Center Financial 10-K 2005
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Amendment No. 1
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2004
Commission file number: 000-50050
CENTER FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
(Registrants telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to section 12(g) of the Act: Common Stock, No Par Value
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 x No
Check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K/A or any amendment to this Form 10-K/A. ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). x Yes ¨ No
As of June 30, 2004, the aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $163.5 million, based on the closing price reported on the Nasdaq National Market on that date of $15.17 per share.
Shares of Common Stock held by each officer and director and each person owning more than five percent of the outstanding Common Stock have been excluded in that such persons may be deemed to be affiliates. This determination of the affiliate status is not necessarily a conclusive determination for other purposes.
The number of shares of Common Stock of the registrant outstanding as of March 10, 2005 was 16,318,154.
Documents Incorporated by Reference: Portions of the definitive proxy statement for the 2004 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission pursuant to SEC Regulation 14A are incorporated by reference in Part III, Items 10-14.
Table of Contents
We are filing this amendment to the Annual Report on Form 10-K/A for the year ended December 31, 2004 of Center Financial Corporation (the Company), to amend and restate the consolidated financial statements for the years ended December 31, 2004, 2003 and 2002 and the unaudited quarterly data for each of the quarters in the years 2004 and 2003 to reflect a change in the accounting treatment of the Companys interest rate swaps, which swaps were acquired between 2001 and 2003. The restatement affects reported net income by reducing 2004 by $790,000 and increasing 2003 and 2002 by $140,000 and $1.1 million, respectively. See notes 22 and 24 of the consolidated financial statements for additional information.
We have also determined that a control deficiency related to accounting for these derivatives constituted a material weakness in our internal control over financial reporting as of December 31, 2004. See Item 9A below.
In the course of a regularly scheduled review of the Companys second quarter 2005 financial statements, management determined that the Companys prime rate indexed interest rate swaps did not qualify for hedge accounting treatment under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended (FAS 133). Previously, until October 1, 2004, the Companys interest rate swaps had been accounted for under FAS 133 using hedge accounting treatment. Effective October 1, 2004, management determined that the swaps did not qualify for hedge accounting treatment under FAS 133. Management subsequently determined that hedge accounting under FAS 133 was not appropriate from the inception of the swaps in 2001.
After discussions with the Audit Committee, management reviewed these matters in further detail, and after completing its analysis on August 3, 2005, recommended to the Audit Committee that the Companys previously reported financial results be restated to reflect the elimination of hedge accounting treatment since the inception of the swaps. The Audit Committee agreed with this recommendation. The Company determined that the previously reported results for the Company should be restated to eliminate hedge accounting for the swaps for 2001 through 2004.
Except as set forth above, this form 10K/A continues to speak as of the date of the filing of the original Form 10-K filed March 31, 2005, and we have not updated disclosures contained herein to reflect any events that have occurred thereafter.
This Annual Report on Form 10-K/A contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. Such statements are based on the current beliefs of the Companys Management as well as assumptions made by and information currently available to Management. All statements other than statements of historical fact included in this Annual Report, including without limitation, statements under Risk Factors, Managements Discussion and Analysis of Financial Condition and Results of Operations, and Business regarding the Companys financial position, business strategy and plans and objectives of Management for future operations, are forward-looking statements. When used in this Annual Report, the words anticipate, believe, estimate, expect and intend and words or phrases of similar meaning, as they relate to the Company or the Companys Management, are intended to identify forward-looking statements. Although Management believes that the expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to have been correct. Important factors that could cause actual results to differ materially from Managements expectations (cautionary statements) include fluctuations in interest rates, inflation, government regulations, economic conditions, customer disintermediation and competitive product and pricing pressures in the geographic and business areas in which the Company conducts its operations, and are disclosed under Risk Factors and elsewhere in this Annual Report. Based upon changing conditions, if any one or more of these risks or uncertainties materialize, or if any underlying assumptions prove incorrect, actual results may vary materially from those described herein as anticipated, believed, estimated, expected or intended. The Company does not intend to update these forward-looking statements.
ITEM 1. BUSINESS
Center Financial Corporation
Center Financial Corporation (Center Financial or the Company) is a California corporation registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (the BHC Act), and is headquartered in Los Angeles, California. Center Financial was incorporated in April 2000 and acquired all of the outstanding shares of Center Bank (formerly California Center Bank) in October 2002. Center Financials principal subsidiary is Center Bank (the Bank). Center Financial exists primarily for the purpose of holding the stock of the Bank and of such other subsidiaries as it may acquire or establish. Currently, the Companys only other direct subsidiary is Center Capital Trust I, a Delaware statutory business trust which was formed in December 2003 solely to facilitate the issuance of capital trust pass-through securities. (See Note 11 to the Financial Statements in Item 8 herein.)
Our principal source of income is currently dividends from the Bank, but we intend to explore supplemental sources of income in the future. Our expenditures, including (but not limited to) the payment of dividends to shareholders, if and when declared by the Board of Directors, and the cost of servicing debt, will generally be paid from such payments made to us by the Bank. Our liabilities include $18.6 million in debt obligations due to Center Capital Trust I, related to capital trust pass-through securities issued by those entities.
At December 31, 2004, we had consolidated assets of $1.3 billion, deposits of $1.2 billion and shareholders equity of $90.7 million.
Our Administrative Offices are located at 3435 Wilshire Boulevard, Suite 700, Los Angeles, California 90010 and our telephone number is (213) 251-2222. Our website address is www.centerbank.com. As used herein, the terms Company, we, us and our refer collectively to Center Financial Corporation, the Bank, Center Capital Trust I and the Banks subsidiary, CB Capital Trust (discussed below), unless the context otherwise requires. The term Center Financial is used to designate Center Financial Corporation only.
Center Bank and Subsidiary
The Bank is a California state-chartered and FDIC-insured bank, which was incorporated in 1985 and commenced operations in March 1986. The Bank changed its name from California Center Bank to Center Bank in December 2002. The Banks headquarters is located at 3435 Wilshire Boulevard, Suite 700, Los Angeles, California 90010. The Bank is a community bank providing comprehensive financial services for small to medium sized business owners, mostly in Southern California. The Bank specializes in commercial loans, most of which are secured by real property, to multi-ethnic and small business customers. In addition, the Bank is a Preferred Lender of Small Business Administration (SBA) loans and provides trade finance loans and other international banking products. The Banks primary market is the greater Los Angeles metropolitan area, including Orange, San Bernardino, and San Diego counties, primarily focused in areas with high concentrations of Korean-Americans. The Bank currently has fifteen full-service branch offices located in Los Angeles, Orange, San Bernardino, and San Diego counties. The Bank opened all 13 branches as de novo branches. On April 26, 2004, the Company completed its acquisition of the Korea Exchange Bank (KEB) Chicago branch, the Banks first out-of-state branch, which will focus on the Korean-American niche market in Chicago. The Company assumed $12.9 million in FDIC insured deposits and purchased $8.0 million in loans from the KEB Chicago branch. The Company opened its fifteenth branch in Northridge, in the San Fernando Valley, California on December 20, 2004.
The Bank also operates nine Loan Production Offices (LPOs) in Phoenix, Seattle, Denver, Washington D.C., Las Vegas, Atlanta, Honolulu, Houston and Dallas. During the third quarter of 2004, the Company opened LPOs in Atlanta and Honolulu. New LPOs in Houston and Dallas started operation in late October 2004.
Additionally, CB Capital Trust, a Maryland real estate investment trust, was formed as a subsidiary of the Bank in August 2002 with the primary business purpose of investing in the Banks real estate-related assets. CB Capital Trust was capitalized in September 2002, at which time the Bank exchanged real estate-related assets for 100% of the common stock of the CB Capital Trust. CB Capital Trust issued preferred stock to 113 employees of the Bank during January 2003. The value of the preferred shares issued to each employee is minimal.
CB Capital Trust was formed with the intention of ultimately reducing the Companys state taxes and thereby increasing net earnings, although it is currently uncertain whether any such tax savings will be available (see Item 7 MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSProvision for Income Taxes). The Companys effective tax rate for the years ended December 31, 2004, 2003 and 2002 was 37%, 36% and 37%. The Company did not record state tax benefits related to CB Capital Trust. The Company may use CB Capital Trust as a vehicle to raise additional capital in the future.
Through our network of branch offices, we provide a wide range of commercial and consumer banking services to our customers. In the past, we focused primarily on Korean-American individuals and companies, but in recent years we have expanded our target customers to include diverse ethnic businesses and depositors. Our primary focus is on small and medium sized Korean-American businesses, professionals and other individuals in its market area, with particular emphasis on the growth of deposits and the origination of commercial and real estate secured loans. We offer bilingual services to our customers in English and Korean and have a network of ATMs located in twelve of our branch offices.
In 2000, we commenced implementing our strategy of growing our branch network by establishing de novo full service branches to expand our customer base. In September 2000, we opened a branch in Colton, in the Inland Empire area of Southern California. In 2001, we continued these plans by opening five new branches, in Downtown Los Angeles, the Mid-Wilshire District, Torrance, San Diego and Cerritos. We also opened a mini branch office, the Oxford Branch in the heart of Koreatown, in 2002. The new Fullerton Branch opened in July 2003, in the Buena Park area, where the Korean-American population is rapidly growing. All the existing branches are located in Southern California and Chicago area. On April 26, 2004, the Company completed its acquisition of the Korea Exchange Bank (KEB) Chicago branch, the Banks first out-of-state branch, which will focus on the Korean-American niche market in Chicago. The Company assumed $12.9 million in FDIC insured deposits and purchased $8.0 million in loans from the KEB Chicago branch. The Company opened its fifteenth branch in Northridge, in the San Fernando Valley, California on December 20, 2004.
In 2000, we opened two new loan production offices, in Phoenix, Arizona and in Seattle, Washington, to meet the needs of Asian Americans in those markets. In 2001, we opened a loan production office in Denver, Colorado with the same objective. The Company opened a new LPO, at Annandale, Virginia in November 2002 called the Washington D. C. LPO. The Company opened its fifth LPO in Nevada in October 2003. During the third quarter of 2004, the Company opened LPOs in Atlanta and Honolulu. New LPOs in Houston and Dallas started operation in late October 2004. These loan production offices emphasize SBA loans, but also provide a variety of international banking and commercial lending services, including commercial real estate and business commercial loans.
We engage in a full complement of lending activities, including the making of commercial real estate loans, commercial loans, working capital lines, SBA loans, trade financing, automobile loans and other personal loans, and construction loans. We have offered SBA loans since 1989, providing financing for various purposes for small businesses under guarantee of the Small Business Administration, a federal agency created to provide financial assistance for small businesses. We are a Preferred SBA Lender with full loan approval authority on behalf of the SBA.
We also participate in the SBAs Export Working Capital Program. SBA loans are generally secured by deeds of trust on industrial buildings or retail stores. We regularly sell a portion of the guaranteed portion of the SBA guaranteed loans we originate. The Company also initiated the sale of the unguaranteed portion of SBA
loans during the third quarter of 2004. We retain the obligation to service the loans, for which we receive a servicing fee. As of December 31, 2004, we were servicing $137.5 million of sold SBA loans.
As of December 31, 2004, the principal areas in which we directed our lending activities, and the percentage of our total loan portfolio for which each of these areas was responsible, were as follows: commercial loans secured by first deeds of trust on real estate 59%; commercial loans 20%; SBA loans 5%; trade financing 8%; consumer loans 6% and construction loans 2%.
We fund our lending activities primarily with demand deposits, savings and time deposits obtained through our branch network. Our deposit products include demand deposit accounts, money market accounts, and savings accounts, time certificates of deposit and fixed maturity installment savings. Our deposits are insured under the Federal Deposit Insurance Act, up to the maximum applicable limits thereof. Like most state-chartered banks of our size in California, we are not currently a member of the Federal Reserve System. As of December 31, 2004, we had 40,784 deposit accounts with balances totaling approximately $1.2 billion. As of December 31, 2004, we had $347.2 million or 30% in non-interest bearing demand deposits; $210.8 million or 18% in money market and NOW accounts; $73.7 million or 6% in savings accounts; $81.4 million or 7% in time deposits less than $100,000; and $452.4 million or 39% in time deposits of more than $100,000. We have obtained the registered service mark Prime Business Club to serve exclusively our Prime Business Accounts. As of December 31, 2004, the State of California had placed a deposit of $60 million with us.
We also offer international banking services such as letters of credit, acceptances and wire transfers, and merchant deposit services, travelers checks, debit cards, and safe deposit boxes.
In 2001, we introduced Internet banking services to allow our customers to access their loan and deposit accounts through the Internet. Customers can obtain transaction history, account information, transfer funds between accounts and process bill payments. The Company implemented real-time online Internet Banking on April 2004.
We hold no patents or licenses (other than licenses required to be obtained from appropriate bank regulatory agencies), franchises, or concessions. Our business is generally not seasonal. There has been no material effect upon our capital expenditures, earnings, or competitive position as a result of federal, state, or local environmental regulation.
For 2004, income from commercial loans secured by first deeds of trust on real estate properties, income from commercial loans, interest on investments and service charges on deposit accounts generated approximately 40%, 18%, 6% and 11%, respectively, of our total revenues. We segregate our operations into three primary segments: Banking Operations, Trade Finance Services (TFS), and Small Business Administration Lending Services. Total assets as of December 31, 2004 attributable to Banking Operations totaled $1.1 billion, compared with $119.2 million for Trade Finance Services and $84.8 million for Small Business Administration Lending Services. For financial information about our business segments, see footnote 21 of the consolidated financial statements included in Item 8 herein. We are not dependent on a single customer or group of related customers for a material portion of our deposits or loans, nor is a material portion of our loans concentrated within a single industry or group of related industries. Most of our customers are concentrated in the greater Los Angeles area.
We have not engaged in any material research activities relating to the development of new services or the improvement of existing banking services during the last three fiscal years. However, our officers and employees are engaged continually in marketing activities, including the evaluation and development of new services, which enable us to retain and improve our competitive position in our service area.
On March 3, 2005, the Company announced the receipt of regulatory approvals from the Federal Deposit Insurance Corporation (FDIC) to proceed with plans to establish a new full-service branch office in the Seattle, Washington area and to expand its branch network in Southern California with a new office in Irvine.
Cease and Desist Order
On November 30, 2001, the Bank consented to the issuance of a Cease and Desist Order by the FDIC pursuant to Section 8(b)(1) of the Federal Deposit Insurance Act, 12 U.S.C. § 1818(b)(1), concerning compliance with the Bank Secrecy Act and related regulations. This order was disclosed in detail in the Companys Annual Report on Form 10-K/A for the fiscal year ended December 31, 2002. As a result of the regulatory examination in 2002, the FDIC terminated this order on April 9, 2002.
Recent Accounting Pronouncements
For information regarding the recently issued accounting standards, see Note 2, entitled Summary of Significant Accounting Policies, to the Companys consolidated financial statements presented elsewhere herein.
The banking business in our present and intended future market areas is highly competitive with respect to virtually all products and services and has become increasingly so in recent years. While the banking market in the our primary market area is generally dominated by a relatively small number of major banks with many offices operating over a wide geographic area, our direct competitors in our niche market tend to be relatively smaller community banks, which also focus their businesses on Korean-American consumers and businesses.
There is a high level of competition within this specific market. In the greater Los Angeles metropolitan area, our main competitors include seven locally owned and operated Korean-American banks and subsidiaries of two Korean banks. These other banks have branches located in many of the same neighborhoods as we do, provide similar types of products and services and use the same Korean language publications and media for their marketing purposes.
A less significant source of competition in the Los Angeles metropolitan area are a small number of branches of major banks which maintain a limited bilingual staff for Korean-speaking customers. While such banks have not traditionally focused their marketing efforts on our customer base in Southern California, their competitive influence could increase should they in the future choose to focus on this market.
Almost all of the geographical areas in which we operate have one or more other banks focused on serving the banking needs of the local Korean-American community. The only exception is Honolulu, Hawaii where there are currently no other local Korean-American banks serving the banking needs of the local Korean-American community.
Large commercial bank competitors have, among other advantages, the ability to finance wide-ranging and effective advertising campaigns and to allocate their investment resources to areas of highest yield and demand. Many of the major banks operating in our market area offer certain services, which the Bank does not offer directly (but some of which we offer through correspondent institutions). By virtue of their greater total capitalization, such banks also have substantially higher lending limits than we do.
In addition to other banks, competitors include savings institutions, credit unions, and numerous non-banking institutions, such as finance companies, leasing companies, insurance companies, brokerage firms, and investment banking firms. In recent years, increased competition has also developed from specialized finance and non-finance companies that offer money market and mutual funds, wholesale finance, credit card, and other consumer finance services, including on-line banking services and personal finance software. Strong competition for deposit and loan products affects the rates of those products as well as the terms on which they are offered to customers. To the extent that we are affected by more general competitive trends in the industry, those trends are towards increased consolidation and competition. Strong, unregulated competitors have entered banking markets with focused products targeted at highly profitable customer segments. Many largely unregulated competitors are
able to compete across geographic boundaries and provide customers increasing access to meaningful alternatives to banking services in nearly all significant products. Mergers between financial institutions have placed additional pressure on banks within the industry to streamline their operations, reduce expenses, and increase revenues to remain competitive. Competition has also intensified due to federal and state interstate banking laws, which permit banking organizations to expand geographically, and the California market has been particularly attractive to out-of-state institutions The Financial Modernization Act effective March 11, 2000, which has made it possible for full affiliations to occur between banks and securities firms, insurance companies, and other financial companies, has also intensified competitive conditions. (See SUPERVISION AND REGULATION Financial Modernization Act below.)
Technological innovations have also resulted in increased competition in the financial services industry. Such innovations have, for example, made it possible for non-depository institutions to offer customers automated transfer payment services that previously have been considered traditional banking products. In addition, many customers now expect a choice of several delivery systems and channels, including telephone, mail, home computer, ATMS, self-service branches and/or in-store branches. In addition to other banks, the sources of competition for such hi-tech products include savings associations, credit unions, brokerage firms, money market and other mutual funds, asset management groups, finance and insurance companies, and mortgage banking firms.
In order to compete with the other financial services providers, we provide quality, personalized, friendly service and fast decision making to better serve our customers needs. For customers whose loan demands exceed our lending limit, we attempt to arrange for such loans on a participation basis with our correspondent banks. We also distinguish ourselves within the Korean-ethnic community by expanding into geographic markets, which our competitors have not reached. We also maintain an international trade finance department to meet the growing needs of the business communities within our niche market. In order to compete on the technological front, we offer Internet banking services to allow our customers to access their loan and deposit accounts through the Internet. Customers can obtain transaction history, account information, transfer funds between accounts and process bill payments.
The market for the origination of SBA loans is highly competitive. With respect to our origination of SBA loans, we compete with other small, mid-size and major banks in the geographic areas in which our full service branches are located. We also have nine loan production offices, all of which emphasize SBA loans. In addition, because these loans are largely broker-driven, we also compete with banks located outside of our immediate geographic area. As we have been designated a Preferred SBA Lender with the full loan approval authority on behalf of the SBA, our LPOs are able to provide a faster response to loan requests than competitors, which are not Preferred SBA Lenders. In order to compete in this highly competitive market, we place great emphasis on making SBA loans to minority-owned businesses.
Unlike the market for the origination of SBA loans, the secondary market for SBA loans is currently a sellers market. To date, we have had no difficulty in the resale of SBA loans within the secondary market. However, there is no assurance that this condition will continue to last or that the secondary market for SBA loans will be available in the future.
As of December 31, 2004, we had 275 full-time equivalent employees.
Supervision and Regulation
Both federal and state law extensively regulates bank holding companies. This regulation is intended primarily for the protection of depositors and the deposit insurance fund and not for the benefit of shareholders of Center Financial. The following is a summary of particular statutes and regulations affecting Center Financial and Center Bank. This summary is qualified in its entirety by the statutes and regulations.
Regulation of Center Financial Corporation
Center Financial is subject to the periodic reporting requirements of Section 13 of the Securities Exchange Act of 1934 (the Exchange Act), which requires us to file annual, quarterly and other current reports with the SEC. We are also subject to additional regulations including, but not limited to, the proxy and tender offer rules promulgated by the SEC under Sections 13 and 14 of the Exchange Act; the reporting requirements of directors, executive officers and principal shareholders regarding transactions in our Common Stock and short-swing profits rules promulgated by the SEC under Section 16 of the Exchange Act; and certain additional reporting requirements by our principal shareholders promulgated by the SEC under Section 13 of the Exchange Act.
Center Financial is a bank holding company within the meaning of the Bank Holding Company Act of 1956 and is registered as such with the Federal Reserve Board. A bank holding company is required to file with the Federal Reserve Board annual reports and other information regarding its business operations and those of its subsidiaries. It is also subject to examination by the Federal Reserve Board and is required to obtain Federal Reserve Board approval before acquiring, directly or indirectly, ownership or control of any voting shares of any bank if, after such acquisition, it would directly or indirectly own or control more than 5% of the voting stock of that bank, unless it already owns a majority of the voting stock of that bank.
The Federal Reserve Board has determined by regulation certain activities in which a bank holding company may or may not conduct business. A bank holding company must engage, with certain exceptions, in the business of banking or managing or controlling banks or furnishing services to or performing services for its subsidiary banks. The permissible activities and affiliations of certain bank holding companies have been expanded. (See Financial Modernization Act below.)
Center Financial and the Bank are deemed to be affiliates of each other within the meaning set forth in the Federal Reserve Act and are subject to Sections 23A and 23B of the Federal Reserve Act. This means, for example, that there are limitations on loans by the Bank to affiliates, and that all affiliate transactions must satisfy certain limitations and otherwise be on terms and conditions at least as favorable to the Bank as would be available for non-affiliates.
The Federal Reserve Board has a policy that bank holding companies must serve as a source of financial and managerial strength to their subsidiary banks. It is the Federal Reserve Banks position that bank holding companies should stand ready to use their available resources to provide adequate capital to their subsidiary banks during periods of financial stress or adversity. Bank holding companies should also maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting their subsidiary banks.
The Federal Reserve Board also has the authority to regulate bank holding company debt, including the authority to impose interest rate ceilings and reserve requirements on such debt. Under certain circumstances, the Federal Reserve Board may require us to file written notice and obtain its approval prior to purchasing or redeeming our equity securities, unless certain conditions are met.
Center Financial is also a financial holding company which, unlike a bank holding company, may engage in a broad range of activities that are deemed by the Federal Reserve Board as financial in nature or incidental to financial activities. Moreover, even in the case where an activity cannot meet that test, the Federal Reserve Board may approve the activity if the proposed activity is complementary to financial activities and does not pose a risk to the safety and soundness of depository institutions.
Regulation of Center Bank
As a California state-chartered bank whose accounts are insured by the FDIC up to a maximum of $100,000 per depositor, we are subject to regulation, supervision and regular examination by the Department of Financial Institutions and the FDIC. In addition, while we are not a member of the Federal Reserve System, we are subject to certain regulations of the Federal Reserve Board. The regulations of these agencies govern most aspects of our
business, including the making of periodic reports, and activities relating to dividends, investments, loans, borrowings, capital requirements, certain check-clearing activities, branching, mergers and acquisitions, reserves against deposits and numerous other areas. Supervision, legal action and examination by the FDIC is generally intended to protect depositors and is not intended for the protection of shareholders.
The earnings and growth of the Bank are largely dependent on its ability to maintain a favorable differential or spread between the yield on its interest-earning assets and the rate paid on its deposits and other interest-bearing liabilities. As a result, the Banks performance is influenced by general economic conditions, both domestic and foreign, the monetary and fiscal policies of the federal government, and the policies of the regulatory agencies, particularly the Federal Reserve Board. The Federal Reserve Board implements national monetary policies (such as seeking to curb inflation and combat recession) by its open-market operations in United States Government securities, by adjusting the required level of reserves for financial institutions subject to its reserve requirements and by varying the discount rate applicable to borrowings by banks which are members of the Federal Reserve System. The actions of the Federal Reserve Board in these areas influence the growth of bank loans, investments, and deposits and also affect interest rates charged on loans and deposits. The nature and impact of any future changes in monetary policies cannot be predicted.
Capital Adequacy Requirements
Center Financial and Center Bank are subject to the regulations of the Federal Reserve Board and the FDIC, respectively, governing capital adequacy. Each of the federal regulators has established risk-based and leverage capital guidelines for the banks or bank holding companies it regulates, which set total capital requirements and define capital in terms of core capital elements, or Tier 1 capital; and supplemental capital elements, or Tier 2 capital. Tier 1 capital is generally defined as the sum of the core capital elements less goodwill and certain other deductions, notably the unrealized net gains or losses (after tax adjustments) on available for sale investment securities carried at fair market value. The following items are defined as core capital elements: (i) common shareholders equity; (ii) qualifying noncumulative perpetual preferred stock and related surplus; and (iii) minority interests in the equity accounts of consolidated subsidiaries. Supplementary capital elements include: (i) allowance for loan and lease losses (but not more than 1.25% of an institutions risk-weighted assets); (ii) perpetual preferred stock and related surplus not qualifying as core capital; (iii) hybrid capital instruments, perpetual debt and mandatory convertible debt instruments; and (iv) term subordinated debt and intermediate-term preferred stock and related surplus. The maximum amount of supplemental capital elements, which qualifies as Tier 2 capital is limited to 100% of Tier 1 capital, net of goodwill.
The restatement described in Note 24 to the Consolidated Financial Statements does not change the Companys Total Shareholders Equity for any of the restated periods, except for a change of $78 thousand in 2002 and 2003 however the capital ratios are affected. Capital ratios presented are determined in accordance with the regulations of the Companys banking regulators (FDIC, DFI and Federal Reserve Bank). The amount of capital used for regulatory capital ratio calculations does not include the Other Comprehensive Income portion of Shareholders Equity. As a result of the restatement and the elimination of hedge accounting treatment the mark to market adjustment is recognized in current earnings rather than other comprehensive income and accordingly, the retained earnings component of Total Shareholders Equity which is included in the capital amount used for regulatory capital ratio calculations.
The minimum required ratio of qualifying total capital to total risk-weighted assets is 8.0% (Total Risk-Based Capital Ratio), at least one-half of which must be in the form of Tier 1 capital, and the minimum required ratio of Tier 1 capital to total risk-weighted assets is 4.0% (Tier 1 Risk-Based Capital Ratio). Risk-based capital ratios are calculated to provide a measure of capital that reflects the degree of risk associated with a banking organizations operations for both transactions reported on the statements of financial condition as assets, and transactions, such as letters of credit and recourse arrangements, which are recorded as off-balance sheet items. Under the risk-based capital guidelines, the nominal dollar amounts of assets and credit-equivalent amounts of off-balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain U. S. Treasury securities, to 100% for assets with
relatively high credit risk, such as business loans. As of December 31, 2004 and 2003, the Banks Total Risk-Based Capital Ratios were 10.54% and 12.81%, respectively, and its Tier 1 Risk-Based Capital Ratios were 9.52% and 11.72%, respectively. As of December 31, 2004 and 2003, the consolidated Companys Total Risk-Based Capital Ratios were 10.62% and 12.86%, respectively, and its Tier 1 Risk Based Capital Ratios were 9.59% and 11.77%, respectively.
The risk-based capital requirements also take into account concentrations of credit (i.e., relatively large proportions of loans involving one borrower, industry, location, collateral or loan type) and the risks of non-traditional activities (those that have not customarily been part of the banking business). The regulations require institutions with high or inordinate levels of risk to operate with higher minimum capital standards, and authorize the regulators to review an institutions management of such risks in assessing an institutions capital adequacy.
The risk-based capital regulations also include exposure to interest rate risk as a factor that the regulators will consider in evaluating a banks or bank holding companys capital adequacy. Interest rate risk is the exposure of a banks current and future earnings and equity capital arising from adverse movements in interest rates. While interest rate risk is inherent in a banks role as financial intermediary, it introduces volatility to bank earnings and to the economic value of the bank or bank holding company.
The FDIC and the Federal Reserve Board also require the maintenance of a leverage capital ratio designed to supplement the risk-based capital guidelines. Banks and bank holding companies that have received the highest rating of the five categories used by regulators to rate such institutions and are not anticipating or experiencing any significant growth must maintain a ratio of Tier 1 capital (net of all intangibles) to adjusted total assets (Leverage Capital Ratio) of at least 3%. All other institutions are required to maintain a leverage ratio of at least 100 to 200 basis points above the 3% minimum, for a minimum of 4% to 5%. Pursuant to federal regulations, banking institutions must maintain capital levels commensurate with the level of risk to which they are exposed, including the volume and severity of problem loans, and federal regulators may set, however, higher capital requirements when an institutions particular circumstances warrant. As of December 31, 2004, all Center Financials regulatory ratios exceeded regulatory minimums. (See table below.)
On March 1, 2005, the FRB adopted a final rule that allows the continued inclusion of trust preferred securities in the Tier I capital of bank holding companies. However, under the final rule, after a five-year transition period, the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25 percent of Tier I capital elements, net of goodwill. Trust preferred securities currently make up 17.0% of the Companys Tier I capital.
The following table sets forth the Companys and the Banks restated capital ratios at December 31, 2004 and 2003:
Prompt Corrective Action Provisions
Federal law requires each federal banking agency to take prompt corrective action to resolve the problems of insured financial institutions, including but not limited to those that fall below one or more prescribed minimum capital ratios. The federal banking agencies have defined by regulation the following five capital
categories: well capitalized (Total Risk-Based Capital Ratio of 10%; Tier 1 Risk-Based Capital Ratio of 6%; and Leverage Ratio of 5%); adequately capitalized (Total Risk-Based Capital Ratio of 8%; Tier 1 Risk-Based Capital Ratio of 4%; and Leverage Ratio of 4%) (or 3% if the institution receives the highest rating from its primary regulator); undercapitalized (Total Risk-Based Capital Ratio of less than 8%; Tier 1 Risk-Based Capital Ratio of less than 4%; or Leverage Ratio of less than 4%) (or 3% if the institution receives the highest rating from its primary regulator); significantly undercapitalized (Total Risk-Based Capital Ratio of less than 6%; Tier 1 Risk-Based Capital Ratio of less than 3%; or Leverage Ratio less than 3%); and critically undercapitalized (tangible equity to total assets less than 2%). As of December 31, 2004 and 2003, Center Bank was deemed well capitalized for regulatory purposes. A bank may be treated as though it were in the next lower capital category if after notice and the opportunity for a hearing, the appropriate federal agency finds an unsafe or unsound condition or practice so warrants, but no bank may be treated as critically undercapitalized unless its actual capital ratio warrants such treatment.
At each successively lower capital category, an insured bank is subject to increased restrictions on its operations. For example, a bank is generally prohibited from paying management fees to any controlling persons or from making capital distributions if to do so would make the bank undercapitalized. Asset growth and branching restrictions apply to undercapitalized banks, which are required to submit written capital restoration plans meeting specified requirements (including a guarantee by the parent holding company, if any). Significantly undercapitalized banks are subject to broad regulatory authority, including among other things, capital directives, forced mergers, restrictions on the rates of interest they may pay on deposits, restrictions on asset growth and activities, and prohibitions on paying certain bonuses without FDIC approval. Even more severe restrictions apply to critically undercapitalized banks. Most importantly, except under limited circumstances, not later than 90 days after an insured bank becomes critically undercapitalized, the appropriate federal banking agency is required to appoint a conservator or receiver for the bank.
In addition to measures taken under the prompt corrective action provisions, insured banks may be subject to potential actions by the federal regulators for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the issuance of cease and desist orders, termination of insurance of deposits (in the case of a bank), the imposition of civil money penalties, the issuance of directives to increase capital, formal and informal agreements, or removal and prohibition orders against institution-affiliated parties.
Safety and Soundness Standards
The federal banking agencies have also adopted guidelines establishing safety and soundness standards for all insured depository institutions. Those guidelines relate to internal controls, information systems, internal audit systems, loan underwriting and documentation, compensation and interest rate exposure. In general, the standards are designed to assist the federal banking agencies in identifying and addressing problems at insured depository institutions before capital becomes impaired. If an institution fails to meet these standards, the appropriate federal banking agency may require the institution to submit a compliance plan and institute enforcement proceedings if an acceptable compliance plan is not submitted.
Premiums for Deposit Insurance
The FDIC regulations also implement a risk-based premium system, whereby insured depository institutions are required to pay insurance premiums depending on their risk classification. Under this system, insured banks are categorized into one of three capital categories (well capitalized, adequately capitalized, and undercapitalized) and one of three supervisory categories based on federal regulatory evaluations. The three supervisory categories are: financially sound with only a few minor weaknesses (Group A), demonstrates weaknesses that could result in significant deterioration (Group B), and poses a substantial probability of loss
(Group C). The capital ratios used by the FDIC to define well capitalized, adequately capitalized and undercapitalized are the same in the FDICs prompt corrective action regulations. The current base assessment rates (expressed as cents per $100 of deposits) are summarized as follows:
In addition, banks must pay an amount, which fluctuates but is currently 1.44 cents per $100 of insured deposits, towards the retirement of the Financing Corporation bonds issued in the 1980s to assist in the recovery of the savings and loan industry.
Community Reinvestment Act
Center Bank is subject to certain requirements and reporting obligations involving Community Reinvestment Act (CRA) activities. The CRA generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of its local communities, including low and moderate-income neighborhoods. The CRA further requires the agencies to take a financial institutions record of meeting its community credit needs into account when evaluating applications for, among other things, domestic branches, consummating mergers or acquisitions, or holding company formations. In measuring a banks compliance with its CRA obligations, the regulators utilize a performance-based evaluation system which bases CRA ratings on the banks actual lending service and investment performance, rather than on the extent to which the institution conducts needs assessments, documents community outreach activities or complies with other procedural requirements. In connection with its assessment of CRA performance, the FDIC assigns a rating of outstanding, satisfactory, needs to improve or substantial noncompliance. Center Bank was last examined for CRA compliance in 2003 and received a satisfactory CRA Assessment Rating.
Other Consumer Protection Laws and Regulations
Bank regulatory agencies are increasingly focusing attention on compliance with consumer protection laws and regulations. Examination and enforcement has become intense, and banks have been advised to carefully monitor compliance with various consumer protection laws and their implementing regulations. The federal Interagency Task Force on Fair Lending issued a policy statement on discrimination in home mortgage lending describing three methods that federal agencies will use to prove discrimination: overt evidence of discrimination, evidence of disparate treatment, and evidence of disparate impact. In addition to CRA and fair lending requirements, Center Bank is subject to numerous other federal consumer protection statutes and regulations. Due to heightened regulatory concern related to compliance with consumer protection laws and regulations generally, Center Bank may incur additional compliance costs or be required to expend additional funds for investments in the local communities it serves.
Interstate Banking and Branching
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the Interstate Banking Act) regulates the interstate activities of banks and bank holding companies and establishes a framework for nationwide interstate banking and branching. Since June 1, 1997, a bank in one state has generally been permitted to merge with a bank in another state without the need for explicit state law authorization. However, states were given the ability to prohibit interstate mergers with banks in their own state by opting-out (enacting state legislation applying equality to all out-of-state banks prohibiting such mergers) prior to June 1, 1997.
Since 1995, adequately capitalized and managed bank holding companies have been permitted to acquire banks located in any state, subject to two exceptions: first, any state may still prohibit bank holding companies from acquiring a bank which is less than five years old; and second, no interstate acquisition can be
consummated by a bank holding company if the acquirer would control more than 10% of the deposits held by insured depository institutions nationwide or 30% percent or more of the deposits held by insured depository institutions in any state in which the target bank has branches.
A bank may establish and operate de novo branches in any state in which the bank does not maintain a branch if that state has enacted legislation to expressly permit all out-of-state banks to establish branches in that state.
In 1995, California enacted legislation to implement important provisions of the Interstate Banking Act discussed above and to repeal Californias previous interstate banking laws, which were largely preempted by the Interstate Banking Act.
The changes effected by Interstate Banking Act and California laws have increased competition in the environment in which Center Bank operates to the extent that out-of-state financial institutions directly or indirectly enter Center Banks market areas. It appears that the Interstate Banking Act has contributed to the accelerated consolidation of the banking industry. While many large out-of-state banks have already entered the California market as a result of this legislation, it is not possible to predict the precise impact of this legislation on Center Bank and Center Financial and the competitive environment in which they operate.
Financial Modernization Act
Effective March 11, 2000, the Gramm-Leach-Bliley Act (also known as the Financial Modernization Act) eliminated most barriers to affiliations among banks and securities firms, insurance companies, and other financial service providers, and enabled full affiliations to occur between such entities. This legislation permits bank holding companies to become financial holding companies and thereby acquire securities firms and insurance companies and engage in other activities that are financial in nature. A bank holding company may become a financial holding company if each of its subsidiary banks is well capitalized and well managed under applicable definitions, and has at least a satisfactory rating under the CRA by filing a declaration that the bank holding company wishes to become a financial holding company. No regulatory approval will be required for a financial holding company to acquire a company, other than a bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board. Center Financial is a financial holding company, in order to take advantage, if appropriate, of the increased flexibility provided by the Gramm-Leach-Bliley Act. However, Center Financial has no specific plans at this time with respect to any activities it may conduct because of this increased flexibility.
The Financial Modernization Act defines financial in nature to include securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agency; merchant banking activities; and activities that the Board has determined to be closely related to banking. A national bank (and therefore, a state bank as well) may also engage, subject to limitations on investment, in activities that are financial in nature, other than insurance underwriting, insurance company portfolio investment, real estate development and real estate investment, through a financial subsidiary of the bank, if the bank is well capitalized, well managed and has at least a satisfactory CRA rating. Subsidiary banks of a financial holding company or national banks with financial subsidiaries must continue to be well capitalized and well managed in order to continue to engage in activities that are financial in nature without regulatory actions or restrictions, which could include divestiture of the financial in nature subsidiary or subsidiaries. In addition, a financial holding company or a bank may not acquire a company that is engaged in activities that are financial in nature unless each of the subsidiary banks of the financial holding company or the bank has a CRA rating of satisfactory or better.
The Financial Modernization Act also imposes significant requirements on financial institutions with respect to the privacy of customer information, and modifies other existing laws, including those related to community reinvestment.
USA Patriot Act of 2001
On October 26, 2001, President Bush signed the USA Patriot Act of 2001 (the Patriot Act). Enacted in response to the terrorist attacks in New York, Pennsylvania and Washington, D.C. on September 11, 2001, the Patriot Act is intended to strengthen U.S. law enforcements and the intelligence communities ability to work cohesively to combat terrorism on a variety of fronts. The potential impact of the Act on financial institutions of all kinds is significant and wide ranging. The Act contains sweeping anti-money laundering and financial transparency laws and requires various regulations applicable to financial institutions, including:
We implemented most of the requirements under the Patriot Act during the fourth quarter of 2001. To fulfill the requirements, we added four additional full-time employees to its BSA Compliance Department and intensified due diligence procedures concerning the opening of new accounts. We also implemented new systems and procedures to identify suspicious activity reports and report to FINCEN. The cost of additional staff in the BSA Compliance Department and the system enhancement described above was reflected in the statements of operations for the years ended December 31, 2004, 2003 and 2002.
The Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley) was enacted to increase corporate responsibility, provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies, and protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. Sarbanes-Oxley includes important new requirements for public companies in the areas of financial disclosure, corporate governance, and the independence, composition and responsibilities of audit committees. Among other things, Sarbanes-Oxley mandates chief executive and chief financial officer certifications of periodic financial reports, additional financial disclosures concerning off-balance sheet items, and speedier transaction reporting requirements for executive officers, directors and 10% shareholders. In addition, penalties for non-compliance with the Exchange Act were heightened. SEC rules promulgated pursuant to Sarbanes-Oxley impose obligations and restrictions on auditors and audit committees intended to enhance their independence from management, and include extensive additional disclosure, corporate governance and other related rules. Sarbanes-Oxley represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees.
The Company has incurred, and expects to continue to incur, significant costs in connection with its compliance with Sarbanes-Oxley, particularly with Section 404 thereof, which requires management to undertake an assessment of the adequacy and effectiveness of the Companys internal controls over financial reporting and requires the Companys auditors to attest to, and report on, managements assessment and the operating effectiveness of these controls. As discussed in Item 9A, the Company had a material weakness in these internal controls as of December 31, 2004.
Other Pending and Proposed Legislation
Other legislative and regulatory initiatives, which could affect Center Financial, Center Bank and the banking industry, in general are pending, and additional initiatives may be proposed or introduced, before the United States Congress, the California legislature and other governmental bodies in the future. Such proposals, if enacted, may further alter the structure, regulation and competitive relationship among financial institutions, and may subject Center Bank and Center Financial to increased regulation, disclosure and reporting requirements. In addition, the various banking regulatory agencies often adopt new rules and regulations to implement and enforce existing legislation. It cannot be predicted whether, or in what form, any such legislation or regulations may be enacted or the extent to which the business of Center Financial or Center Bank would be affected thereby.
You should carefully consider the following risk factors and all other information contained in this Annual Report before making investment decisions concerning our common stock. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently believe are immaterial also may impair our business. If any of the events described in the following risk factors occur, our business, results of operations and financial condition could be materially adversely affected. In addition, the trading price of our common stock could decline due to any of the events described in these risks.
Poor economic conditions in California may cause us to suffer higher default rates on our loans.
A substantial majority of our loans are generated in the greater Los Angeles area in Southern California. As a result, poor economic conditions in the Los Angeles area may cause us to incur losses associated with higher default rates and decreased collateral values in our loan portfolio. The Los Angeles area has experienced stagnant economic activity in line with the slowdown in California during the past year. Economic growth slowed significantly as a result continuation of recessionary conditions and brush fires, which has taken place throughout Southern California, although delinquencies on our loans as a result of the current conditions have been minimal. High unemployment levels experienced since mid 2001 continued in 2004, especially in Los Angeles County, which is our geographic center and the base of our deposit and lending activity. In addition, it is likely that the continued US presence in Iraq will continue to have a significant negative effect on the national economy. If the current recessionary conditions continue or deteriorate, we expect that our level of problem assets would increase accordingly, resulting in increases in the level of delinquencies and losses for us.
Concentrations of real estate loans could subject us to increased risks in the event of a real estate recession or natural disaster.
Approximately $607.3 million or 59% of our loan portfolio as of December 31, 2004, and $384.8 million or 53% of our loan portfolio as of December 31, 2003, were concentrated in commercial real estate loans. Of this amount, $105.6 million represented loans secured by industrial buildings, and $125.4 million represented loans secured by retail shopping centers as of December 31, 2004. Although commercial loans generally provide for higher interest rates and shorter terms than single-family residential loans, such loans generally involve a higher degree of risk, as the ability of borrowers to repay these loans is often dependent upon the profitability of the borrowers businesses. An increase in the percentage of nonperforming assets in commercial real estate, commercial and industrial loan portfolios may have a material impact on our financial condition and results of operations, by reducing our income, increasing our expenses, and leaving us with less cash available for lending and other activities.
As the primary collateral for many of our loans rests on commercial real estate properties, a downturn in real estate values in the greater Southern California region could negatively impact us by providing us with decreased collateral values in our loan portfolio. In the early 1990s, the entire state of California experienced an economic recession, particularly impacting real estate values that resulted in increases in the level of
delinquencies and losses for many of the states financial institutions. If any similar real estate recession affecting our market areas should occur in the future, the security for many of our loans could be reduced and the ability of many of our borrowers to pay could decline. Similarly, the occurrence of a natural disaster like those California has experienced in the past, including earthquakes, brush fires, and recent flooding, could impair the value of the collateral we hold for real estate secured loans and negatively impact our results of operations. The California real estate market rapid appreciation rates seem to be slowing down in 2005. According to Data Quick News, a real estate information service, the Southern California residential real estate market finished off 2004 with new price peaks and a strong, but not record-breaking sales pace. If real estate sales and appreciation weakens, we might experience an increase in the percentage of nonperforming assets in commercial real estate, commercial and industrial loan portfolios may have a material impact on our financial condition and results of operations, by reducing our income, increasing our expenses, and leaving us with less cash available for lending and other activities.
We have not experienced any deterioration in our commercial real estate loan portfolio during the 2004. However, there was an increase in charge-offs among construction loans, due to one large participated construction loan in the amount of $2.3 million. Construction has been completed and the hotel is operational. The borrower filed a bankruptcy petition to the court followed by a Chapter 11 Plan in July 2004. On November 3, 2004, the Court approved the Chapter 11 Plan. According to the Plan, the participating group, of which the Company is a member, will be paid in 6 years. (See Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations Financial Condition Nonperforming Assets.)
We may experience loan losses in excess of our allowance for loan losses.
We maintain an allowance for loan losses at a level that we believe is adequate to absorb any inherent losses in the loan portfolio. However, changes in economic, operating and other conditions, including changes in interest rates that are beyond our control may cause our actual loan losses to exceed current allowance estimates. If the actual loan losses exceed the allowance for loan losses, it will hurt our business. In addition, the FDIC and the Department of Financial Institutions, as part of their supervisory functions, periodically review our allowance for loan losses. Such agencies may require us to increase our provision for loan losses or to recognize further loan losses, based on their judgments, which may be different from those of our Management. Any increase in the allowance required by the FDIC or the Department of Financial Institutions could also hurt our business.
We try to limit the risk that borrowers will fail to repay loans by carefully underwriting the loans. Losses nevertheless occur. We establish loan loss allowances for probable losses inherent in the loan portfolio as of the statements of financial condition date. We base these allowances on estimates of the following:
We may have difficulty managing our growth.
Our total assets have increased to $1.3 billion as of December 31, 2004, from $1.0 billion and $818.6 million as of December 31, 2003 and 2002. The Company has achieved a compounded annual growth rate of 18% in total assets since 2002. We opened one new branch office in September 2000, five additional branches in the second half
of 2001, one each in 2002 and 2003, and two in 2004 (including the Chicago branch acquisition). We intend to investigate other opportunities to open additional branches that would complement our existing business as such opportunities may arise; however, we can provide no assurance that we will be able to identify additional locations or finalize additional branch openings.
Our ability to manage our growth will depend primarily on our ability to:
If we fail to achieve those objectives in an efficient and timely manner, we may experience interruptions and dislocations in our business which could substantially increase our expenses and negatively impact our ability to retain our customers. In addition, such concerns may cause federal and state banking regulators to require us to delay or forgo any proposed growth until such problems have been addressed to the satisfaction of those regulators.
We have found that growth by de novo branch banking in 2004 and prior years has temporarily increased our overhead expenses as a percentage of our total assets. The overall effect of opening two new branches and four new LPOs opened in 2004 was that our earnings were reduced because of these increased costs. If we continue to open additional branches, we expect to face similar increased costs in the future.
Our earnings are subject to interest rate risk, especially if rates fall.
Banking companies earnings depend largely on the relationship between the cost of funds, primarily deposits and borrowings, and the yield on earning assets, such as loans and investment securities. This relationship, known as the interest rate spread, is subject to fluctuation and is affected by the monetary policies of the Federal Reserve Board, the international interest rate environment, as well as by economic, regulatory and competitive factors which influence interest rates, the volume and mix of interest-earning assets and interest-bearing liabilities, and the level of nonperforming assets. Many of these factors are beyond our control. Fluctuations in interest rates affect the demand of customers for our products and services. We are subject to interest rate risk to the degree that our interest-bearing liabilities reprice or mature more slowly or more rapidly or on a different basis than our interest-earning assets. Given our current volume and mix of interest-bearing liabilities and interest-earning assets, our interest rate spread could be expected to increase during times of rising interest rates and, conversely, to decline during times of falling interest rates. Therefore, significant fluctuations in interest rates may have an adverse or a positive effect on our results of operations. (See Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations Interest Rate Risk.)
All of our lending involves underwriting risks, especially in a competitive lending market.
At December 31, 2004, commercial real estate loans represented 59% of our total loan portfolio; commercial lines and term loans to businesses represented 20% of our total loan portfolio; and SBA loans represented 5% of our total loan portfolio.
Real estate lending involves risks associated with the potential decline in the value of underlying real estate collateral and the cash flow from income producing properties. Declines in real estate values and cash flows can be caused by a number of factors, including adversity in general economic conditions, rising interest rates, changes in tax and other governmental and other policies affecting real estate holdings, environmental conditions, governmental and other use restrictions, development of competitive properties, and increasing vacancy rates. Our dependence increases the risk of loss both in our loan portfolio and with respect to any other real estate owned when real estate values decline. We seek to reduce our risk of loss through our underwriting and monitoring procedures.
Commercial lending, even when secured by the assets of a business, involves considerable risk of loss in the event of failure of the business. To reduce such risk, we typically take additional security interests in other collateral, such as real property, certificates of deposit or life insurance, and/or obtain personal guarantees.
Specific risks associated with SBA lending are discussed in a separate risk factor below.
We operate in a highly competitive market, and some of our competitors offer a broader range of services than we provide, and have lower cost structures.
The banking business in our current and intended future market areas is highly competitive with respect to virtually all products and services. While the banking market in our primary market area is generally dominated by a relatively small number of major banks with many offices operating over a wide geographic area, our main competitors include several locally owned and operated Korean-American banks and subsidiaries of one Korean bank. These other banks have branches located in many of the same neighborhoods as we do, provide similar types of products and services and use the same Korean language publications and media for their marketing purposes. There is a high level of competition within this specific market. While major banks have not historically focused their marketing efforts on the Banks Korean-American customer base in Southern California, their competitive influence could increase in the future. Such banks have substantially greater lending limits than we have, offer certain services we cannot, and often operate with economies of scale that result in lower operating costs than ours on a per loan or per asset basis. In addition to competitive factors impacting our specific market niche, we are affected by more general competitive trends in the banking industry, including intra-state and interstate consolidation, competition from non-bank sources and technological innovations. Many of our competitors have advantages over us in conducting certain businesses and providing certain services, and there can be no assurance that we will be able to compete successfully.
We also compete with other financial institutions such as savings and loan associations, credit unions, thrift and loan companies, mortgage companies, securities brokerage companies and insurance companies located within and without our service area and with quasi-financial institutions such as money market funds for deposits and loans. Financial services like ours are increasingly offered over the Internet on a national and international basis, and we compete with providers of these services as well. Ultimately, competition can drive down our interest margins and reduce our profitability. It also can make it more difficult for us to continue to increase the size of our loan portfolio and deposit base. See Competition.
We might not be able to continue to pay cash dividends in the future.
As a banking holding company which currently has no significant assets other than our equity interest in Center Bank, our ability to pay dividends primarily depends upon the dividends we receive from Center Bank. The dividend practice of Center Bank, like our dividend practice, will depend upon its earnings, financial position, current and anticipated cash requirements and other factors deemed relevant by Center Banks board of directors at that time. In addition, during any period in which Center Financial has deferred payment of interest otherwise due and payable on its subordinated debt securities, we may not make any dividends or distributions with respect to our capital stock. See Managements Discussion and Analysis of Financial Condition and Results of Operations Capital Resources.
We paid a quarterly cash dividend of 4 cents per share (adjusted for two-for-one stock split paid on March 2, 2004) starting in October 2003, and currently plan to continue to pay cash dividends on a quarterly basis. However, the amount of any such dividend will be determined each quarter by our Board of Directors in its discretion, based on the factors described in the previous paragraph. No assurance can be given that the Banks and the Companys future performance will justify the payment of dividends in any particular quarter. We are a legal entity separate and distinct from our subsidiaries. Substantially all of our revenue and cash flow, including funds available for the payment of dividends and other operating expenses, is dependent upon the payment of dividends to us by our subsidiaries. Dividends payable to us by Center Bank are restricted under California and federal laws and regulation. See Item 5, Market for Common Equity and Related Shareholder Matters Dividends.
We have specific risks associated with Small Business Administration loans.
We realized $4.2 million, $2.7 million, and $1.3 million, respectively, in 2004 and in 2003 and 2002, in gains recognized on secondary market sales of our SBA loans. We have regularly sold the guaranteed portions of these loans in the secondary market in previous years. However, the Company initiated the sale of the unguaranteed portion of SBA loans during the third quarter of 2004. We can provide no assurance that we will be able to continue originating these loans, or that a secondary market will exist for, or that we will continue to realize premiums upon the sale of the SBA loans. The federal government presently guarantees 75% to 80% of the principal amount of each qualifying SBA loan. We can provide no assurance that the federal government will maintain the SBA program, or if it does, that such guaranteed portion will remain at its current funding level. Furthermore, we can provide no assurance that we will retain our preferred lender status, which, subject to certain limitations, allows us to approve and fund SBA loans without the necessity of having the loan approved in advance by the SBA, or that if it does, the federal government will not reduce the amount of such loans which we can make. We believe that our SBA loan portfolio does not involve more than a normal risk of collectibility. However, since we have sold some of the guaranteed portions of our SBA loan portfolio, we incur a pro rata credit risk on the non-guaranteed portion of the SBA loans since we share pro rata with the SBA in any recoveries. In the event of default on an SBA loan, our pursuit of remedies against a borrower would be subject to SBA approval, and where the SBA establishes that its loss is attributable to deficiencies in the manner in which the loan application has been prepared and submitted, the SBA may decline to honor its guarantee with respect to our SBA loans or it may seek the recovery of damages from us. The SBA has never declined to honor its guarantees with respect to its SBA loans, although no assurance can be given that the SBA would not attempt to do so in the future. (See Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations Financial Condition Loan Portfolio Small Business Administration (SBA) Loans.)
Another economic downturn in South Korea could cause us to incur losses with respect to certain of our loans and credit transactions which expose us to the Korean Economy.
Because a significant portion of our customer base is Korean-American, we have historically had exposure to the Korean economy with respect to certain of our loans and credit transactions. We make three types of credit extensions involving direct exposure to the Korean economy: commercial loans to U.S. affiliates/subsidiaries/branches of companies located in South Korea (Korean Affiliate Loans), acceptances with Korean banks, and standby letters of credit issued by Korean banks. We also have indirect exposure to the economies of various Pacific Rim countries because we provide short term trade financing to local import and/or export businesses in connection with issuing letters of credit to overseas suppliers/sellers, as well as making working capital and other business loans to such businesses, some of which businesses could be hurt by a downturn in the economies of such countries. The Korean economy and its capital markets suffered significant downturns in late 1997 and early 1998, and we had one Korean Affiliate Loan for $2 million that had to be charged off in 1997 because such customer was directly impacted by the problems in South Korea. Since that time the Bank fully recovered all $2.0 million as of December 31, 2004. This one charge-off in 1997 represented in excess of 42.7% of our total charge-offs in 1997. See Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations Financial Condition Nonperforming Assets, Allowance for Loan Losses and Market Risk/Interest Rate Risk Management. Since that time, we have been closely monitoring our exposure to the Korean economy and those of other Pacific Rim countries and have taken steps to reduce our exposure and to make sure that our allowance for loan losses is adequate to absorb any losses that might occur if problems were to arise again in South Korea or those other countries. However, another severe downturn in the Korean economy or in the economies of other Pacific Rim countries could cause us to incur significant credit losses.
Our directors and executive officers control a large amount of our stock, and your interests may not always be the same as those of the board and management.
As of December 31, 2004, our directors and executive officers together with their affiliates, beneficially owned approximately 30.8% of our outstanding voting stock (not including vested option shares). As a result, if all of these shareholders were to take a common position, they would be able to significantly affect the election
of directors as well as the outcome of most corporate actions requiring shareholder approval, such as the approval of mergers or other business combinations. Such concentration may also have the effect of delaying or preventing a change in control of Center Financial.
In some situations, the interests of our directors and executive officers may be different from yours. However, our Board of Directors and executive officers have a fiduciary duty to act in the best interests of the shareholders, rather than in their own best interests, when considering a proposed business combination or any of these types of matters.
Provisions in our Articles of Incorporation will delay or prevent changes in control of our corporation or our management.
These provisions make it more difficult for another company to acquire us, which could reduce the market price of our common stock and the price that you receive if you sell your shares in the future. These provisions include the following:
We are involved in litigation.
From time to time, we are involved in litigation. If litigation arises against us, we will vigorously enforce and defend our rights. However, some litigation may result in significant expense to us and divert the efforts of our management personnel from their day-to-day responsibilities. In the event of an adverse result in litigation, we could also be required to pay substantial damages. We are currently a party to a lawsuit entitled Korea Export Insurance Corporation v. Korea Data Systems (USA), Inc., et al. We expect to incur substantial legal fees and expenses in connection with this lawsuit. As a result, our defense of this lawsuit, regardless of its eventual outcome, will likely be costly and time consuming. We have insurance against certain types of claims, and while it is possible that a portion of this claim may ultimately be covered, this determination cannot be made until after the final disposition of the case. If the outcome of this litigation is adverse to us and we are required to pay significant monetary damages, our financial condition and results of operations may be materially and adversely affected. For a more detailed discussion of this lawsuit, see Item 3, Legal Proceedings.
ITEM 2. PROPERTIES
Our headquarters are located at 3435 Wilshire Boulevard, Los Angeles, California 90010. We lease approximately 23,188 square feet of rentable area, which includes a ground floor branch and administrative offices located on the seventh floor of the building. The initial lease term will expire in 2006. We have options to renew the lease for two additional terms of five years each.
As of December 31, 2004, we operated full-service branches at thirteen leased locations (including the branch described in the previous paragraph). Expiration dates of our leases range from August 2005 to September 2019. Certain properties currently leased have renewal options, which could extend the use of the facility for additional specified terms. We have leased 5,303 square foot rentable for new Fullerton Branch opened in July 2003. We have options to renew the lease for one additional term of ten years. Monthly rent for Fullerton was $17,261 as of December 31, 2004. In addition, the Company acquired a branch in Chicago and opened a new branch in San Fernando Valley during the 2004. The assumed Chicago lease will be expired in October 2005 and the Company has already leased a new facility. The Company operates nine LPOs in different states including new LPOs opened in Atlanta, Honolulu, Houston and Dallas in 2004.
In addition, we own two properties in Los Angeles: our Olympic office at 2222 West Olympic Boulevard and our Western office at 253 N. Western Avenue. Our old facility at 4301 West 3rd Street was sold during the third quarter of 2002 and leased back for approximately 9 months until the new facility was fully renovated for the new branchs use. Construction was completed in 2003, and the Company relocated the Western branch to the Companys owned facility on October 2003. We have a branch in both the Western and Olympic offices, and house our SBA department and auto loan departments in our Western office; and our Trade Financing Department and Credit Card Center in our Olympic office. The net book value of the two owned facilities (building and land) as of December 31, 2004, was $6.8 million. In the opinion of Management, all properties are adequately covered by insurance. All of our existing facilities are considered adequate for our present and anticipated future use.
ITEM 3. LEGAL PROCEEDINGS
From time to time, we are a party to claims and legal proceedings arising in the ordinary course of our business. With the exception of the potentially adverse outcome in the litigation described in the next two paragraphs, after taking into consideration information furnished by our counsel as to the current status of these claims and proceedings, we do not believe that the aggregate potential liability resulting from such proceedings would have a material adverse effect on our financial condition or results of operation.
On or about March 3, 2003, Center Bank (the Bank) was served with a complaint filed by Korea Export Insurance Corporation (KEIC) in Orange County, California Superior Court, entitled Korea Export Insurance Corporation v. Korea Data Systems (USA), Inc., et al. KEIC is seeking to recover alleged losses from a number of parties involved in international trade transactions that gave rise to bills of exchange financed by various Korean Banks but not ultimately paid. KEIC is seeking to recover damages of approximately $56 million from us based on a claim that we, in our capacity as a collecting bank for these bills of exchange, acted negligently in presenting and otherwise handling trade documents for collection. Initially, we moved to dismiss KEICs claims based on the pleadings. The Bank has answered KEICs complaint denying liability, and has asserted claims against various other parties seeking indemnification to the extent it may be found liable, and also seeking damages. Other parties against whom the Bank has made claims have made tort liability and indemnification claims against the Bank (and other parties in the case). None of the claims against us or the other parties has yet been adjudicated, and the litigation is still in the preliminary stages. We are vigorously defending this lawsuit.
We believe that we have meritorious defenses against the claims made by KEIC and the parties alleged to have accepted the bills of exchange subject to the lawsuit. However, we cannot predict the outcome of this litigation, and it will be expensive and time-consuming to defend. While it is possible that a portion of the claims may ultimately be covered by insurance, it is unlikely that this determination can be made until after the final disposition of the case. If the outcome of this litigation is adverse to us, and we are required to pay significant monetary damages, our financial condition and results of operations are likely to be materially and adversely affected.
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
Center Financials Common Stock has been listed on the Nasdaq National Market since October 29, 2002 (the day after the completion of the holding company reorganization). Prior to the reorganization, the common stock of Center Bank was traded on the Over-the-Counter Bulletin Board, and was not listed on any national stock exchange or with Nasdaq. Management is aware of the following securities dealers who are involved in trading of the Companys stock: Hoefer & Arnett, San Francisco, California; Seidler Companies, Inc., Big Bear Lake, California; and Wedbush Morgan Securities, Portland, Oregon (the Securities Dealers).
The information in the following table indicates the high and low bid and asked quotations and approximate volume of trading for the Companys common stock for the periods indicated, based upon information provided by the Nasdaq Stock Market, Inc. The high and low prices have been adjusted to give effect to all stock dividends, and the two-for one stock split paid on March 2, 2004. These quotations reflect inter-dealer prices, without retail mark-up, mark-down, or commission, do not reflect actual transactions and do not include nominal amounts traded directly by shareholders or through other dealers and not through the Securities Dealers.
As of December 31, 2004, there were approximately 154 shareholders of record of the common stock, and about 2,183 street name holders.
As a banking holding company, which currently has no significant assets other than our equity interest in Center Bank, our ability to pay dividends primarily depends upon the dividends we receive from Center Bank. The dividend practice of Center Bank, like our dividend practice, will depend upon its earnings, financial position, current and anticipated cash requirements and other factors deemed relevant by Center Banks board of directors at that time. In addition, during any period in which it has deferred payment of interest otherwise due and payable on its subordinated debt securities, Center Financial may not make any dividends or distributions with respect to its capital stock. See Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations Capital Resources.
Beginning in October 2003 Center Financial commenced a new dividend policy of paying quarterly cash dividends to its shareholders. In accordance with this policy, the Company paid a cash dividend of 8 cents per share in October 2003 and again in February 2004 and 4 cents per share in May 2004, August 2004, October 2004 and January 2005. The Company plans to continue to pay quarterly cash dividends in the future, provided
that such dividends allow the Company to continue to meet regulatory capital requirements and are not overly restrictive to its growth capacity. However, no assurance can be given that the Banks and the Companys future earnings and/or growth expectations in any given year will justify the payment of such a dividend. Prior to October 2003, the Company had been reinvesting its earnings into its capital in order to support the Companys continuous growth through the payment of stock rather than cash dividends. In addition, in January 2004, the Company declared a two-for-one stock split of its Common Stock. As a result, each shareholder of record as of February 17, 2004 received one additional share of common stock for each share they held on that date, and the Companys outstanding shares doubled to 16,048,520.
Center Banks ability to pay cash dividends to us is also subject to certain legal limitations. Under California law, banks may declare a cash dividend out of their net profits up to the lesser of retained earnings or the net income for the last three fiscal years (less any distributions made to shareholders during such period), or with the prior written approval of the Commissioner of Financial Institutions, in an amount not exceeding the greatest of (i) the retained earnings of the bank, (ii) the net income of the bank for its last fiscal year, or (iii) the net income of the bank for its current fiscal year. In addition, under federal law, banks are prohibited from paying any dividends if after making such payment they would fail to meet any of the minimum regulatory capital requirements. The federal regulators also have the authority to prohibit banks from engaging in any business practices which are considered to be unsafe or unsound, and in some circumstances the regulators might prohibit the payment of dividends on that basis even though such payments would otherwise be permissible.
Our ability to pay dividends is also limited by state corporation law. The California General Corporation Law allows us to pay dividends to our shareholders if our retained earnings equal at least the amount of the proposed dividend. If we do not have sufficient retained earnings available for the proposed dividend, we may still pay a dividend to our shareholders if we meet two conditions after giving effect to the dividend. Those conditions are generally as follows: (i) our assets (exclusive of goodwill and deferred charges) would equal at least 1 1/4 times our liabilities; and (ii) our current assets would equal at least our current liabilities or, if the average of our earnings before taxes on income and before interest expense for two preceding fiscal years was less than the average of our interest expense for such fiscal years, then our current assets must equal at least 1 1/4 times our current liabilities.
ITEM 6. SELECTED FINANCIAL DATA
The following table presents selected historical financial information, as restated (See Note 24 to the Consolidated Financial Statements), concerning the Company,1 which should be read in conjunction with our audited consolidated financial statements, including the related notes and Managements Discussion and Analysis of Financial Condition and Results of Operations, included elsewhere herein. The following selected financial data as of December 31, 2004 and 2003 and for the three year period ended December 31, 2004 is derived from our audited consolidated financial statements and related notes, which are included in this Annual Report. All per share information has been adjusted for stock splits and dividends declared by the Company from time to time, including the two-for-one stock split paid on March 2, 2004. Statistical information below is generally based on average daily amounts.
As discussed in Note 24 to the Consolidated Financial Statements, we have restated our financial statements and other financial information for the years ended December 31, 2004, 2003, 2002 and 2001 and for each of the quarters in the years 2004 and 2003 to reflect a change in the accounting treatment of the Companys interest rate swaps, which swaps were acquired between 2001 and 2003. (See Note 24 to the consolidated financial statements for discussion of the restatement).
This discussion presents Managements analysis of the financial condition and results of operations of the Company 9 as of and for each of the years in the three-year period ended December 31, 2004, and includes the statistical disclosures required by SEC Guide 3 (Statistical Disclosure by Bank Holding Companies). The
discussion should be read in conjunction with the financial statements of the Company and the notes related thereto which appear elsewhere in this Form 10-K/A Annual Report (See Item 8 below). All share and per share information, set forth herein has been adjusted to reflect stock splits and dividends declared by the Company from time to time, including the two-for-one stock split paid on March 2, 2004.
Critical Accounting Policies
Accounting estimates and assumptions discussed in this section are those that we consider to be the most critical to an understanding of our financial statements because they inherently involve significant judgments and uncertainties. The financial information contained in these statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. These critical accounting policies are those that involve subjective decisions and assessments and have the greatest potential impact on the Companys results of operations. Management has identified its most critical accounting policies to be those relating to the following: investment securities, loan sales, allowance for loan losses, and interest rate swaps. The following is a summary of these accounting policies. In each area, we have identified the variables most important in the estimation process. We have used the best information available to make the estimations necessary to value the related assets and liabilities. Actual performance that differs from our estimates and future changes in the key variables could change future valuations and impact net income.
The classification and accounting for investment securities are discussed in detail in Note 2 of the consolidated financial statements presented elsewhere herein. Under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, investment securities generally must be classified as held-to-maturity, available-for-sale or trading. The appropriate classification is based partially on our ability to hold the securities to maturity and largely on managements intentions with respect to either holding or selling the securities. The classification of investment securities is significant since it directly impacts the accounting for unrealized gains and losses on securities. Unrealized gains and losses on trading securities flow directly through earnings during the periods in which they arise, whereas for available-for-sale securities, they are recorded as a separate component of stockholders equity (accumulated comprehensive other income or loss) and do not affect earnings until realized. The fair values of our investment securities are generally determined by reference to quoted market prices and reliable independent sources. We are obligated to assess, at each reporting date, whether there is an other-than-temporary impairment to our investment securities. Such impairment must be recognized in current earnings rather than in other comprehensive income. Aside from the Fannie Mae and Freddie Mac preferred stocks that were determined to be impaired and written down during the twelve months of 2004, we did not have any other investment securities that were deemed to be other-than-temporarily impaired as of December 31, 2004. Investment securities are discussed in more detail in Note 3 to the consolidated financial statements presented elsewhere herein.
Certain Small Business Administration (SBA) loans that we have the intent to sell prior to maturity are designated as held for sale at origination and are recorded at the lower of cost or market value, on an aggregate basis. A valuation allowance is established if the market value of such loans is lower than their cost, and operations are charged or credited for valuation adjustments. A portion of the premium on sale of SBA loans is recognized as other operating income at the time of the sale. The remaining portion of the premium (relating to the portion of the loan retained) is deferred and amortized over the remaining life of the loan as an adjustment to yield. Servicing assets are recognized when loans are sold with servicing retained. Servicing assets are recorded based on the present value of the contractually specified servicing fee, net of servicing costs, over the estimated life of the loan, using a discount rate based on the related note rate plus 2 %. Servicing assets are amortized in proportion to and over the period of estimated future servicing income. Management periodically evaluates the
servicing asset for impairment, which is the carrying amount of the servicing asset in excess of the related fair value. Impairment, if it occurs, is recognized in a write down or charge-off in the period of impairment.
Allowance for Loan Losses
Our allowance for loan loss methodologies incorporate a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan loss that management believes is appropriate at each reporting date. Quantitative factors include our historical loss experience, delinquency and charge-off trends, collateral values, changes in nonperforming loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers sensitivity to interest rate movements and borrowers sensitivity to quantifiable external factors including commodity and finished good prices as well as acts of nature (earthquakes, floods, fires, etc.) that occur in a particular period. Qualitative factors include the general economic environment in our markets and, in particular, the state of certain industries. Size and complexity of individual credits, loan structure, extent and nature of waivers of existing loan policies and pace of portfolio growth are other qualitative factors that are considered in our methodologies. As we add new products, increase the complexity of our loan portfolio, and expand our geographic coverage, we will enhance our methodologies to keep pace with the size and complexity of the loan portfolio. Changes in any of the above factors could have significant impact to the loan loss calculation. We believe that our methodologies continue to be appropriate given our size and level of complexity. Detailed information concerning our loan loss methodology is contained in Item 7, Management Discussion and Analysis of Financial Condition and Results of Operations- Allowance for Loan Losses.
Interest Rate Swaps
As a part of our asset and liability management strategy we have included derivative financial instruments, such as interest rate swaps, with the overall goal of minimizing the impact of interest rate fluctuations. The Companys interest rate swaps were intended to constitute cash flow hedges under Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended and interpreted, when effectiveness testing at the beginning of each quarter shows that they are effective. In accordance with SFAS No. 133, such interest rate swap agreements are measured at fair value and reported as assets or liabilities on the consolidated statement of financial condition. (See Note 24 to the Consolidated Financial Statements for Discussion of the Restatement.)
When such swaps qualify for hedge accounting treatment, the change in the fair value of the swaps is recorded as a component of the accumulated other comprehensive income component of total shareholders equity . However, if the swaps do not qualify for hedge accounting treatment, then the change in the fair value of the swaps is recorded as a gain or loss directly to the consolidated statements of operations as a part of non-interest expense. As of December 31, 2004 and for prior periods, our swaps did not qualify for hedge accounting treatment. (See Note 24 to the Consolidated Financial Statements for Discussion of the Restatement.)
Pursuant to this restatement, the Company does not use hedge accounting treatment to account for its interest rate swaps. Therefore, the difference between the market and book value of these instruments is included in current earnings. During 2004, a mark to market loss of $1.8 million was recognized, compared to a mark to market gain of $376 thousand and a gain of $1.7 million for 2003 and 2002, respectively. (See Item 9A, Controls and Procedures.)
The Company, in compliance with SFAS 133, includes the swap settlement payments in Interest Income when hedge accounting treatment is used and in Non Interest Expense when hedge accounting treatment is not used. In the originally filed Form 10K swap settlement payments of $1.3 million were included in Interest Income during the first three quarters ended September 30, 2004 when hedge accounting treatment was used and for the fourth quarter ended December 31, 2004, when hedge accounting treatment was not used, $273 thousand was included in Non Interest Expense. As restated in Form 10K/A the total swap settlement payments for 2004 of $1.6 million was included in Non Interest Expense as described in Footnote 18 to the Consolidated Financial Statements.
The Company reported solid growth in loans and deposits for the year ended December 31, 2004. Consolidated net income for the year ended December 31, 2004 was $14.2 million, or $0.86 per diluted share compared to $11.8 million, or $0.73 per diluted share in 2003 and $10.4 million or $0.68 per diluted share in 2002. (All per share figures have been adjusted to reflect the two-for-one stock split paid on March 2, 2004.) The Companys improvement in 2004 earnings compared to the same period in 2003 represents an increase of 21%. The following were significant factors related to 2004 results as compared to 2003:
Our financial condition and liquidity remain strong. The following are important factors in understanding our financial condition and liquidity:
Results of Operations
Net Interest Income
The Companys earnings depend largely upon its net interest income, which is the difference between the income received from its loan portfolio and other interest-earning assets and the interest paid on its deposits and other liabilities. The Companys net interest income is affected by the change in the level and the mix of interest-earning assets and interest-bearing liabilities, referred to as volume changes. The Companys net interest income is also affected by changes in the yields earned on assets and rates paid on liabilities, referred to as rate changes. Interest rates charged on our loans are affected principally by the demand for such loans, the supply of money available for lending purposes and competitive factors. Those factors are, in turn, affected by general economic conditions and other factors beyond our control, such as federal economic policies, the general supply of money in the economy, legislative tax policies, governmental budgetary matters and the actions of the Federal Reserve Board. Interest rates on deposits are affected primarily by rates charged by competitors.
Net interest income was $42.1 million, $30.1 million, and $25.5 million for the years ended December 31, 2004, 2003, and 2002, respectively. The increase in net interest income of $12.0 million, or 40%, in 2004 was principally due to increases in average loans by $256.1 million and in average fed funds sold by $16.9 million, offset by an increase in average deposits by $165.1 million and increase in other borrowings by $3.1 million.
The following table sets forth, for the periods indicated, the dollar amount of changes in interest earned and interest paid for interest-earning assets and interest-bearing liabilities and the amount of change attributable to (i) changes in average daily balances (volume), (ii) changes in interest rates (rate), and (iii) changes in both rate and volume (rate/volume):
Net Interest Margin
Net interest income, when expressed as a percentage of average total interest-earning assets, is referred to as the net interest margin. The net interest margins for the years ended December 31, 2004, 2003, and 2002 were 3.98%, 3.72%, and 4.16%, respectively. The twenty six basis point increase in net interest margin in 2004 was primarily due to increases in market rates set by Federal Reserve Board. The average yield on loans for the twelve months of 2004 increased to 6.03% compared to 5.93% for the like period in 2003, a decrease of 10 basis points. The Company charges its customers prime plus margin for trade finance loans. This decrease was mainly due to a decrease in the margins on the trade finance loan portfolio during 2004, resulting from the fact that the Company reduced its margin on trade finance loans in order to compete with other banks as well as to expand its presence in this segment.
During 2004, the yield on average interest-earning assets increased to 5.43% or 27 basis points from 5.16% in 2003, as a result of interest rate hikes in 2004. The average investment portfolios for the twelve months of 2004 and 2003 were $126.3 million and $137.6 million, respectively. The average yields on the investment portfolio as of the twelve months of 2004 and 2003 were 3.28% and 3.40%, respectively. High prepayments recorded on mortgage-backed and collateralized mortgage obligations due to the low rate environment were the major contributors to the decrease.
Similarly, the Companys overall cost of funds slightly decreased to 2.04% or 1 basis point at December 31, 2004 from 2.05% in 2003. The cost of funds decreased because of the lag in the repricing to a lesser degree of the interest rates on the Companys substantial portfolio of time deposits. However, the increase of $80.0 million to $315.5 million in average noninterest-bearing demand deposits in 2004 from $235.5 million in 2003, on which the Company relied on as a considerable funding source, contributed to the increase in net interest margin during 2004. For the twelve months of 2004, average money market and NOW and average savings accounts grew $48.3 million or 23% as compared to the like period in 2003. The average yield on savings for the twelve months of 2004 increased 30 basis points to 3.21% as compared to 2.91% for the same period in 2003, mainly due to an increase in the volume of higher rate installment savings accounts.
Comparing 2003 to 2002, the Companys net interest margin decreased 44 basis points to 3.72% from 4.16%. The 44 basis point decrease in net interest margin in 2003 was primarily due to a reduction of 25 basis point in market rates set by Federal Reserve Board and high prepayments of mortgage-backed securities and collateralized mortgage obligations.
During 2003, the yield on average interest-earning assets decreased to 5.16% or 80 basis points from 5.96% in 2002, as a result of the 25 basis points decline in interest rates in 2003. The prime rate, to which the majority of the Companys loans are tied, was at its lowest rate in several decades. This decrease in yield was mainly due to a 142 basis point decrease in taxable investment securities, which decreased to 3.33% in 2003 from 4.75% in 2002. High prepayments recorded on mortgage-backed and collateralized mortgage obligations due to the low rate environment were the major contributors to the decrease.
The following table shows the Companys average balances of assets, liabilities and shareholders equity; the amount of interest income and interest expense; the average yield or rate for each category of interest-earning assets and interest-bearing liabilities; and the net interest spread and the net interest margin for the periods indicated:
The decrease in the ratio of average interest earning assets to interest bearing liabilities to 140.3% at December 31, 2004 from 142.3% in December 31, 2003, was primarily due to full year effect of investments in BOLI, and increased investment in affordable housing partnerships. Even though they are funded mostly with interest-bearing liabilities, these types of investments are not classified as an interest-earning asset. The Company invested $20 million in the ATM funding program launched during the third quarter of 2003, $10.0 million in BOLI in December 2003, and increased its investment in affordable housing partnerships by $192,000 to $3.9 million at December 31, 2004 from $3.7 million in 2003. The Company recorded $447,000 in noninterest income for 2004 related to its investment in BOLI. (See Noninterest Income.)
Provision for Loan Losses
For the year ended December 31, 2004, the provision for loan losses was $3.3 million, compared to $2.0 million and $2.1 million for 2003 and 2002, respectively. A 65% increase in provision for loan losses during 2004 was mainly attributable to loan growth and net charge-offs of $827,000 in 2004 as compared to net recoveries of $44,000 in 2003. While Management believes that the allowance for loan losses of 1.1% of total loans was adequate at December 31, 2004, future additions to the allowance will be subject to continuing evaluation of estimated and known, as well as inherent, risks in the loan portfolio. The procedures for monitoring the adequacy of the Allowance, as well as detailed information concerning the allowance itself, are included below under Allowance for Loan Losses.
Noninterest income increased 24% or $4.0 million to $20.6 million for the twelve months ended December 31, 2004 compared to $16.6 million for the twelve months ended December 31, 2003, but decreased as a percentage of average earning assets. The primary sources of recurring noninterest income continue to be customer service fee charges on deposit accounts, fees from trade finance transactions and gain on sale of SBA loans. Customer service fees increased by $1.4 million, or 20% from 2003 to 2004, and by $1.0 million, or 17% from 2002 to 2003. An increase of $1.4 million in customer service fees was mainly due to an increase in NFS/RI fees of $1.1 million in 2004 compared to 2003 and $690,000 in 2003 compared to 2002. During 2003, fee increases implemented on customer deposit accounts and the higher number of account relationships from new branches, were the other contributors for the customer service fee income increase in 2003. Customer service fees as a percentage of noninterest income decreased to 42% for 2004, compared to 43% and 45% in 2003 and 2002, respectively. This decrease was due to increased volume in SBA loan sales.
Fee income from trade finance transactions increased by $907,000, or 34%, to $3.6 million for twelve months ended December 31, 2004 as compared to $2.7 million in same period in 2003. This increase was a result of Managements continuous efforts to capitalize on improving trends in the Asia Pacific trade volumes and a new trade finance team brought in during 2003. Fee income from trade finance transactions as a percentage of total noninterest income also slightly increased in 2004 to 17%, as compared to 16% in 2003, but decreased as compared to 20% in 2002.
Since Managements decision to sell SBA loans on a regular basis, the gain on loan sales increased by 72% to $4.6 million in 2004, as compared to $2.7 million in 2003. The Company sold guaranteed and unguaranteed loans of $71.8 million SBA loans during 2004 as compared to $52.5 million of guaranteed loans during 2003. The gain on SBA loan sales also increased by $1.4 million in 2003 as compared to 2002; mainly due to the increased volume of SBA loan sales. The Company had a gain on the sale of fixed assets of $738,000 during 2002, in which it sold one of its branch facilities in order to relocate the branch to a more desirable site, which did not apply in the same periods of 2004 and 2003.
Mainly due to the increased volume of SBA loan sales and retention of servicing rights during 2004, other loan related service fees increased by $101,000 or 8% to $1.4 million during 2004 as compared to $1.3 million during 2003. Other loan related fees totaled $945,000 in 2002.
Slowing mortgage activity as a result of rising interest rates was partially contributed to a decline in the Companys other income in 2004. Other income decreased by 8% to $1.6 million for the twelve months ended December 31, 2004, as compared to $1.7 million in the like period of 2003. Other income as a percentage of total noninterest income also decreased to 7% for 2004 from 10% in the like period a year ago. The new fee income generating products, including Center Banks mortgage referral program and the ATM funding program, helped to boost other income by $128,000 or 60% to $1.7 million in 2003 as compared to $1.1 million in 2002. In addition, the Companys investment of $10.0 million in bank-owned life insurance (BOLI) in December 2003 generated $447,000 and $36,000 of noninterest income for 2004 and 2003, respectively. BOLI income, which is not taxable, is generated by the increase in the cash surrender values of bank-owned life insurance policies net of the cost associated with mortality charges and certain consulting expenses.
The following table sets forth the various components of the Companys noninterest income for the periods indicated:
Noninterest expense is comprised primarily of compensation and employee benefits; occupancy; furniture, fixture, and equipment; data processing; professional service fees; business promotions and advertising; gain/loss on interest rate swaps; and other operating expenses. Noninterest expense increased 41% to $36.8 million for the year ended December 31, 2004, compared to $26.0 million and $20.6 million for the years ended December 31, 2003 and 2002, respectively. Noninterest expense also increased as a percentage of average earning assets in 2004 to 3.48% for 2004, compared to 3.22% and 3.34% for 2003 and 2002, respectively.
The efficiency ratio, defined as the ratio of noninterest expense to the sum of net interest income before provision for loan losses and noninterest income, was 58.7% for the year ended December 31, 2004, compared with 55.8% and 52.3% for the years ended December 31, 2003 and 2002, respectively.
Although the credit quality of the issuer of a floating rate agency preferred stock is not in question, the interest rate environment has created an other than temporary decline in the value of floating rate agency preferred stocks whose fair market value has been lower than its cost basis for over twelve months; therefore a $2.3 million other than temporary decline in value charge was taken in during 2004 as compared to $880,000 in 2003.
The largest dollar increase was in compensation and employee benefits, which increased by $2.9 million or 22% to $16.4 million during 2004 compared to $13.5 million in 2003, but decreased from 52% to 44% as a percentage of total noninterest expense. The increase was attributed increased hiring activity of highly qualified personnel due to the Companys expansion of its management infrastructure in preparation for the next stage of the Companys growth. Compensation and employee benefits increased 9% to $13.5 million during 2003 compared to $12.3 million in 2002, but decreased from 59% to 52% as a percentage of total noninterest expense. The increase was primarily due incentive compensation as well as normal increases in annual salary for existing employees.
Occupancy expense increased by 24% to $2.5 million during 2004, compared to $2.0 million and $1.7 million in years 2003 and 2002 respectively, but remained almost constant at the 7% level as a percentage of total noninterest expense. This increase was mainly due to geographic expansion by opening and acquiring new branches and LPOs. The primary reason for the increase in 2003 as compared to 2002 was the opening of the
Fullerton branch office and relocation of the Western branch office. Furniture, fixture, and equipment expense increased by the $64,000, or 5%, to $1.4 million in 2004 compared to $1.3 million and $1.1 million in 2003 and 2002, respectively. However, the ratio of furniture, fixture, and equipment expense to total noninterest expense slightly decreased to 4% in 2004 as compared to 5% in 2003. The increase in 2004 mainly resulted from opening of new branches and LPOs. The increase in 2003 as compared to 2002 was mainly due to additional depreciation expense associated with the opening of the Fullerton branch office and relocation of Western branch office.
Data processing expense grew by $425,000, or 26%, in 2004 as compared to $1.6 million in 2003, mainly due to increased costs related to the newly acquired Chicago branch and increased activity as a result of the Companys expansion and growth. Data processing expense remained flat at $1.6 million in 2003 and 2002.
Due primarily to the higher consulting fees associated with complying with the Sarbanes-Oxley Act, and ongoing legal cases, professional service fees increased by $1.4 million to $3.6 million in 2004 compared to $2.2 million in 2003. Professional service fees also increased to 10% as a percentage of total noninterest expenses in 2004. Because of the higher professional fees and increased expenses associated with ongoing legal cases, professional service fees increased by 60% to $2.2 million in 2003 as compared to $1.4 million in 2002, and to 9% compared to 7% of total noninterest expenses. While non-litigation related professional fees were actually lower in 2003 compared to 2002 because the 2002 fees were unusually high as noted above, such fees in 2003 were still significant, and reflected the ongoing costs of compliance with the many SEC and Nasdaq requirements, including compliance with certain provisions of the Sarbanes-Oxley Act of 2002.
Business promotion and advertising expense increased by 42% to $2.5 million in 2004 as compared to $1.8 million and $1.6 million in 2003 and 2002, respectively. This increase in 2004 was mainly due to the increased promotional activity for the Companys products and new LPOs. Business promotion and advertising expense increased by 16% to $1.8 million in 2003 as compared to $1.6 million in 2002. This increase was primarily due to our name change and increased promotions for new products and services such as our mortgage lending program and Money Smart Program. The Company has participated in the Money Smart Program by the Federal Deposit Insurance Corporation as it aims to educate people on banking services by translating the training material into Korean.
The Company recorded $2.3 million and $880,000 of impairment losses for the years ended December 31, 2004 and 2003, respectively, as a result of an other than temporary decline in market value due to changes in interest rates, on Fannie Mae and Freddie Mac preferred stock. The Company holds these investment grade, high yielding, floating-rate securities as part of its available-for- sale investment portfolio. The unrealized losses were deemed a permanent impairment and were recognized in 2003 and 2004. These preferred stocks are rated AA- and AA3 by S&P and Moodys and are widely held by financial institutions and other investors across the country.
During the first quarter of 2005, all of the Companys holdings on the FHLMC floating-rate preferred stocks totaling approximately $5.2 million were sold with a slight net gain from the December 31, 2004 adjusted book value. The bank currently holds approximately $5.0 million of the FNMA floating-rate securities that reset every two years at the 2-year U.S. Treasury Note minus 16bps. The next reset date is on March 20, 2006. Should there be additional permanent impairments on these securities in the future, these impairments would be recognized on the income statement. However, it is impossible to predict at this time whether or to what extent such losses will occur.
Gain or loss on interest rate swaps, net of counter party settlements, is included in noninterest expense. In 2004 a loss of $235 thousand was recognized compared to gains of $2.2 million and $2.8 million in 2003 and 2002, respectively. The mark to market is influenced by expectations of future interest rates and the length of the remaining contractual life of the swap instruments.
Other operating expense also increased significantly. Other operating expense includes court settlements, correspondent bank charge expense, regulatory assessment expense, loan related expense, director compensation
expense, corporate administrative expense, and loss on investment in affordable housing partnerships, for which the Company receives federal income tax credits and CRA credits. Other operating expenses increased by $742,000 in 2004 to $3.5 million, as compared to $2.8 million in 2003. This increase was mainly due to increases in corporate administration and loan related fee expenses, blanket bond and D&O expenses, and passive losses in CRA investments. Other operating expense in 2003 increased 56% to $2.8 million, compared to $1.8 million in 2002 and from 9% to 11% as a percentage of total noninterest expenses increase, primarily due to settlement costs relating to long-standing legal proceedings. There was no other significant legal case outstanding other than KEIC at December 31, 2004, see Item 3, Legal Proceedings.
The remaining noninterest expenses include such items as stationery and supplies, telecommunications, postage, courier service and security service expenses. For the year ended 2004, these noninterest expenses increased 10% to $2.4 million compared to $2.2 million for the same period in 2003. Increases were primarily due to the Chicago branch acquisition and relocation of our Inland Branch Office. For the year ended 2003, these noninterest expenses increased 18% to $2.2 million compared to $1.8 million for the same period in 2002. Increases were primarily due to Center Banks name change and opening of new branches.
The following table sets forth the noninterest expenses for the periods indicated with the percentages adjusted to reflect the restatement described herein:
Provision for Income Taxes
Income tax expense is the sum of two components, current tax expense and deferred tax expense. Current tax expense is the result of applying the current tax rate to taxable income. The deferred portion is intended to reflect that income on which taxes are paid differs from financial statement pre-tax income because some items of income and expense are recognized in different years for income tax purposes than in the financial statements.
For the years ended December 31, 2004, 2003, and 2002, the provisions for income taxes were $8.4 million $6.8 million, and $6.2 million, representing effective tax rates of 37% and 37%, and 37%, respectively. The
primary reasons for the difference from the statutory federal tax rate of 35% and the state statutory tax rate of 11% are the reductions related to tax favored investments in low-income housing, municipal obligations and agency preferred stocks. The Company reduced taxes utilizing the tax credits from investments in the low-income housing projects in the amount of $517,000 for the twelve months of 2004 compared to $503,000 for the twelve months ended in December 31, 2003.
Deferred income tax assets or liabilities reflect the estimated future tax effects attributable to differences as to when certain items of income or expense are reported in the financial statements versus when they are reported in the tax return. The Companys deferred tax asset was $7.1 million as of December 31, 2004, $3.0 million, and $824,000 as of December 31, 2003, and 2002, respectively. As of December 31, 2004, the Companys deferred tax asset was primarily due to book reserves for losses on loans and impairment losses on preferred stocks.
Total assets increased by $310.7 million, or 30%, to $1.3 billion as of December 31, 2004 compared to $1.0 billion at December 31, 2003. The increase in total assets was mainly due to a $293.1 million growth in net loans $42.9 million increase in investment securities. These increases were partially offset by a $37.8 million decrease in cash and cash equivalents. Net loans including loans held for sale, investments, and money market and short-term investments as a percentage of total assets were 76%, 13% and 3% respectively as of December 31, 2004, as compared to 70%, 12% and 6% at December 31, 2003. The growth of total assets was financed primarily by the increase in deposits.
Total assets increased $209 million, or 26%, to $1,027 million as of December 31, 2003 compared to $819 million at December 31, 2002. The increase in total assets was mainly due to a $196 million growth in net loans $38 million increase in cash and due from banks, resulting from a $20 million investment in the ATM funding program and a $10 million increase in investment in BOLI. These increases were partially offset by a $31 million decrease in the investment portfolio. Loans net of allowance for loan losses, deferred fees, and deferred gains on SBA loans retained, investments, and money market and short-term investments as a percentage of total assets were 70%, 12% and 6% respectively as of December 31, 2003, as compared to 64%, 19% and 9% at December 31, 2002. The growth of total assets was financed by the increase of $141 million in deposits; $33 million of Federal Home Loan Bank borrowing and the issuance of long-term subordinated debenture at the end of 2003 of $18 million in pass-through trust preferred securities.
The Companys loan portfolio represents the largest single portion of earning assets, substantially greater than the investment portfolio or any other asset placement category. The quality and diversification of the Companys loan portfolio are important considerations when reviewing the Companys results of operations. The Company offers a range of products designed to meet the credit needs of its borrowers. The Companys lending activities consist of commercial real estate lending, construction loans, commercial business and trade finance loans, and consumer loans.
As of December 31, 2004, 2003 and 2002, gross loans represented 76%, 71% and 65% of total assets. In 2003, the Company used proceeds from investment securities to finance higher yielding loans. The biggest volume increases among loan types in 2004 were commercial real estate loans, commercial business loans and trade finance loans, which increased 58%, 42% and 35%, respectively, dollar increase was $222.5 million, $61.6 million and $21.9 million, respectively, as compared to 2003. The Loan Distribution table below reflects the gross and net amounts of loans outstanding as of December 31 for each year from 2000 to 2004.
As of December 31, 2004, no single industry or business category represented more than 10% of the loan portfolio. The Company also monitors the diversification of collateral of the real estate loan portfolio by area, by type of building, and by the type of building usage.
The following table sets forth the composition of the Companys loan portfolio as of the dates indicated:
Loan Portfolio Composition
(Dollars in Thousands)
Commercial Real Estate Loans. Real estate lending involves risks associated with the potential decline in the value of the underlying real estate collateral and the cash flow from the income producing properties. Declines in real estate values and cash flows can be caused by a number of factors, including adversity in general economic conditions, rising interest rates, changes in tax and other governmental and other policies affecting real estate holdings, environmental conditions, governmental and other use restrictions, development of competitive properties, and increasing vacancy rates. The Companys dependence on real estate values increases the risk of loss both in the Companys loan portfolio and with respect to any other real estate owned when real estate values decline.
The Company offers commercial real estate loans secured by industrial buildings, retail stores, or office buildings, where the propertys repayment source generally comes from tenants or businesses that fully or partially occupy the building. When real estate collateral is owner-occupied, the value of the real estate collateral must be supported by a formal appraisal in accordance with applicable regulations, subject to certain exceptions. The majority of the properties securing these loans are located in Los Angeles and Orange Counties.
The Company has established general underwriting guidelines for commercial property real estate loans requiring a maximum loan-to-value (LTV) ratio of 70%. The Companys underwriting policies also generally require that the properties securing commercial real estate loans have debt service coverage ratios of at least 1.25:1 for investor-owned property. Additionally, for owner-occupied properties, the Company expects additional debt service capacity from the business itself. As additional security, the Company generally requires personal guarantees when commercial real estate loans are extended to corporations, limited partnerships, and other legal entities.
Commercial real estate loans are in all cases secured by first deeds of trust, generally for terms extending no more than seven years, and are amortized over periods of up to 25 years. The majority of the commercial real estate loans currently being originated contain interest rates tied to the Companys prime rate that adjusts with changes in the national prime rate. The Company also extends commercial real estate loans with fixed rates.
Payments on loans secured by such properties are often dependent on the successful operation or management of the properties. Repayment of such loans may therefore be affected by adverse conditions in the real estate market or the economy. The Company seeks to minimize these risks in a variety of ways, including limiting the size of such loans and strictly scrutinizing the properties securing the loans. The Company generally obtains loan guarantees from financially capable parties. The Companys lending personnel inspect substantially all of the properties collateralizing the Companys real estate loans before such loans are made.
As of December 31, 2004, commercial real estate loans totaled $607.3 million, representing 59% of total loans, compared to $384.8 million or 53% of total loans at December 31, 2003. The increase in the percentage of commercial real estate loans resulted from Managements efforts to promote this segment of the portfolio, as such loans involve a somewhat lesser degree of risk than certain other loans in the portfolio due to the nature and value of the collateral.
Real Estate Construction Loans. The Company finances the construction of various projects within the Companys market area, including motels, industrial buildings, tax-credit low-income apartment complexes and single-family residences. The future condition of the local economy could negatively impact the collateral values of such loans.
The Companys construction loans typically have the following characteristics: (i) maturity of two years or less; (ii) a floating interest rate based on the Companys Prime rate; (iii) advance of anticipated interest cost during construction; (iv) advance of fees; (v) first lien position on the underlying real estate; (vi) loan to value ratio of 65%; and (vii) recourse against the borrower or guarantor in the event of default. The Company does not participate in joint ventures or make equity investments in connection with its construction lending.
Construction loans involve additional risks compared to loans secured by existing improved real property. These risks include the following: (i) the uncertain value of the project prior to completion; (ii) the inherent uncertainty in estimating construction costs, which is often beyond the control of the borrower; (iii) construction delays and cost overruns; and (iv) the difficulty in accurately evaluating the market value of the completed project.
As a result of these uncertainties, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project rather than on the ability of the borrower or guarantor to repay principal and interest. If the Company is forced to foreclose on a project prior to
or at completion due to a default, there can be no assurance that the Company will be able to recover all of the unpaid balance of and its accrued interest on the construction loan.
Real estate construction loans totaled $16.9 million or 2% of total loans and $18.5 million or 3% of total loans at December 31, 2004 and 2003, respectively. The decrease in construction loans is primarily due to loan payoffs and a charge-off related to one large loan in the amount of $2.3 million. The borrower filed a bankruptcy petition to the court followed by a Chapter 11 Plan in July 2004. On November 3, 2004, the Court approved the Chapter 11 Plan. According to the Plan, the participating group, of which the Company is a member, will be paid in 6 years. The Company charged off $435,000 of this construction loan in the first quarter of 2004.
Commercial Business Loans. The Company offers commercial loans for intermediate and short-term credit. Commercial loans may be unsecured, partially secured or fully secured. The majority of the originations of commercial loans are in Los Angeles County or Orange County, in California. The Company originates commercial business loans to facilitate term working capital and to finance business acquisitions, fixed asset purchases, accounts receivable and inventory financing. These term loans to businesses generally have terms of up to five years, have interest rates tied to the Companys Prime rate, and may be secured in whole or in part by owner-occupied real estate or time deposits at the Company. For a term loan, the Company typically requires monthly payments of both principal and interests. In addition, the Company grants commercial lines of credit to finance accounts receivable and inventory on a short-term basis, usually one year or less. Short-term business loans are generally intended to finance current transactions and typically provide for principal payments with interest payable monthly. The Company requires a complete re-analysis before considering any extension. The Company finances primarily small and middle market businesses in a wide spectrum of industries. In general, it is the Companys intent to take collateral whenever possible regardless of the purpose of the loan. Collateral may include liens on inventory, accounts receivable, fixtures and equipment and in some cases leasehold improvements and real estate. As a matter of policy, the Company generally requires all principals of a business to be co-obligors on all loan instruments, and all significant shareholders of corporations to execute a specific debt guaranty. All borrowers must demonstrate the ability to service and repay not only the debt with the Company but also all outstanding business debt, exclusive of collateral, on the basis of historical earnings or reliable projections.
Commercial loans typically involve relatively large loan balances and are generally dependent on the businesses cash flows and thus may be subject to adverse conditions in the general economy or in specific industry.
As of December 31, 2004 and 2003, commercial business loans, which include Korean Affiliate Loans and other commercial loans, totaled $209.0 million and $147.4 million, respectively representing 20% of total gross loans at both dates. Commercial business loans totaled $108.6 million at December 31, 2002, representing 20% of total loans. Although commercial business loans increased in 2004, mainly due to a $60.5 increase in other commercial business loans not related to South Korea, commercial loans as a percentage of total loans remained unchanged at 20%. This was due to faster growth in other sectors and more emphasis on other types of secured loans, primarily real estate loans.
Trade Finance Loans. For the purpose of financing overseas transactions, the Company provides short term trade financing to local borrowers in connection with the issuance of letters of credit to overseas suppliers/sellers. In accordance with these letters of credit, the Company extends credit to the borrower by providing assurance to the borrowers foreign suppliers that payment will be made upon shipment of goods. Upon shipment of goods, and when the foreign suppliers negotiate the letters of credit, the borrowers inventory is financed by the Company under the approved line of credit facility. The underwriting procedure for this type of credit is the same as for commercial business loans.
As of December 31, 2004, trade finance loans totaled $83.8 million, compared to $61.9 million as of December 31, 2003. This increase in trade finance loans was mainly due to Managements efforts to capitalize on
improving trends in the Asia Pacific trade volumes and a new trade finance team brought in 2003. However, trade finance loans as a percentage of total loans remained at 8% in 2004 and 2003, due to faster growth in other loan categories, primarily real estate loans.
Small Business Administration (SBA) Loans. The Company has offered SBA loans since 1989, providing financing for various purposes for small businesses under guarantee of the Small Business Administration, a federal agency created to provide financial assistance for small businesses. The Company is a Preferred SBA Lender with full loan approval authority on behalf of the SBA. It also participates in the SBAs Export Working Capital Program. SBA loans consist of both real estate and business loans. The SBA guarantees on such loans currently range from 75% to 80% of the principal and accrued interest. Under certain circumstances, the guarantee of principal and interest may be less than 75%. In general, the guaranteed percentage is less than 75% for loans over $1.0 million. The Company typically requires that SBA loans be secured by first or second lien deeds of trust on real property. SBA loans have terms ranging from 7 to 25 years depending on the use of proceeds. To qualify for an SBA loan, a borrower must demonstrate the capacity to service and repay the loan, exclusive of the collateral, on the basis of historical earnings or reliable projections.
At December 31, 2004, 69% of total SBA loans, net of participations sold, were real estate loans secured by deeds of trust on industrial buildings or retail stores. During the years 2004 and 2003, the Company originated $101.7 million, and $60.7 million, respectively in SBA loans. The Company adopted a new practice in 2003 of selling SBA loans every quarter. Since the shift in our SBA loan sale policy, the Company sold $71.8 million of SBA loans in 2004, an increase of 37% as compared to previous level of $52.5 million SBA loans sold in 2003, and retained the obligation to service the loans for a servicing fee and to maintain customer relations. In addition, the Company initiated the sale of the unguaranteed portion of SBA loans during the third quarter of 2004. As of December 31, 2004, the Company was servicing $137.5 million of sold SBA loans, compared to $91.5 million as of December 31, 2003. SBA loans as a percentage of total loans decreased to 5% in 2004 as compared to 9% in 2003, primarily due to increased sale volume in 2004.
Consumer Loans. Consumer loans, also termed loans to individuals, are extended for a variety of purposes. Most are to finance the purchase of automobiles. Other consumer loans include secured and unsecured personal loans, home equity lines, overdraft protection loans, and unsecured lines of credit. The Company grants a small portfolio of credit card loans, mainly to the owners of its corporate customers. Management assesses the borrowers ability to repay the debt through a review of credit history and ratings, verification of employment and other income, review of debt-to-income ratios and other measures of repayment ability. Although creditworthiness of the applicant is of primary importance, the underwriting process also includes a comparison of the value of the security, if any, to the proposed loan amount. The Company generally makes these loans in amounts of 80% or less of the value of collateral. An appraisal is obtained from a qualified real estate appraisal for substantially all loans secured by real estate. Most of the Companys consumer loans are repayable on an installment basis.
Consumer loans are generally unsecured or secured by rapidly depreciating assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance, because the collateral is more likely to suffer damage, loss or depreciation. The remaining deficiency often does not warrant further collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, the collection of loans to individuals is dependent on the borrowers continuing financial stability, and thus is more likely to be adversely affected by job loss, divorce,
illness or personal bankruptcy. Furthermore, various federal and state laws, including federal and state bankruptcy and insolvency laws, often limit the amount, which a lender can recover on consumer loans. Consumer loans may also give rise to claims and defense by consumer loan borrowers against the lender on these loans, such as the Company, and a borrower may be able to assert against such assignee claims and defenses that it has against the seller or the underlying collateral.
Consumer loans remained a small percentage of 6% of total loans as of December 31, 2004, compared to 7% as of December 31, 2003. Automobile loans are the largest component of consumer loans, representing 64% and 85% of total consumer loans as of December 31, 2004 and 2003.
Off-Balance Sheet Commitments. As part of its service to its small to medium-sized business customers, the Company from time to time issues formal commitments and lines of credit. These commitments can be either secured or unsecured and 90% are short term, or less than one year. They may be in the form of revolving lines of credit for seasonal working capital needs. However, these commitments may also take the form of standby letters of credit and commercial letters of credit. Commercial letters of credit facilitate import trade. Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party.
Total unused commitments to extent credit were $171.7 million and $114.0 million at December 31, 2004 and 2003, respectively. Unused commitments represented 17% and 16% of outstanding gross loans at December 31, 2004 and 2003, respectively. The Companys stand-by letters of credit and commercial letters of credit at December 31, 2004 were $11.9 million and $22.2 million, respectively, as compared to $6.2 million and $19.1 million at December 31, 2003.
Loans Involving Country Risk
The Company has historically made three types of credit extensions involving direct exposure to the Korean economy: (i) commercial loans to U.S. affiliates or subsidiaries or branches of companies located in South Korea (Korean Affiliate Loans), (ii) Unused commitments for loans to U.S. affiliates of Korean companies (iii) advances on acceptances by Korean banks, and (iv) loans against standby letters of credit issued by Korean banks. In certain instances, standby letters of credit issued by Korean banks support the loans made to the U.S. affiliates or branches of Korean companies, to which the Company has extended loans. In addition, the Company makes certain loans involving indirect exposure to the economies of South Korea as well as other Pacific Rim countries, as discussed at the end of this section.
The following table sets forth the amounts of outstanding balances in the above four categories for South Korea:
Loans and Commitments Involving Korean Country Risk
Loans and commitments involving direct exposure to the Korean economy totaled $53.1 million or 4% of total loans and commitments and $36.2 million or 4% of total loans and commitments as of December 31, 2004 and 2003, respectively. The Companys level of loans and commitments involving such exposure in 2004 has increased as compared to 2003 due to $10.5 million increase in unused commitments to U.S. affiliates of Korean companies, $5.3 million increase in acceptances with Korean Banks and $3.2 million increase in Commercial
loans to U.S. affiliates or branches of Korean companies, but remained the same as a percentage of total loans and commitments.
In addition to the loans included in the above table, which involve direct exposure to the Korean economy, the Company also makes loans to many U.S. business customers in the import or export business whose operations are indirectly affected by the economies of various Pacific Rim countries including South Korea. As of December 31, 2004, loans outstanding involving indirect country risk totaled $29.9 million, or 2.9% of the Companys total loans, and loans and commitments involving indirect country risk totaled $107.1 million, or 9% of the Companys total loans and commitments. Indirect country risk is defined as the risk associated with loans to such U.S. businesses, which are dependent upon foreign countries for business and trade. Of the $107.1 million in total loans and commitments involving indirect country risk, approximately 68% involve borrowers doing business with Korea, with the remaining percentages to other individual Pacific Rim countries being relatively small in relation to the total indirect loans involving country risk. As a result, with the exception of South Korea, the Company does not believe it has significant indirect country risk exposure to any other specific Pacific Rim country.
Of the total loans outstanding and commitments involving indirect country risk identified above, approximately 53% of such loans and commitments were to businesses which import goods from Korea and 7% were loans or commitments to businesses which export goods to Korea.
The potential risks to the Company differ depending upon whether the customer is in the export or the import business. The primary manner in which adverse changes in the economic conditions in the relevant Pacific Rim countries would affect business customers in the export business is a decrease in the volume in their respective businesses. As a result, the Companys volume of such loans would tend to decrease due to lower demand. In addition, export loans are generally dependent on the businesses cash flows and thus may be subject to adverse conditions in the general economy of the country or countries with which the customer does its exporting business. The Companys import loans are generally to U.S. domestic business entities whose operations would not be directly affected by the economic conditions of foreign countries, as importers can typically obtain goods from an alternative market if necessary, so the effect on the borrowers business is less significant.
The Company limits its risk exposure with respect to export loans by participating in the state and federal agency supported export programs such as the Export Working Capital Program and the California Export Finance Office, which guarantee 70 to 90% of the export loans. The Company also requires that a majority of export finance loans are supported by letters of credit issued by established creditworthy commercial banks. The Company also monitors other foreign countries for economic or political risks to the portfolio. As part of its loan loss allowance methodology, the Company assigns one of three rating factors to borrowers in these businesses, depending upon the perceived degree of indirect country risk and allocates an additional amount to the allowance to reflect the potential additional risk from such indirect exposure to the economies of those foreign countries. (See Allowance for Loan Losses - Allowance for Country Risk Exposure.)
Loan Maturities and Sensitivity to Changes in Interest Rates
The following table shows the maturity distribution and repricing intervals of the Companys outstanding loans as of December 31, 2004. In addition, the table shows the distribution of such loans between those with floating interest rates and those with fixed interest rates. The table includes nonaccrual loans of $ $3.4 million.
Loan Maturities Schedule
Nonperforming assets are comprised of loans on nonaccrual status, loans 90 days or more past due but not on nonaccrual status, loans restructured where the terms of repayment have been renegotiated resulting in a reduction or deferral of interest or principal, and OREO (Other Real Estate Owned). Management generally places loans on nonaccrual status when they become 90 days past due, unless they are both fully secured and in process of collection. Loans may be restructured by Management when a borrower has experienced some change in financial status causing an inability to meet the original repayment terms, where the Company believes the borrower will eventually overcome those circumstances and repay the loan in full. OREO consists of real property acquired through foreclosure or similar means that Management intends to offer for sale.
Managements classification of a loan as nonaccrual or restructured is an indication that there is reasonable doubt as to the full collectibility of principal or interest on the loan. At this point, the Company stops recognizing income from the interest on the loan and reverses any uncollected interest that had been accrued but unpaid. The remaining balance of the loan will be charged off if the loan deteriorates further due to a borrowers bankruptcy or similar financial problems, unsuccessful collection efforts or a loss classification by regulators and/or auditors. These loans may or may not be collateralized, but collection efforts are continuously pursued.
There was no OREO outstanding at December 31, 2004. If the Company acquires OREO, it records it at the lower of its carrying value or its fair value less anticipated disposal costs. Any write-down of OREO is charged to earnings. The Company may make loans to potential buyers of OREO to facilitate the sale of OREO. In those
cases, all loans made to such buyers must be reviewed under the same guidelines as those used for making customary loans, and must conform to the terms and conditions consistent with the Companys loan policy. Any deviations from this policy must be specifically noted and reported to the appropriate lending authority. The Company follows Statement of Financial Accounting Standards No. 66, Accounting for Sales of Real Estate (SFAS No. 66) when accounting for loans made to facilitate the sale of OREO. In accordance with paragraph 5 of SFAS No.66, profit on real estate sales transactions shall not be recognized by the full accrual method until all of the following criteria are met:
As of December 31, 2002, the Company provided loans in the amount of $480,000 to facilitate the sale of OREO which resulted in a gain on sale on OREO of $85,000 in 2002.
The following table provides information with respect to the components of the Companys nonperforming assets as of the dates indicated:
Nonperforming loans totaled to $3.4 million at December 31, 2004, an increase of $104,000 as compared to $3.3 million in last year. However, in 2004, nonperforming loans as a percentage of total loans decreased to 0.34% as compared to 0.46% in 2003. The slight increase in nonperforming loans in 2004 was mainly due to the increase in nonperforming SBA and consumer loans. The increase in nonperforming loans in the consumer portfolio was primarily due to auto loans. SBA loans currently are guaranteed by the federal government at 75% to 85% of the principal amount.
Nonperforming loans increased by $899,000 to $3.3 million at December 31, 2003, as compared to $2.4 million in 2002. The increase in volume of nonperforming loans in 2003, as compared to 2002, was mainly due to one large participated construction loan in the amount of $2.3 million. Construction has been completed and the hotel is operational. The borrower filed a bankruptcy petition to the court followed by a Chapter 11 Plan in July 2004. On November 3, 2004, the Court approved the Chapter 11 Plan. According to the Plan, the participating group, of which the Company is a member, will be paid in 6 years. The Company charged off $435,000 of this construction loan in the first quarter of 2004.
The Company evaluates impairment of loans according to the provisions of SFAS No. 114, Accounting by Creditors for Impairment of a Loan. Under SFAS No. 114, loans are considered impaired when it is probable that the Company will be unable to collect all amounts due as scheduled according to the contractual terms of the loan agreement, including contractual interest payments and contractual principal payments. Impaired loans are measured based on the net present value of expected future cash flows discounted at the loans effective interest rate or, as an expedient, at the loans observable market price or the fair value of the collateral, if the loan is collateral dependent, less costs to sell.
The following table provides information on impaired loans for the periods indicated:
Allowance for Loan Losses
The allowance for loan losses reflects Managements judgment of the level of allowance adequate to provide for probable losses inherent in the loan portfolio as of the statement of financial condition date. On a monthly basis, the Company assesses the overall adequacy of the allowance for loan losses, utilizing a disciplined and systematic approach which includes the application of a specific allowance for identified problem loans, a formula allowance for identified graded loans, an allocated allowance for large groups of smaller balance homogenous loans, and an allocated allowance for country risk exposure.
Allowance for Specifically Identified Problem Loans. A specific allowance is established for impaired loans in accordance with SFAS 114. A loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. The specific allowance is determined based on the present value of expected future cash flows discounted at the loans effective interest rate, except that as a practical expedient, the Company may measure impairment based on a loans observable market price, or the fair value of the collateral if the loan is collateral dependent. Regardless of the measurement method, the Company measures impairment based on the fair value of the collateral when it is determined that foreclosure is probable.
Formula Allowance for Identified Graded Loans. Non-homogenous loans such as commercial real estate, construction, commercial business, trade finance and SBA loans that are not subject to the allowance for specifically identified loans discussed above are reviewed individually and subject to a formula allowance. The formula allowance is calculated by applying loss factors to outstanding Pass, Special Mention, Substandard and Doubtful loans. The evaluation of inherent loss for these loans involves a high degree of uncertainty, subjectivity
and judgment because probable loan losses are not identified with a specific loan. In determining the formula allowance, we rely on a mathematical calculation that incorporates a twelve-quarter rolling average of historical losses. In order to reflect the impact of recent events, the twelve-quarter rolling average has been weighted. Loans risk rated Pass, Special Mention and Substandard for the most recent three quarters are adjusted to an annual basis as follows:
The formula allowance may be further adjusted to account for the following qualitative factors:
Allowance for Large Groups of Smaller Balance Homogenous Loans. The portion of the allowance allocated to large groups of smaller balance homogenous loans is focused on loss experience for the pool rather than on an analysis of individual loans. Large groups of smaller balance homogenous loans consist of consumer loans to individuals. The allowance for groups of performing loans is based on historical losses over a three-year period. In determining the level of allowance for delinquent groups of loans, we classify groups of homogenous loans based on the number of days delinquent.
Allowance for Country Risk Exposure. The allowance for country risk exposure is based on an estimate of probable losses relating to both direct exposure to the Korean economy, and indirect exposure to the economies of various Pacific Rim countries. The exposure is related to trade finance loans made to support export/import business between the U.S. and Korea, Korean Affiliate Loans, and certain loans to local U.S. business that are supported by stand by letters of credit issued by Korean banks. As with the credit rating system, we use a country risk grading system under which risk gradings have been divided into three ranks. To determine the risk grading, the Company evaluates loans to companies with a significant portion of their business reliant upon imports or exports to Pacific Rim countries. The Company then analyzes the degree of dependency on business, suppliers or other business areas dependent upon such countries and applies an individual rating to the credit. The Company provides an allowance for country risk exposure based upon the rating of dependency. Most of the Companys business customers whose operations are indirectly affected by the economies of such countries are in the import or export business. As part of its methodology, the Company assigns one of three rating factors (25, 50 or 75 basis points) to borrowers in these businesses, depending upon the perceived degree of indirect exposure to such economies. The country risk exposure factor reflected in the table below is in addition to the allowance for such loans, which is already reflected, in the formula allowance. This factor takes into account both the direct risk on the loans included in the Loans Involving Country Risk table above, and the loans to import or export businesses involving indirect exposure to the economies of South Korea or other Pacific Rim countries.
The process of assessing the adequacy of the allowance for loan losses involves judgmental discretion, and eventual losses may therefore differ from even the most recent estimates. Further, the Companys independent loan review consultants, as well as the Companys external auditors, the FDIC and the California Department of Financial Institutions review the allowance for loan losses as an integral part of their examination process.
The Company continued to record loss provisions to compensate for both the continued growth in the Companys loan portfolio and the continued change in the composition of the overall loan portfolio, reflecting a steady shift toward commercial real estate and commercial loans. The allowance for loan losses was $11.2 million, $8.8 million and $6.8 million as of December 31, 2004, 2003 and 2002, respectively. The allowance for loan losses was 1.1% of total loans as of December 31, 2004 compared to 1.2% and 1.3% as of December 31, 2003 and 2002, respectively. The Company provides an allowance for the new credits based on the migration analysis. The ratio of the allowance for loan losses to nonperforming loans increased to 327% at December 31, 2004 as compared to 265%, and 278% in 2003, and 2002, respectively. Management believes the risks in the portfolio are sufficiently lower to justify reducing the ratio of the allowance to total loans, since the Companys mix of loans shifted towards real estate loans secured by first deeds of trust, the ratio of the allowance to nonaccrual loans increased slightly. Management believes that the level of allowance for loan losses is adequate to cover the known and probable risks of the nonperforming loans as of December 31, 2004.
The following table sets forth the composition of the allowance for loan losses as of dates indicated:
Composition of Allowance for Loan Losses
The balance of the allowance for loan losses increased to $11.2 million as of December 31, 2004 compared to $8.8 million as of December 31, 2003. This increase was mainly due to a $3.2 million increase in the formula (non-homogeneous) allowance. Formula allowances were increased due to loan growth. These increases were partially offset by a decrease in the country risk allowance and specific allowance related to impaired loans.
Management is committed to maintaining the allowance for loan losses at a level that is considered commensurate with estimated and known risks in the portfolio. Although the adequacy of the allowance is reviewed monthly, Management performs an ongoing assessment of the risks inherent in the portfolio. As of December 31, 2004, Management believes the allowance to be adequate based on its assessment of the estimated and known risks in the portfolio migration analysis of charge-off history, which indicated stabilized loss ratios. There has been no need to adjust the risk ratios applied to graded loans. Classified loans stood at $4.6 million as of December 31, 2004 compared to $6.6 million as of December 31, 2003. This decrease in 2004 was primarily due to charge-offs.
Based on the calculation and continued loan recoveries, Management believes that the level of allowance as of December 31, 2004 is adequate to absorb the estimated losses from any known or inherent risks in the loan portfolio and the loan growth for the year. However, no assurance can be given that economic conditions which adversely affect our service areas or other circumstances will not be reflected in increased provisions or loan losses in the future.
The provisions for loan losses in 2004, 2003, and 2002 were $3.3 million, $2.0 million, and $2.1 million, respectively. The increase in provision for 2004 was due to the considerable expansion in Companys loan portfolio as well as increased net charge-offs of $827,000 in 2004 as compared to net recoveries of $44,000 in 2003. Because of the net recoveries recorded in 2003 the Company was able to maintain its loan loss provision at $2.0 million for 2003. Due to net recoveries of $44,000 during 2003 as compared to net charge-offs of $837,000 in 2002, the Company kept its provision nearly flat at $2.0 million in 2003, compared to 2002 provision despite average loan grow of 41% in 2003. Total charge-offs for 2004 were $1.6 million as compared to $1.3 million in 2003. The increase in charge-offs was mainly due to the charge-off in the first quarter of 2004 of $435,000 relating to a construction loan as to which the borrower is currently in Chapter 11. (SeeNonperforming Assets above.) The biggest single charge-off during 2004 and 2003 was $435,000 and $249,000, respectively. Net charge-offs (recoveries) were $827,000, ($44,000) and $837,000 in 2004, 2003 and 2002, respectively. The biggest single charge-off during 2002 was $250,000 related to a high technology manufacturer whose business failed due to the general slowdown in the technology sector in the U.S. Charge-offs in 2002 were significantly less than in 2001 due to greater oversight by the Company in monitoring and addressing delinquent and classified loans. Charge-offs in 2001 were the highest in the past 5 years. No Korean related loans were nonperforming as of December 31, 2004 and 2003.
The table below summarizes the activity in the Companys allowance for loan losses for the periods indicated.
Allowance for Loan Losses
Allocation of Allowance for Loan Losses
The largest increase in the allocated allowance was for commercial real estate loans, an increase of $2.3 million or 63% to $5.9 million during 2004 compared to $3.7 million in 2003. The increase in the allocated allowance for 2004 was primarily due to the increase in loan volume. Because commercial real estate loans are secured by real estate and historically have a low charge-off ratio, commercial real estate loans required a somewhat lower reserve requirement than other loans. The Company allocated 53% of the total allowance for commercial real estate loans, while the proportion of such loans to the total loan portfolio was 59%.
The allocated allowance for other commercial business loans increased by $405,000 or 18% to $2.7 million at December 31, 2004, compared to $2.3 million as of the December 31, 2003, reflecting 42% growth in this portfolio. At December 31, 2004, the Company allocated 24% of the total allowance to other commercial loans, in spite of the fact that the ratio of other commercial loans to total loans was only 20%, because the Company has historically experienced the highest percentage losses from this type of loan.
The allocated allowance for other trade finance loans increased $201,000 or 30% to $875,000 during 2004, compared to $674,000 as of December 31, 2003, as a result of an increase in the volume of bankers acceptances with investment grade Korean banks and the Korean government backed National Federation of Fisheries. Bankers acceptances rely upon repayment at maturity by the accepting bank. Credit exposure related to bankers acceptances is limited by the underlying strength of the accepting bank. However, the Company increased the allocated allowance for trade finance loans due the to higher historical charge-off ratio.
The Company has not substantively changed any aspect of its overall approach in the determination of its allocation of allowance for loan losses in the periods discussed above. There have been no material changes in assumptions or estimation techniques in the periods discussed above that affected the determination of the current year allowance.
The following table provides a breakdown of the allowance for loan losses by category as of the dates indicated:
Allocation of Allowance for Loan Losses