances and rates paid by deposit type for the three-month periods ended March 31, 2017 and 2016 is included in the Average Balances and Rates table appearing above, in the section titled “Net Interest Income and Net Interest Margin.” A distribution of the Company’s deposits showing the balance and percentage of total deposits by type is presented as of the dates indicated in the following table.

 

Deposit Distribution        
(dollars in thousands, unaudited)        
   March 31, 2017   December 31, 2016 
Non-interest bearing demand deposits  $504,247   $524,552 
Interest bearing demand deposits   143,929    132,586 
NOW   378,944    366,238 
Savings   229,300    215,693 
Money market   120,956    119,417 
CDAR's, under $250,000   -    251 
Time, under $250,000   152,544    152,561 
Time, $250,000 or more   190,501    184,173 
Total deposits  $1,720,421   $1,695,471 
           
Percentage of Total Deposits          
Non-interest bearing demand deposits   29.31%   30.94%
Interest bearing demand deposits   8.37%   7.82%
NOW   22.03%   21.60%
Savings   13.33%   12.72%
Money market   7.03%   7.04%
CDAR's, under $250,000   -    0.01%
Time, under $250,000   8.86%   9.01%
Time, $250,000 or more   11.07%   10.86%
Total   100.00%   100.00%

 

Total deposit balances reflect net organic growth of $25 million, or 1%, during the first three months of 2017. Core non-maturity deposits were up by $19 million, or 1%, but within non-maturity deposits there was a drop of $20 million, or 4%, in non-interest bearing transaction account balances, due in part to the migration of some of those accounts to the following deposit types: interest-bearing demand deposits, which were up $11 million, or 9%; NOW accounts, which increased by $13 million, or 3%; and savings deposits, which rose by $14 million, or 6%. Money market deposits also increased by close to $2 million, or 1%. Total time deposits were up by $6 million, or 2%, as growth in larger time deposits more than offset a slight decline in deposits under $250,000. Management is of the opinion that a relatively high level of core customer deposits is one of the Company’s key strengths and we continue to strive for core deposit retention and growth. Our deposit-targeted promotions are still favorably impacting growth in the number of accounts and it is expected that balances in these accounts will grow over time consistent with our past experience, although no assurance can be provided with regard to future core deposit increases.

 

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OTHER INTEREST-BEARING LIABILITIES

 

The Company’s non-deposit borrowings may, at any given time, include fed funds purchased from correspondent banks, borrowings from the Federal Home Loan Bank, advances from the Federal Reserve Bank, securities sold under agreement to repurchase, and/or junior subordinated debentures. The Company uses short-term FHLB advances and fed funds purchased on uncommitted lines to support liquidity needs created by seasonal deposit flows, to temporarily satisfy funding needs from increased loan demand, and for other short-term purposes. The FHLB line is committed, but the amount of available credit depends on the level of pledged collateral.

 

Total non-deposit interest-bearing liabilities were reduced by $64 million, or 59%, in the first three months of 2017, due to a drop in FHLB borrowings enabled by the decline in total assets and increase in deposits. There were no overnight borrowings from the FHLB at March 31, 2017 as compared to $65 million at December 31, 2016, and there were no overnight fed funds purchased or advances from the FRB on our books at March 31, 2017 or December 31, 2016. Repurchase agreements totaled $9 million at March 31, 2017, an increase of $1 million relative to their balance at year-end 2016. Repurchase agreements represent “sweep accounts”, where commercial deposit balances above a specified threshold are transferred at the close of each business day into non-deposit accounts secured by investment securities. The Company had junior subordinated debentures totaling $34 million at March 31, 2017 and December 31, 2016, in the form of long-term borrowings from trust subsidiaries formed specifically to issue trust preferred securities.

 

OTHER NON-INTEREST BEARING LIABILITIES

 

Other liabilities are principally comprised of accrued interest payable, other accrued but unpaid expenses, and certain clearing amounts. Other liabilities increased by $982,000, or 4%, during the first three months of 2017, due primarily to a higher reserve for income taxes and an increase in our accrued liability for capital commitments to a small business investment corporation, partially offset by a seasonal reduction in expense accruals and lower balances in clearing accounts.

 

liquidity and market RisK MANAGEMENT

 

LIQUIDITY

 

Liquidity management refers to the Company’s ability to maintain cash flows that are adequate to fund operations and meet other obligations and commitments in a timely and cost-effective manner. Detailed cash flow projections are reviewed by Management on a monthly basis, with various stress scenarios applied to assess our ability to meet liquidity needs under unusual or adverse conditions. Liquidity ratios are also calculated and reviewed on a regular basis. While those ratios are merely indicators and are not measures of actual liquidity, they are closely monitored and we are focused on maintaining adequate liquidity resources to draw upon should unexpected needs arise.

 

The Company, on occasion, experiences cash needs as the result of loan growth, deposit outflows, asset purchases or liability repayments. To meet short-term needs, the Company can borrow overnight funds from other financial institutions, draw advances via Federal Home Loan Bank lines of credit, or solicit brokered deposits if deposits are not immediately obtainable from local sources. Availability on lines of credit from correspondent banks and the FHLB totaled $365 million at March 31, 2017. An additional $127 million in credit is available from the FHLB if the Company pledges sufficient additional collateral and maintains the required amount of FHLB stock. The Company is also eligible to borrow approximately $79 million at the Federal Reserve Discount Window, if necessary, based on pledged assets at March 31, 2017. Furthermore, funds can be obtained by drawing down the Company’s correspondent bank deposit accounts, or by liquidating unpledged investments or other readily saleable assets. In addition, the Company can raise immediate cash for temporary needs by selling under agreement to repurchase those investments in its portfolio which are not pledged as collateral. As of March 31, 2017, unpledged debt securities plus pledged securities in excess of current pledging requirements comprised $405 million of the Company’s investment balances, compared to $386 million at December 31, 2016. Other forms of balance sheet liquidity include but are not necessarily limited to any outstanding fed funds sold and vault cash. The Company has a higher level of actual balance sheet liquidity than might otherwise be the case, since we utilize a letter of credit from the FHLB rather than investment securities for certain pledging requirements. That letter of credit, which is backed by loans that are pledged to the FHLB by the Company, totaled $97 million at March 31, 2017. Management is of the opinion that available investments and other potentially liquid assets, along with the standby funding sources it has arranged, are more than sufficient to meet the Company’s current and anticipated short-term liquidity needs.