Center Financial 10-K 2008
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended December 31, 2007
For the transition period from ____ to ____.
Commission file number: 000-50050
CENTER FINANCIAL CORPORATION
(Exact Name of Registrant as Specified in its Charter)
Registrants telephone number, including area code - (213) 251-2222
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in rule 405 of the Securities Act.
¨ Yes x No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15 (d) of the Act.
¨ Yes x No
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.
x Yes ¨ No
Indicate by 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 or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of Exchange Act:
Large accelerated filer ¨ Accelerated Filer x Non-accelerated filer ¨ Smaller reporting company ¨
Indicate by check mark whether the registrant is a shell company (as defined in rule 12b-2 of the Act). ¨ Yes x No
As of June 29, 2007, the aggregate market value of the voting stock held by nonaffiliates of the Registrant computed by reference to the reported closing sale price of $16.92 on such date was $216.8 million. Excluded from this computation are 3,908,908 shares held by all directors and executive officers as a group on that date.
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 January 31, 2008 was 16,366,791.
DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the definitive proxy statement for the 2008 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
This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and 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 Recent Development, Risk Factors, Legal Proceedings, 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. Forward-looking statements often use words such as anticipate, believe, estimate, expect and intend and words or phrases of similar meaning. 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, or 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 expressed or implied herein. The Company disclaims any obligations or undertaking to publicly release any updates or revisions to any forward-looking statement contained herein (or elsewhere) to reflect any change in the Companys expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.
Center Financial Corporation
Center Financial Corporation (Center Financial) 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, Center Financials only other direct subsidiary is Center Capital Trust I, a Delaware statutory business trust that 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.) As used herein, the term Center Financial is used to designate Center Financial Corporation only, the term the Bank is used to designate Center Bank and its subsidiary (CB Capital Trust) and the term the Company refers 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.
Center Financials principal source of income is currently dividends from the Bank, but it intends to explore supplemental sources of income in the future. 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 Center Financial by the Bank. The Companys liabilities include $18.6 million in debt obligations due to Center Capital Trust I, related to capital trust pass-through securities issued by that entity.
At December 31, 2007, the Company had consolidated assets of $2.1 billion, deposits of $1.6 billion and shareholders equity of $157.5 million.
The Companys and the Banks headquarters are located at 3435 Wilshire Boulevard, Suite 700, Los Angeles, California 90010 and its telephone number is (213) 251-2222. Our Website address is www.centerbank.com. Information contained on the web site is not part of this report.
Center Bank and Subsidiary
The Bank is a California state-chartered and Federal Deposit Insurance Corporation (FDIC) insured financial institution, 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 Bank provides comprehensive financial services for small to medium sized business owners, primarily in Southern California. The Bank specializes in commercial loans, which are mostly secured by real property, to small
business customers. In addition, the Bank is a Preferred Lender of Small Business Administration (SBA) loans and provides trade finance loans. The Banks primary market is the greater Los Angeles metropolitan area, including Los Angeles, Orange, San Bernardino, and San Diego counties, primarily focused in areas with high concentrations of Korean-Americans. The Bank currently has 18 full-service branch offices, 15 of which are located in Los Angeles, Orange, San Bernardino, and San Diego counties. The Bank opened all California branches as de novo branches. On April 26, 2004, the Bank completed its acquisition of the Korea Exchange Bank (KEB) Chicago branch, the Banks first out-of-state branch, with a focus on the Korean-American market in Chicago. The Bank assumed $12.9 million in FDIC insured deposits and purchased $8.0 million in loans from the KEB Chicago branch. The Bank opened two new branches in Irvine, California and Seattle, Washington in 2005. The Bank opened a new branch in Federal Way, Washington in November 2007. The Bank also operates eight Loan Production Offices (LPOs) in Seattle, Denver, Washington D.C., Las Vegas, Atlanta, Dallas, Houston and Northern California.
CB Capital Trust, a Maryland real estate investment trust (REIT), which is a consolidated subsidiary of the Bank, was formed in August 2002 for the primary business purpose of investing in the Banks real-estate related assets, and enhancing and strengthening the Banks capital position and earnings primarily through tax advantaged income from such assets. On December 31, 2003, the California Franchise Tax Board issued an opinion listing bank-owned REITs as potentially abusive tax shelters subject to possible penalties, and stating that REIT consent dividends are not deductible for California state income tax purposes. In view of this opinion, it was determined that the REIT will not be able to fulfill its original intended purposes, and it was dissolved in December 2007.
The Banks 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 and consumer banking services. The Bank offers bilingual services to its customers in English and Korean and has a network of ATMs located in sixteen of its branch offices.
The Bank engages in a full complement of lending activities, including the origination of commercial real estate loans, commercial loans, working capital lines, SBA loans, trade financing, automobile loans and other personal loans, and construction loans. The Bank 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 Bank is a Preferred SBA Lender with full loan approval authority on behalf of the SBA.
The Bank also participates in the SBAs Export Working Capital Program. SBA loans are generally secured by deeds of trust on industrial buildings or retail establishments. The Bank regularly sells a portion of the guaranteed and unguaranteed portion of the SBA loans it originates. The Bank retains the obligation to service the loans and receives a servicing fee. As of December 31, 2007, the Bank was servicing $117.5 million of sold SBA loans.
As of December 31, 2007, the principal areas of focus related to the Banks lending activities, and the percentage of total loan portfolio composition for each of these areas, were as follows: commercial loans secured by first deeds of trust on real estate 66.0%; commercial loans 17.2%; SBA loans 3.9%; trade financing 3.7%; and consumer loans 5.5%. The Bank funds its lending activities were funded primarily with demand deposits, savings and time deposits (obtained through its branch network) and Federal Home Loan Bank (FHLB) borrowings. The Banks deposit products include demand deposit accounts, money market accounts, and savings accounts, time certificates of deposit and fixed maturity installment savings. The Banks deposits are insured under the Federal Deposit Insurance Act, up to the maximum applicable limits thereof. Like most state-chartered banks of Center Banks size in California, it is not currently a member of the Federal Reserve System. As of December 31, 2007, the Bank had approximately 47,000 deposit accounts with balances totaling approximately $1.6 billion. As of December 31, 2007, the Bank had $363.5 million or 23.0% in non-interest bearing demand deposits; $244.2 million or 15.5% in money market and NOW accounts; $54.8 million or 3.5% in savings accounts; $112.6 million or 7.1% in time deposits less than $100,000; and $802.5 million or 50.9% in time deposits of more than $100,000. As of December 31, 2007, the State of California had a time deposit of $75.0 million and brokered deposits of $70.3 million with the Bank.
The Bank also offers international banking services such as letters of credit, acceptances and wire transfers, as well as merchant deposit services, travelers checks, debit cards and safe deposit boxes.
The Bank provides Internet banking services to allow its customers to access their loan and deposit accounts through the Internet. Customers can obtain transaction history and account information, transfer funds between the Banks accounts and process bill payments. The Bank implemented real-time online Internet banking in April 2005.
The Bank does not hold any patents or licenses (other than licenses required to be obtained from appropriate banking regulatory agencies), franchises or concessions. The Banks business is generally not seasonal. Federal, state and local environmental regulations have not had any material effect upon our capital expenses, earnings or competitive position.
For 2007, 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 59.7%, 21.8%, 4.9% and 7.3%, respectively, of our total revenues. The Bank is not dependent on a single customer or group of related customers for a material portion of its deposits or loans, nor is a material portion of its loans concentrated within a single industry or group of related industries. Most of our customers are concentrated in the greater Los Angeles area but efforts have been made in the last several years to diversify the geographic risk with branches in Chicago and Seattle and LPOs strategically located throughout the country.
The Bank has 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, the Bank, with its officers and employees, is engaged continually in marketing activities, including the evaluation and development of new services, which enable it to retain and improve our competitive position in our service area.
On September 18, 2007, Center Financial entered into a definitive agreement to acquire First Intercontinental Bank (FICB), a Georgia State chartered commercial bank with assets of approximately $224.7 million as of September 30, 2007, for an aggregate purchase price of approximately $65.2 million. Under the agreement, Center Financial will acquire all outstanding shares of FICB for consideration consisting of 60% cash and 40% in Center Financials common stock. FICB shareholders may elect to receive cash, stock or a combination of both. As part of the total consideration, Center Financial will pay approximately $3.6 million related to the outstanding stock options of FICB.
Under the agreement, FICB will be merged into a newly formed Georgia state-chartered banking subsidiary of Center Financial that will operate under the First Intercontinental Bank name. Center Financial will become a multi-bank holding company with the Bank and FICB as its two wholly-owned banking subsidiaries.
The closing of the transaction is subject to the approvals of the Federal Reserve Board, the FDIC and the Georgia Department of Banking and Finance, as well as the approval of FICBs shareholders. The acquisition is expected to close in the second quarter of 2008.
Organized in 2000, FICB is a Georgia state-chartered commercial bank headquartered in Doraville, Georgia, a commercial business center of Atlantas Asian community. FICB currently operates four full-service branches, one located in Doraville, two in Duluth and one in Suwannee, all in Georgia, targeting the Korean-American and other ethnic communities in the greater Atlanta metropolitan area.
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 current banking business and intended future strategic market areas are highly competitive with respect to virtually all products and services and have become increasingly so in recent years. While the Banks primary market area is generally dominated by a relatively small number of major banks with many offices operating over a wide geographic area, the Banks direct competitors in the niche markets are three Korean American banks of which two are comparable in size and one twice the size in assets, which also focus their business strategy on the Korean-American consumers and businesses.
There is significant competition within this specific market. In the greater Los Angeles, Chicago and Seattle metropolitan areas, the Banks main competitors are locally owned and operated Korean-American banks and subsidiaries of Korean banks. These competitors have branches located in many of the same neighborhoods as the Bank, 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 is 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 the Banks customer base primarily in Southern California, the competitive influence of these major bank branches could increase in the event they choose to focus on this market. 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 (some of which the Bank can offer through the use of correspondent institutions). By virtue of their greater total capitalization, such banks also have substantially higher lending limits than the Bank.
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 the Bank is affected by more general competitive trends in the industry, those trends are towards increased consolidation and competition. Unregulated competitors have entered banking markets with strategies directly targeted at the Banks customers. 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. Consolidation of the banking industry has placed additional pressure on surviving community 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.
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. Other 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, the Bank provides quality, personalized, friendly service and fast decision making to better serve our customers needs. For customers whose loan demands exceed the Banks lending limit, the Bank has attempted to establish relationships with correspondent banks for the development of such loans on a participation basis. The Bank also maintains 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, the Bank offers Internet banking services to allow its customers to access their loan and deposit accounts through the Internet. Customers can obtain transaction history and account information, transfer funds between bank accounts and process bill payments.
The market for the origination of SBA loans is highly competitive. With respect to the origination of SBA loans, the Bank competes with other small, mid-size and major banks in the geographic areas in which our full service branches are located. The Bank also has eight LPOs, all of which emphasize SBA loans. Because these loans are largely broker-driven, the Bank also competes with banks located outside of our immediate geographic area. As the Bank has 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 that are not Preferred SBA Lenders. In order to compete in this highly competitive market, the Bank places greater 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, the Bank has had no difficulty in the resale of SBA loans within the secondary market. Due to the recent credit crunch, pricing of SBA premiums declined approximately 15 to 20% compared to the beginning of 2007 but there still exists adequate profits in SBA loan sales. 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, 2007, the Company had 368 total employees and 361 full-time employees.
Supervision and Regulation
Both federal and state laws extensively regulate bank holding companies. These regulations are intended primarily for the protection of depositors and the deposit insurance fund and not for the benefit of shareholders. The following is a summary of particular statutes and regulations affecting Center Financial and the Bank. This summary is qualified in its entirety by the statutes and regulations. On December 12, 2006, Interagency Guidance on Concentrations in Real Estate Lending Sound Risk Management Practices was issued. The Bank falls under the provisions of the Interagency Guidance.
Regulation of Center Financial Corporation Generally
Center Financials stock is traded on the NASDAQ Global Select Market under the symbol CLFC, and as such the Company is subject to NASDAQ rules and regulations including those related to corporate governance. Center Financial is also 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, current and other reports with the Securities and Exchange Commission (the SEC). The Company is 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 Center Financials common stock and short-swing profits rules promulgated by the SEC under Section 16 of the Exchange Act; and certain additional reporting requirements to Center Financials 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.
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 companies debt, including the authority to impose interest rate ceilings and reserve requirements on such debt. Under certain circumstances, the Federal Reserve Board may require a bank holding company to file written notice and obtain its approval prior to purchasing or redeeming our equity securities, unless certain conditions are met.
Regulation of Center Bank Generally
As a California state-chartered bank whose accounts are insured by the FDIC up to the maximum limits thereof, the Bank is subject to regulation, supervision and regular examination by the California Department of Financial Institutions (DFI) and the FDIC. In addition, while the Bank is not a member of the Federal Reserve System, the Bank is 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 are generally intended to protect depositors and are 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 the 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 non-cumulative 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, that qualifies as Tier 2 capital is limited to 100% of Tier 1 capital, net of goodwill.
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, 2007 and 2006, the Banks Total Risk-Based Capital Ratios were 10.19% and 10.42%, respectively, and its Tier 1 Risk-Based Capital Ratios were 9.08% and 9.33%, respectively. As of December 31, 2007 and 2006, the Companys consolidated Total Risk-Based Capital Ratios were 10.42% and 10.54%, respectively, and its Tier 1 Risk-Based Capital Ratios were 9.31% and 9.45%, respectively.
The risk-based capital requirements also take into account concentrations of credit involving 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.
Additionally, the regulatory Statements of Policy on risk-based capital include exposure to interest rate risk as a factor that the regulators will consider in evaluating an institutions capital adequacy, although interest rate risk does not impact the calculation of risk-based capital ratios. 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. Both the Company and the Bank were well capitalized as of December 31, 2007.
On March 1, 2005, the Federal Reserve Board 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 that could qualify as Tier I capital would be limited to 25 percent of Tier I capital elements, net of goodwill. As of December 31, 2007, trust preferred securities made up 10.4% of the Companys Tier I capital.
The following table sets forth Center Financials and the Banks capital ratios at December 31, 2007 and 2006:
Risk Based Ratios
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%). The most recent notification from the FDIC in May 2007 categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. 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 bonuses or increasing compensation to senior executive officers 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 Banks deposits are insured under the Federal Deposit Insurance Act, up to the maximum applicable limits by the Deposit Insurance Fund (DIF) of the FDIC and are subject to deposit insurance assessments to maintain the DIF. The Bank paid no deposit insurance assessments on its deposits under the risk-based assessment system utilized by the FDIC through December 31, 2006.
In November 2006 the FDIC adopted a new risk-based insurance assessment system effective January 1, 2007 designed to tie what banks pay for deposit insurance more closely to the risks they pose. The FDIC also adopted a new base schedule of rates that the FDIC can adjust up or down, depending on the needs of the DIF, and set initial premiums for 2007 that range from 5 cents per $100 of domestic deposits in the lowest risk category to 43 cents per $100 of domestic deposits for banks in the highest risk category. The new assessment system resulted in increased annual assessments on the deposits of the Bank of 5 cents per $100 of domestic deposits. An FDIC credit available to the Bank for prior contributions offset the assessments for 2007 and was fully utilized in its second quarter assessment.
In addition, banks must pay an amount, which fluctuates but is currently 0.285 cents per $100 of insured deposits, on a quarterly basis, 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
The 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. The Bank was last examined for CRA compliance in 2006 and received a satisfactory CRA Assessment Rating.
Privacy and Data Security
The Gramm-Leach-Bliley Act imposed new requirements on financial institutions with respect to consumer privacy. The statute generally prohibits disclosure of consumer information to non-affiliated third parties unless the consumer has been given the opportunity to object and has not objected to such disclosure. Financial institutions are further required to disclose their privacy policies to consumers annually. Financial institutions, however, will be required to comply with state law if it is more protective of consumer privacy than the Gramm-Leach-Bliley Act. The statute also directed federal regulators, including the Federal Reserve and the FDIC, to prescribe standards for the security of consumer information. The Company and the Bank are subject to such standards, as well as standards for notifying consumers in the event of a security breach.
Other Consumer Protection Laws and Regulations
Activities of all insured banks are subject to a variety of statutes and regulations designed to protect consumers, such as including the Fair Credit Reporting Act, Equal Credit Opportunity Act, and Truth-in-Lending Act. Interest and other charges collected or contracted for by the Bank are also subject to state usury laws and certain other federal laws concerning interest rates. The Banks loan operations are also subject to federal laws and regulations applicable to credit transactions. Together, these laws and regulations include provisions that:
The Banks deposit operations are also subject to laws and regulations that:
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 the Interstate Banking Act and California laws have increased competition in the environment in which the Bank operates to the extent that out-of-state financial institutions directly or indirectly enter the 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 the Bank and Center Financial and the competitive environment in which they operate.
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 impact of the Patriot Act on financial institutions of all kinds has been significant and wide ranging. The Patriot Act substantially enhanced existing anti-money laundering and financial transparency laws, and required appropriate regulatory authorities to adopt rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. Under the Patriot Act, financial institutions are subject to prohibitions regarding specified financial transactions and account relationships, as well as enhanced due diligence and know your customer standards in their dealings with foreign financial institutions and foreign customers. For example, the enhanced due diligence policies, procedures, and controls generally require financial institutions to take reasonable steps:
The Patriot Act also requires all financial institutions to establish anti-money laundering programs, which must include, at minimum:
To fulfill the requirements, the Bank expanded its BSA Compliance Department and intensified due diligence procedures concerning the opening of new accounts. The Bank also implemented new systems and procedures to identify suspicious activity reports and report to the Financial Crimes Enforcement Network (FINCEN). The substantial 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, 2007, 2006 and 2005.
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 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 audit the operating effectiveness of these controls.
Commercial Real Estate Lending and Concentrations
On December 2, 2006, the federal bank regulatory agencies released Guidance on Concentrations in Commercial Real Estate (CRE) Lending, Sound Risk Management Practices (the Guidance). The Guidance, which was issued in response to the agencies concern that rising CRE concentrations might expose institutions to unanticipated earnings and capital volatility in the event of adverse changes in the commercial real estate market, reinforces existing regulations and guidelines for real estate lending and loan portfolio management.
Highlights of the Guidance include the following:
The Bank believes that the Guidance is applicable to it, as it has a concentration in CRE loans. The Bank and its board of directors have discussed the Guidance and believe that that the Banks underwriting policy, management information systems, independent credit administration process and monthly monitoring of real estate loan concentrations will be sufficient to address the Guidance. With respect to its CRE portfolio as of December 31, 2007, the Bank believes that the risks typically associated with high CRE concentration are mitigated by such factors as low loan-to-value ratios, adequate debt coverage ratios and a well diversified CRE loan portfolio.
Allowance for Loan and Lease Losses
On December 13, 2006, the federal bank regulatory agencies released Interagency Policy Statement on the Allowance for Loan and Lease Losses (ALLL), which revises and replaces the banking agencies 1993 policy statement on the ALLL. The revised statement was issued to ensure consistency with generally accepted accounting principles (GAAP) and more recent supervisory guidance. The revised statement extends the applicability of the policy to credit unions. Additionally, the agencies issued 16 FAQs to assist institutions in complying with both GAAP and ALLL supervisory guidance.
Highlights of the revised statement include the following:
The Bank and its board of directors have discussed the revised statement and believe that the Banks ALLL methodology is comprehensive, systematic, and that it is consistently applied across the Bank. The Bank believes its management information systems, independent credit administration process, policies and procedures are sufficient to address the guidance.
Fiscal and Monetary Policy
Banking is a business that depends on interest rate differentials. In general, the difference between the interest paid by a bank on its deposits and its other borrowings, and the interest received by a bank on its loans and securities holdings, constitutes the major portion of a banks earnings. Thus, the Companys earnings and growth will be subject to the influence of economic conditions generally, both domestic and foreign, and also to the monetary and fiscal policies of the United States and its agencies, particularly the Federal Reserve. The Federal Reserve regulates the supply of money through various means, including open market dealings in United States government securities, the discount rate at which banks may borrow from the Federal Reserve, and the reserve requirements on deposits.
These policies have a direct effect on the amount of the Companys loans and deposits and on the interest rates charged on loans and paid on deposits, with the result that federal policies may have a material effect on the Companys earnings. Policies that are directed toward changing the supply of money and credit and raising or lowering interest rates may have an effect on the Companys earnings. It is not possible to predict the conditions in the national and international economies and money markets, the actions and changes in policy by monetary and fiscal authorities, or their effect on the Companys operations.
Memorandum of Understanding
On May 10, 2005, the Bank entered into a memorandum of understanding (the MOU) with the FDIC and the DFI, primarily concerning the Banks compliance with Bank Secrecy Act (BSA) regulations. In accordance with the MOU, the Bank agreed, among other things, to (i) implement a written action plan, policies and procedures, and comprehensive independent compliance testing to ensure compliance with all BSA-related rules and regulations; (ii) correct any apparent BSA violations previously disclosed by the FDIC; and (iii) develop the expertise to ensure that generally accepted accounting principles and regulatory reporting guidelines are observed in all of the Banks financial transactions and reporting. Effective May 17, 2007, the MOU was terminated by the FDIC and the DFI as a result of the Banks remediation of the above issues.
Other Pending and Proposed Legislation
Other legislative and regulatory initiatives, which could affect Center Financial, the 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 Financial and the Bank 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 the 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 the Companys common stock. The risks and uncertainties described below are not the only ones the Company faces. Additional risks and uncertainties not presently known to the Company or that the Company currently believes are immaterial but may also impair the Companys business. If any of the events described in the following risk factors occur, the Companys business, results of operations and financial condition could be materially adversely affected. In addition, the trading price of the Companys common stock could decline due to any of the events described in these risks.
Changes in economic conditions in our market areas could hurt our business materially.
A substantial majority of our loans are generated in the greater Los Angeles area of Southern California. The Los Angeles area has, at times, experienced a stagnant economic activity in line with slowdowns in California. The State of California continues to face challenges with the subprime mortgage situation upon which the long-term impact on the States economy cannot be predicted. A deterioration in economic conditions in Southern California is occurring, whether caused by national concerns or local concerns, and this may result in higher than expected loan delinquencies or problem assets, a decline in the values of the collateral that we take to secure our loan portfolio, a decrease in demand for our products and services, or lack of growth or a decrease in low cost or non-interest bearing deposits; any of which may materially hurt our business. While our market areas have not experienced the same degree of challenges as other parts of the state, no assurance can be given that this will continue to be the case. As of December 31, 2007, the Company had no nonperforming commercial real estate loans and no subprime mortgage loans
Concentrations of real estate loans could subject us to increased risks in the event of a real estate recession or natural disaster.
Approximately $1.3 billion or 69.8% of the Companys loan portfolio as of December 31, 2007, and $1.1 billion or 69.7% of the Companys loan portfolio as of December 31, 2006, were concentrated in commercial real estate and construction loans. Of this amount, $322.6 million represented loans secured by industrial buildings, and $171.7 million represented loans secured by retail shopping centers as of December 31, 2007. 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. The Southern California real estate market ended 2006 with declining prices and a slower sales pace and has maintained these levels into 2007. If real estate sales and appreciation continue to weaken, the Company might experience an increase in nonperforming assets in its commercial real estate and commercial and industrial loan portfolios. The result of such an increase result could be reduced income, increased expenses, and less cash available for lending and other activities. Such an increase may have a material impact on the Companys financial condition and results
of operations, by reducing the Companys income, increasing the Companys expenses, and leaving less cash available for lending and other activities. Total nonperforming loans increased to $6.3 million as of December 31, 2007 from $3.3 million as of December 31, 2006, representing 0.35% and 0.21%, respectively, of total loans. Total nonperforming loans, net of SBA guarantees, were $3.9 million as of December 31, 2007 as compared to $2.3 million as of December 31, 2006. The increases were the result of additions to non-accrual status in the Companys SBA, trade finance and consumer loan portfolio offset by the reductions in the commercial loan portfolios. As of December 31, 2007 and 2006, the Company had no nonperforming commercial real estate loans and no subprime mortgage loans.
As the primary collateral for many of the Companys loans rests on commercial real estate properties, deterioration in the real estate market in the areas the Company serves could reduce the value of the collateral value for many of the Companys loans and negatively impact the repayment ability of many of its borrowers. Such deterioration would likely also reduce the amount of loans the Company makes to businesses in the construction and real estate industry, which could negatively impact its business. Similarly, the occurrence of a natural disaster like those California has experienced in the past, including earthquakes, brush fires, and flooding, could impair the value of the collateral we hold for real estate secured loans and negatively impact the Companys results of operations.
In addition, the banking regulators have begun to give commercial real estate or CRE loans greater scrutiny, due to perceived risks relating to the cyclical nature of the real estate market and the related risks for lenders with high concentrations of such loans. The regulators may require banks with higher levels of CRE loans to implement improved underwriting, internal controls, risk management policies and portfolio stress testing, and may possibly require higher levels of allowances for possible loan losses and capital levels as a result of CRE lending growth and exposures.
The Company may experience loan losses in excess of its allowance for loan losses.
The Company maintains an allowance for loan losses at a level it believes 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 the Companys control may cause its actual loan losses to exceed current allowance estimates. If the actual loan losses exceed the allowance for loan losses, it would aversely affect the Companys business. In addition, the FDIC and the DFI, as part of their supervisory functions, periodically review the Companys allowance for loan losses. Such agencies may require the Company to increase its provision for loan losses or to recognize further loan losses, based on their judgments, which may be different from those of the Companys management. Any increase in the allowance required by the FDIC or the DFI could also adversely affect the Companys business.
The Company tries to limit the risk that borrowers will fail to repay loans by carefully underwriting the loans. Losses nevertheless occur. The Company establishes a loan loss allowance for probable losses inherent in the loan portfolio as of the statements of financial condition date. The Company bases allowance on estimates of the following:
All of the Companys lending involves underwriting risks, especially in a competitive lending market.
At December 31, 2007, commercial real estate loans represented 66.0% of the Companys total loan portfolio; commercial lines and term loans to businesses represented 17.2% of the Companys total loan portfolio; and SBA loans represented 3.9% of the Companys 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. The Companys dependence on commercial real estate loans 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 seeks to reduce risk of loss through 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, the Company typically takes additional security interests in other collateral, such as real property, certificates of deposit or life insurance, and/or obtains personal guarantees.
Specific risks associated with SBA lending are discussed in a separate risk factor below.
The Company has specific risks associated with Small Business Administration loans.
The Company realized $618,000 $3.3 million, $2.5 million, and $4.2 million in the years ended December 31, 2007, 2006, 2005 and 2004, respectively, in gains recognized on secondary market sales of SBA loans. The Company has regularly sold the guaranteed and unguaranteed portions of these loans in the secondary market in previous years. The Company can provide no assurance that it will be able to continue originating these loans, or that a secondary market will continue to exist for, or that it will continue to realize premiums upon, the sale of the SBA loans. During 2007, management determined that the sale of the guaranteed portions of SBA loans was not in the best interest of the Company. The credit environment recently has negatively impacted the market values of SBA loans by approximately 15 to 20%.
The federal government presently guarantees approximately 75% of the principal amount of each qualifying SBA loan. The Company 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, the Company can provide no assurance that it will retain the preferred lender status, which, subject to certain limitations, allows it 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. The Company believes that the SBA loan portfolio does not involve more than a normal risk of collectibility. However, since the Company has sold some of the guaranteed portions of the SBA loan portfolio, the Company incurs a pro rata credit risk on the non-guaranteed portion of the SBA loans since the Company shares pro rata with the SBA in any recoveries. In the event of default on an SBA loan, pursuit of remedies against a borrower 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 the SBA loans or it may seek the recovery of damages from the Company. As of December 31, 2007, SBA loans comprised 64% of the Companys total nonperforming assets compared to 41% as of December 31, 2006. These loans typically have approximately 75% guaranteed by the SBA. For additional discussion see Managements Discussion and Analysis of Financial Condition and Results of Operations Financial Condition Loan Portfolio in Item 2.
Adverse developments in the Companys litigation could negatively impact the Companys results of operations.
From time to time, the Company or the Bank is involved in litigation. If litigation arises, the Company or the Bank will vigorously enforce and defend its rights. Litigation may result in significant expense to us and divert the efforts of the Companys or the Banks management personnel from their day-to-day responsibilities. In addition, in the event of an adverse result in litigation, the Company or the Bank could also be required to pay substantial damages. The Bank is currently a party to a lawsuit involving substantial claims entitled Korea Export Insurance Corporation v. Korea Data Systems (USA), Inc., et al. If the outcome of this litigation is adverse and the Bank is required to pay significant monetary damages, the Banks financial condition and results of operations are likely to be materially and adversely affected. Although the Bank believes that it has meritorious defenses and intends to vigorously defend these lawsuits, management cannot predict the outcome of this litigation. In addition, the Banks defense of this lawsuit, regardless of its eventual outcome, has been and will likely continue to be costly and time consuming. For a more detailed discussion of this lawsuit, see Item 3Legal Proceedings.
The Company may not be able to continue to attract and retain banking customers at current levels, and its efforts to compete may reduce profitability.
Competition in the banking industry in the markets served and to be served by the Company may limit the Companys ability to continue to attract and retain banking customers. The banking business in the Companys current and intended future market areas is highly competitive with respect to virtually all products and services. While the Companys primary market area is generally dominated by a relatively small number of major banks with many offices operating over a wide geographic area, the Companys
three main competitors in its niche markets are three Korean-American banks of which two are comparable in size and the third is twice its asset size, which also focus their business strategies on Korean-American consumers and businesses. Primary competitors in the greater Chicago and Seattle metropolitan areas are also locally owned and operated Korean-American banks and subsidiaries of Korean banks. These competitors have branches located in many of the same neighborhoods as the Company, 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 Korean-American customer base in Southern California, their competitive influence could increase in the future. Such banks have substantially greater lending limits than the Company, offer certain services the Company cannot, and often operate with economies of scale that result in lower operating costs than the Company on a per loan or per asset basis. In addition to competitive factors impacting the Companys specific market niche, the Company is affected by more general competitive trends in the banking industry, including intra-state and interstate consolidation, competition from non-bank sources and technological innovations. Ultimately, competition can and does increase the Companys cost of funds and drive down its net interest margin, thereby reducing profitability. It can also make it more difficult for the Company to continue to increase the size of its loan portfolio and deposit base, and could cause the Company to need to rely more heavily on borrowings, which are generally more expensive than deposits, as a source of funds in the future. See Item 1, Business Competition.
The Company may have difficulty managing its growth.
The Companys total assets have increased to $2.1 billion as of December 31, 2007 from $1.8 billion and $1.7 billion as of December 31, 2006 and 2005, respectively. The Company opened on average, two new branch offices from 2002 through 2005, one new branch in 2007, and plans to add four additional banking offices in 2008 as a result of the acquisition of First Intercontinental Bank. The Company intends to investigate other opportunities to open additional branches that would complement the Companys existing business as such opportunities may arise; however, the Company can provide no assurance that it will be able to identify additional locations or open additional branches.
The Companys ability to manage its growth will depend primarily on its ability to:
If the Company fails to achieve those objectives in an efficient and timely manner, the Company may experience interruptions and dislocations in its business, which could substantially increase the expenses and negatively impact the ability to retain the Companys 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.
The acquisition of First Intercontinental Bank may subject us to unknown risks.
On September 18, 2007, the Company entered into a definitive agreement to acquire First Intercontinental Bank (FICB), a Georgia state-chartered commercial bank with assets of approximately $225 million as of September 30, 2007. The acquisition involves potential risks that may materially affect the Companys business, results of operations and financial condition as a result of our acquisition of FICB. In addition, the trading price of the Companys common stock could decline due to any of the events described in these risks.
Certain events may arise after the date of the acquisition of FICB, or we may learn of certain facts, events or circumstances after the closing of the acquisition, that may affect our financial condition or performance or subject us to risk of loss. These events include, but are not limited to: litigation resulting from circumstances occurring at FICB prior to the date of acquisition, loan downgrades and credit loss provisions resulting from underwriting of certain acquired loans determined not to meet our credit standards, increased risk from fluctuations in interest rates, delays in implementing new policies or procedures or implementing our internal control over financial reporting at FICB, or the failure to apply new policies or procedures and other events relating to the performance of our business. We also make certain estimates and assumptions in order to determine purchase price allocation and estimate the fair value of acquired assets and liabilities. If our estimates or assumptions used to value acquired assets and liabilities are not accurate, we may be exposed to gains or losses that may be material and possible impairment of goodwill.
Unanticipated costs relating to the merger could reduce the Companys future earnings per share.
The Company believes it has reasonably estimated the likely costs of integrating the operations of FICB into the Company and the incremental costs of operating as a combined company. However, it is possible that unexpected transaction costs such as taxes, fees or professional expenses or unexpected future operating expenses such as increased personnel costs or increased taxes, as well as other types of unanticipated adverse developments, could have a material adverse effect on the results of operations and financial condition of the Company after the merger. If unexpected costs are incurred, the merger could have a significant dilutive effect on the Companys earnings per share. In other words, if the merger is completed and the Company incurs such unexpected costs and expenses as a result of the merger, the Company believes that the earnings per share of the Companys common stock could be less than they would have been if the merger had not been completed. FICB had total assets of approximately $225 million as of September 30, 2007, compared to $183 million, $131.4 million and $96.2 million as of December 31, 2006, 2005 and 2004, respectively.
The Company may be unable to successfully integrate FICBs operations and retain key FICBs employees.
The merger involves the integration of two companies that have previously operated independently. The difficulties of combining the companies operations include:
The process of integrating operations could cause an interruption of, or loss of momentum in, the activities of one or more of the combined companys businesses and the loss of key personnel. The integration of the two companies will require the experience and expertise of certain key employees of First Intercontinental who are expected to be retained by the Company. There can be no assurances, however, that the Company will be successful in retaining these employees for the time period necessary to successfully integrate FICBs operations with those of the Company. Four of FICBs senior personnel the Chief Executive Officer, the Chief Financial Officer, the Chief Operating Officer, and the Senior Loan Officer recently resigned. The Chief Executive Officer and the Senior Loan Officer have been replaced. The Company is working very closely with FICB to appoint additional replacement officers and to assist in overseeing and supporting critical functions in order to maintain the business momentum during the interim period until the closing. The Company plans to replace some, but not all, of the vacant positions effective as of the closing. The diversion of managements attention and any delays or difficulties encountered in connection with the merger and the integration of the two companies operations could have an adverse effect on the business and results of operations of the combined company. As with any merger of banking institutions, there also may be business disruption that causes the Company and FICB to lose customers or cause customers to take their deposits or move their loans out of our banks and move their business to other financial institutions.
The Company may face risks with respect to future expansion and acquisitions or mergers.
The Company expects to acquire other financial institutions or parts of those institutions, and to continue to engage in de novo branch expansion in the future. The Company may also consider and enter into new lines of business or offer new products or services. Acquisitions and mergers involve a number of risks, including:
The Company depends on its executive officers and key personnel to implement its business strategy and could be harmed by the loss of their services.
The Company believes that its growth and future success will depend in large part upon the skills of its management team. The competition for qualified personnel in the financial services industry is intense, and the loss of the Companys key personnel or an inability to continue to attract, retain or motivate key personnel could adversely affect the Companys business. There can be no assurance that the Company will be able to retain its existing key personnel or to attract additional qualified personnel. The Companys President and Chief Executive Officer joined the Company in January 2007; its Executive Vice President and Chief Financial Officer joined the Company in an acting capacity in February 2007 and as permanent Chief Financial Officer in April 2007; its Executive Vice President and General Counsel joined the Company in February 2007; its Senior Vice President and Chief Credit Officer joined the Company in 1991 as Senior Vice President and Manager of the SBA Department, and was promoted to his current position in April 2007; and its Senior Vice President and Chief Lending Officer joined the Company in April 2006 as Senior Vice President and Chief Marketing Officer, and was promoted to her current position in April 2007. While the President and Chief Executive Officer has a 3-year employment agreement for a term beginning in January 2007, his employment may be terminated by him or by the Company at any time. None of the Companys other officers have employment agreements.
The Companys 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 and 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 the Companys control. Fluctuations in interest rates affect the demand of customers for products and services. The Company is subject to interest rate risk to the degree that interest-bearing liabilities reprice or mature more slowly or more rapidly or on a different basis than interest-earning assets. Given the current volume and mix of interest-bearing liabilities and interest-earning assets, the interest rate spread could be expected to decrease during times of rising interest rates and, conversely, to increase during times of falling interest rates. Therefore, significant fluctuations in interest rates may have an adverse or a positive effect on results of operations. See Item 7, Managements Discussion and Analysis of Financial Condition and Results of OperationsInterest Rate Risk.
Center Financial might not be able to continue to pay cash dividends in the future.
As a bank holding company which currently has no significant assets other than Center Financials equity interest in the Bank, Center Financials ability to pay dividends depends on the dividends it receives from the Bank. The dividend practice of the Bank depends on its earnings, financial position, current and anticipated cash requirements and other factors deemed relevant by its 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, it may not make any dividends or distributions with respect to our capital stock. See Item 7Managements Discussion and Analysis of Financial Condition and Results of OperationsCapital Resources.
Center Financial paid quarterly cash dividends of 5 cents per share in July and October 2007 and 4 cents per share in January and April of 2007 and in each quarter of 2006 and 2005, Center Financial currently plans 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 future performance will justify the payment of dividends in any particular quarter. As a legal entity separate and distinct from its subsidiaries, substantially all of Center Financials revenue and cash flow, including funds available for the payment of dividends and other operating expenses, is dependent upon the payment of dividends from its subsidiaries. Dividends payable to Center Financial by the Bank are restricted under California and federal laws and regulation. See Item 5, Market for Common Equity and Related Shareholder MattersDividends.
Center Financials and the Banks directors and executive officers control a large amount of the Companys stock and shareholders interests may not always be the same as those of the board and management.
As of December 31, 2007, the Companys directors and executive officers together with their affiliates beneficially owned approximately 23.8% of Companys 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 Center Financials directors and executive officers may be different from the shareholders. However, Center Financials 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 contained in Center Financials Articles of Incorporation may delay or prevent a change in control of the Company or its management
These provisions include:
These provisions may make it more difficult for another company to acquire the Company, which could reduce the market price of the companys common stock and the price that the shareholder may ultimately receive when their stock is sold.
The Board of Directors has recently approved an amendment to the Companys Articles of Incorporation which would eliminate the staggered terms of office for directors and re-institute the annual election of directors, subject to approval of the shareholders at the 2008 Annual Meeting of Shareholders.
The Company is subject to extensive regulation that could limit or restrict its activities.
The Company operates in a highly regulated industry and is subject to examination, supervision, and comprehensive regulation by various federal and state agencies. The Companys compliance with these regulations is costly and restricts certain of its activities, including payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits and locations of offices. The Company is also subject to capitalization guidelines established by its regulators, which require the Company to maintain adequate capital to support its growth.
The laws and regulations applicable to the banking industry could change at any time, and the Company cannot predict the effects of these changes on its business and profitability. Because government regulation greatly affects the business and financial results of all commercial banks and bank holding companies, the Companys cost of compliance could adversely affect its ability to operate profitably.
The Sarbanes-Oxley Act of 2002, and the related rules and regulations promulgated by the Securities and Exchange Commission and NASDAQ that are now applicable to the Company, have increased the scope, complexity and cost of corporate governance, reporting and disclosure practices.
The Company may incur additional costs for environmental clean up.
The cost of cleaning up or paying damages or penalties associated with environmental problems could increase the Companys operating expenses. If a borrower defaults on a loan secured by real property, the Company will often purchase the property in foreclosure or accept a deed to the property surrendered by the borrower. The Company also could be compelled to assume the
management responsibilities of commercial properties whose owners have defaulted on their loans. The Company also leases premises for its branch operations and corporate office in locations where environmental problems may exist. Although the Company has lending and facility leasing guidelines intended to identify properties with an unreasonable risk of contamination, hazardous substances may exist on some of these properties. As a result, environmental laws could force the Company to clean up the hazardous waste located on these properties (at the Companys expense) and cost might exceed their fair market value. Further, even if environmental laws did not hold the Company responsible for the environmental clean up of such properties, it might be difficult or impossible to sell properties until the environmental problems were remediated.
The Companys headquarters are located at 3435 Wilshire Boulevard, Los Angeles, California 90010. The Company leases approximately 25,000 square feet, which includes a ground floor branch and administrative offices located on the third and seventh floor of the building. The lease term expires in 2011. The Company has an option to renew the lease for an additional five years after expiration of the current lease.
As of December 31, 2007, the Company operated full-service branches at sixteen leased locations (including the branch described in the previous paragraph). Expiration dates of the Companys leases range from April 2008 to September 2019. The Company owns two facilities, the Olympic and Western branches, with carrying values of $955,000 and $2.4 million, respectively, at December 31, 2007. Certain properties currently leased have renewal options, which could extend the use of the facility for additional specified terms. In the opinion of Management, all properties are adequately covered by insurance and existing facilities are considered adequate for present and anticipated future use.
From time to time, the Company or the Bank is a party to claims and legal proceedings arising in the ordinary course of business. With the exception of the potentially adverse outcome in the litigation herein described, after taking into consideration information furnished by counsel as to the current status of these claims and proceedings, management does not believe that the aggregate potential liability resulting from such proceedings would have a material adverse effect on the Companys or the Banks financial condition or results of operations.
KEIC Claims - In March 2003, 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 seeks 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 the Bank based on a claim that, in its capacity as a presenting bank for these bills of exchange, the Bank acted negligently in presenting and otherwise handling trade documents for collection.
Korean Bank Claims - In July 2006 the Bank was served with cross-claims from a number of Korean banks who are also third party defendants in the KEIC action. The Korean banks are Citibank Korea, Inc. (formerly known as KorAm Bank), Industrial Bank of Korea, Kookmin Bank, Korea Exchange Bank and Hana Bank (hereinafter the Korean Banks). The Korean Banks allege, in both suits, various claims for breach of contract, negligence, negligent misrepresentation and breach of fiduciary duty in the handling of similar but a different set of documents against acceptance transactions that occurred in the years 2000 and 2001. The total amount of the Korean Bank claims is approximately $46.1 million plus interest and punitive damages. These claims are in addition to KEICs claims against the Bank in the approximate amount of $56 million originally filed in March 2003.
Status of the Consolidated Action - The claims brought by KEIC and the Korean Banks, which total approximately $100 million, have been consolidated into a single action. The consolidated action was recently remanded back from the federal to the state court. In November 2005, the Orange County Superior Court had dismissed all claims of KEIC against the Bank in the state court on the grounds that federal courts have exclusive jurisdiction over the claims. In December 2006, the court of appeals reversed the earlier decision by the state court and remanded the case back to the state court. No trial date has been set.
If the outcome of this litigation is adverse and the Bank is required to pay significant monetary damages, the Companys financial condition and results of operations are likely to be materially and adversely affected. Although the Bank believes that it has meritorious defenses and intends to vigorously defend these lawsuits, management cannot predict the outcome of this litigation.
Center Financials common stock has been listed on the NASDAQ Global Select Market under the symbol CLFC since October 29, 2002 (the day after the completion of the holding company reorganization). The information in the following table indicates the high and low sales prices and approximate volume of trading for the Companys common stock for the periods indicated, based upon information provided by the NASDAQ Stock Market, LLC.
As of February 18, 2008, there were approximately 159 shareholders of record of the common stock, and about 1,320 street name holders.
As a bank holding company, which currently has no significant assets other than its equity interest in the Bank, Center Financials ability to pay dividends primarily depends upon the dividends received from the Bank. The dividend practice of the Bank, like the Companys dividend practice, will depend upon its earnings, financial position, current and anticipated cash requirements and other factors deemed relevant by the Banks board of directors at that time.
Since October 2003, Center Financial has paid quarterly cash dividends to its shareholders. Center Financial paid cash dividends of 4 cents per share throughout 2006 and in January and April 2007, and 5 cents per share in July 2007, October 2007 and January 2008. Center Financial plans to continue to pay quarterly cash dividends in the future, provided that such dividends allow it to continue to meet regulatory capital requirements and are not overly restrictive to its growth capacity. However, no assurance can be given that future earnings and/or growth expectations in any given year will justify the payment of such a dividend and any such dividend will be at the sole discretion of Center Financials board of directors.
The Banks ability to pay cash dividends 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.
Center Financials ability to pay dividends is also limited by state corporation law. The California General Corporation Law allows dividends to the companys shareholders if the companys retained earnings equal at least the amount of the proposed dividend. If a California corporation does not have sufficient retained earnings available for the proposed dividend, it may still pay a dividend to its shareholders if it meets two conditions immediately after giving effect to the dividend, but it is extremely unlikely that those conditions would ever be met by the Company. In addition, during any period in which Center Financial has deferred payment of interest otherwise due and payable on its subordinated debt securities, it 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.
Securities Authorized for Issuance under Equity Compensation Plans
The following table provides information as of December 31, 2007 with respect to stock options and restricted stock awards outstanding and available under our 2006 Stock Incentive Plan, which is our only equity compensation plan other than an employee benefit plan meeting the qualification requirements of Section 401(a) of the Internal Revenue Code:
The graph below compares the yearly percentage change in cumulative total shareholders return on the Companys stock with the cumulative total return of (i) of the NASDAQ market index; (ii) all banks and bank holding companies listed on NASDAQ; and (iii) an index comprised of banks and bank holding companies located throughout the United States with total assets of between $1.0 billion and $5.0 billion. The latter two peer group indexes were complied by SNL Financial of Charlottesville, Virginia. The Company reasonably believes that the members of the third group listed above constitute peer issuers for the period from December 31, 2002 through December 31, 2007. The graph assumes an initial investment of $100 and reinvestment of dividends. The graph is not necessarily indicative of future price performance.
Issuer Purchase of Equity Securities
On May 24, 2007, the Company announced a stock buyback program, under which up to $10 million of the Companys issued and outstanding common shares in the open market can be repurchased for a period of twelve months ending in May 2008. Since its inception, the Company has repurchased a total of 373,820 shares at an average price of $12.33 through this program in 2007. At December 31, 2007, approximately $5.4 million was available for repurchase. The share repurchase activity during the year ended December 31, 2007 is as follows:
The following table presents selected historical financial information, concerning the Company, which should be read in conjunction with the Companys audited consolidated financial statements, including the related notes and Managements Discussion and Analysis of Financial Condition and Results of Operations, included elsewhere herein. 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.
This discussion presents Managements analysis of the Companys financial condition and results of operations as of, and for each of the years in the three-year period ended December 31, 2007, and include 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 Annual Report (See Item 8 below). All share and per share information set forth herein has been adjusted to reflect stock splits and stock dividends declared by the Company from time to time.
Critical Accounting Policies
Accounting estimates and assumptions discussed in this section are those that the Company considers to be the most critical to an understanding of its financial statements because they inherently involve significant judgments and uncertainties. The financial information contained in these statements is, to a significant extent, 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, interest rate swaps and share-based compensation. The following is a summary of these accounting policies. In each area, the Company has identified the variables most important in the estimation process. The Company has used the best information available to make the estimations necessary to value the related assets and liabilities. Actual performance that differs from the Companys estimates and future changes in the key variables could change future valuations and impact net income.
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 the Companys 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 shareholders equity (accumulated comprehensive other income or loss) and do not affect earnings until realized (the Company had no securities classified as trading for the periods included in this report). The fair values of the Companys investment securities are generally determined by reference to quoted market prices and reliable independent sources. The Company is obligated to assess, at each reporting date, whether there is an other-than-temporary impairment to the Companys investment securities. Such impairment must be recognized in current earnings rather than in other comprehensive income. Aside from the Fannie Mae preferred stocks that were determined to be impaired and written down as of December 31, 2007, the Company did not have any other investment securities deemed to be other-than-temporarily impaired as of December 31, 2007. Investment securities are discussed in more detail in Note 3 to the consolidated financial statements presented elsewhere herein.
Certain Small Business Administration loans that the Company has the intent to sell prior to maturity are designated as held for sale at origination and 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 loans 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 1 to 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 in the period of impairment.
Allowance for Loan Losses
The Companys 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 the Companys 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 the Companys 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 its methodologies. As the Company adds new products, increases the complexity of the loan portfolio and expands the geographic coverage, the Company will enhance the 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. The Company believes that its methodologies continue to be appropriate given its size and level of complexity. Detailed information concerning the Companys loan loss methodology is contained in Item 7, Managements Discussion and Analysis of Financial Condition and Results of OperationsAllowance for Loan Losses.
Interest Rate Swaps
Part of the Companys asset and liability management strategy has included derivative financial instruments, such as interest rate swaps, with the overall goal of minimizing the impact of interest rate fluctuations. 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. When such swaps qualify for hedge accounting treatment, the change in the fair value of the swaps is recorded as a component of accumulated other comprehensive income in 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. The Company did not use hedge accounting treatment in accounting for its
historical interest rate swaps. Therefore, the difference between the market and book value of these instruments is included in current earnings. During 2006, a loss of $26,000 (an increase in market value of $229,000 and net interest settlement payments of $255,000) was recognized, compared to losses of $586,000 (a decrease in market value of $306,000, loss on termination of swap of $306,000 and net interest settlement receipts of $26,000) for 2005. As of December 31, 2007, the Company had no interest rate swap agreements in place (the Companys only remaining interest rate swap having matured in August 2006).
The Company, in compliance with SFAS No. 133, includes the swap settlement payments in non-interest expense when hedge accounting treatment is not used.
The Company adopted SFAS No. 123R as of January 1, 2006 as discussed in Note 14 to the consolidated financial statements. SFAS No. 123R requires the Company to recognize compensation expense for all share-based payments made to employees and directors based on the fair value of the share-based payment on the date of grant. The Company elected to use the modified prospective method for adoption, which requires compensation expense to be recorded for all unvested stock options beginning in the first quarter of adoption. For all unvested options outstanding as of January 1, 2006, the previously measured but unrecognized compensation expense, based on the fair value at the original grant date, is recognized on a straight-line basis in the Consolidated Statements of Operations over the remaining vesting period. For share-based payments granted subsequent to January 1, 2006, compensation expense, based on the fair value on the date of grant, is recognized in the Consolidated Statements of Operations on a straight-line basis over the vesting period. In determining the fair value of stock options, the Company uses the Black-Scholes option-pricing model that employs the following assumptions:
The Companys stock price volatility and option lives involve managements best estimates at that time, both of which impact the fair value of the option calculated under the Black-Scholes methodology and, ultimately, the expense that will be recognized over the life of the option.
Consolidated net income for the year ended December 31, 2007 was $21.9 million, or $1.31 per diluted share compared to $26.2 million or $1.57 per diluted share in 2006. The following were significant factors related to 2007 results as compared to 2006:
The following are important factors in understanding the Companys 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 funding 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 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 the Companys 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.
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) and (ii) changes in interest rates (rate):
Net interest income was $76.3 million, $71.5 million and $63.5 million for the years ended December 31, 2007, 2006 and 2005, respectively. The 2007 increase in net interest income of $4.8 million, or 6.8% was principally due to increases in the Companys average gross loans which was $254.1 million in 2007 and offset by compression of our net interest margin primarily resulting from a 100 basis point decrease by FOMC in its lending rates, which caused an immediate reduction in the variable rate loan portfolio and a delayed reduction of the Companys costs of its portfolio of time deposits.
Net Interest Margin
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 net interest margin for the years ended December 31, 2007, 2006 and 2005 was 4.23%, 4.53%, and 4.77%, respectively. The 30 basis point decrease in net interest margin in 2007 was due primarily to a reduction in the Federal Reserve lending rates by the FOMC of 100 basis points since September 18, 2007 through the end of the year and to a lesser extent, a change in the loan portfolio mix resulting in a higher portion of the loan portfolio being fixed rate in 2007 as compared to 2006, creating less sensitivity to interest rate changes and general rate increases in funding liabilities. In addition, the slight decrease in demand deposits and the increases in time deposits and in other borrowed funds contributed to the decrease in the net interest margin.
The average yield on loans for 2007 decreased to 8.25%, compared to the increase to 8.52% in 2006 from 7.66% in 2005, a decrease of 27 and an increase of 86 basis points, respectively. The increase in 2006 was primarily the result of increased earnings on the Companys prime based loans as interest rates increased throughout 2005 and through the first half of 2006, and stabilized over the remainder of 2006 with the origination of new loans in 2006 and 2005 with effective yields higher than the average for 2007. The lower yields on loans for 2007 was a result of (i) an emphasis on fixed rate lending with lower yields compared to variable rate loans from the second half of 2006, which resulted in lower yields on the loan portfolio in 2007; and (ii) a reduction of 100 basis points in the fed funds rate in the third and fourth quarter of 2007.
The average yield on the investment portfolio was 4.88% in 2007, as compared to 4.43% and 3.64% in 2006 and 2005, respectively, an increase of 45 and 79 basis points, respectively. The increases in the investment portfolio yield for 2007 and 2006 were due mainly to a generally higher yield curve for the first six months of 2007 and managements decision to extend portfolio duration.
The Companys overall cost of interest bearing liabilities increased to 4.88% in 2007 from 4.55% and 3.08% in 2006 and 2005, respectively. The increase in cost of interest bearing liabilities for 2007 was primarily due to competitive deposit pricing, an increase in FHLB borrowings, impacts on credit markets generally resulting from the issue surrounding the subprime mortgage situation and higher interest rates during the first half of 2007. The increase from 2005 to 2006 was due to the funding of the Companys loans growth with FHLB borrowings, which are more sensitive to market rate increases set by the Federal Reserve Board and time deposits over $100,000 which were secured in the later half of 2005 versus funding such growth with lower cost demand, money market and NOW or savings deposits.
The Company offers a wide variety of retail deposit account products to both consumer and commercial deposit customers. Time deposits, which are the Companys highest cost deposits, consist primarily of retail fixed-rate certificates of deposit, and comprised 58.1% and 54.1% of the deposit portfolio at December 31, 2007 and 2006, respectively. The ratio of non-interest-bearing deposits to total deposits was 23.0% and 27.2% at December 31, 2007, and 2006, respectively. All other deposits, which include interest-bearing checking accounts called Negotiable Order Withdrawal (NOW), savings and money market accounts, accounted for the remaining 19.0% and 18.7% of the deposit portfolio at December 31, 2007 and 2006, respectively.
Deposit growth remains challenging as the Company continues to experience heightened market competition. Deposits increased 10.4% to $1.58 billion at December 31, 2007, from $1.43 billion at December 31, 2006, largely due to $70.3 million in deposits acquired through broker deposits. Deposit growth was comprised of increases in money market accounts of $53.8 million or 28.2% and time deposits of $141.2 million or 18.2%. These increases were partially offset by decreases in savings accounts of $22.0 million or 28.6%, and non-interest-bearing demand deposits of $24.7 million or 6.4%. Core deposits, or non-time jumbo deposit accounts, amounted to $775.2 million at December 31, 2007, representing 49.1% of total deposits, with jumbo time deposits representing the remaining 51.9%. This is lower than the Companys core deposit ratio of 52.3% at December 31, 2006.
The Companys ratio of average interest earning assets to interest bearing liabilities has remained relatively stable at 131.4%, 134.6% and 139.1% for 2007, 2006 and 2005, respectively.
Provision for Loan Losses
The Company sets aside an allowance for potential loan losses through charges to earnings, which are reflected in the consolidated statements of operations as the provision for loan losses. Specifically, the provision for loan losses represents the amount charged against current period earnings to achieve an allowance for loan losses that in managements judgment is adequate to address inherent risks in the Companys loan portfolio.
Due primarily to loan growth and an increase in net write-offs, the provision for loan losses increased to $6.5 million for the year ended December 31, 2007, compared to $5.7 million and $3.4 million for 2006 and 2005, respectively. During 2007 net charge-offs were $3.4 million as compared to $2.1 million and $726,000 in 2006 and 2005, respectively. While Management believes that the allowance for loan losses of 1.13% of total loans was adequate at December 31, 2007, 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.
The following table sets forth the various components of the Companys non-interest income for the periods indicated:
Non-interest income decreased 33.1%, or $7.4 million, to $14.9 million for the year ended December 31, 2007 compared to $22.2 million for the year ended December 31, 2006. The 2007 decrease in non-interest income was due to a one time insurance settlement in 2006, the decrease in gain on sale of loans and the decreases in customer service fees and other income (see discussion below). For the year ended December 31, 2007 non-interest income as a percentage of average earning assets decreased to 0.82% compared to 1.41% and 1.54% for the years ended December 31, 2006 and 2005, respectively. These decreases in non-interest income as a percentage of average earning assets are the result of decreases in non-interest income amounts over the past three years including by virtue of a reduction of gain on sale of loans in 2007 while average earning assets have increased from $1.6 billion at December 31, 2006 to $1.8 billion at December 31, 2007 and the reduction of gain on sale of loans in 2007. The primary sources of recurring non-interest income continue to be customer service fee charges on deposit accounts, fees from trade finance transactions, loan service fees and gains on the sale of SBA loans.
Customer service fees decreased $1.2 million, or 15.2%, from 2006 to 2007, and decreased $944,000, or 10.3%, from 2005 to 2006. The 2007 decrease of $1.2 million and the 2006 decrease of $944,000 were due primarily to managements decision to close certain customer operating accounts whose activities, while generating service charges, were inconsistent with the Companys risk management process and requirements. The decision was consistent with the Companys intention of maintaining full compliance with all risk management polices and regulatory requirements. As a result of the aforementioned decreases, combined with the $7.4 million decrease in 2007 and the $1.7 million increase in 2006 of total non-interest income, customer service fees amounted to 46.7% of total non-interest income for 2007, compared to 36.8% and 44.5% in 2006 and 2005, respectively.
Fee income from trade finance transactions decreased $791,000, or 23.2%, from 2006 to 2007, and $79,000, or 2.3%, from 2005 to 2006. While Management continues efforts to increase the Companys Asia Pacific trade, the Company has seen significant competition from larger financial institutions and peer banks. As a result of the lower volume and related fees, combined with the $7.4 million decrease in 2007 and the $1.7 million increase in 2006 of total non-interest income, fee income from trade finance transactions amounted to 17.6% of total non-interest income for 2007, as compared to 15.3%% and 17.0% in 2006 and 2005, respectively.
The gain on loan sales decreased $2.7 million, or 81.5%, from 2006 to 2007, and increased $848,000, or 34.1%, from 2005 to 2006. The Company sold $7.7 million of its SBA loans comprised of only the unguaranteed portion which accounted for the $618,000 gain in 2007 and $57.9 million comprised of guaranteed and unguaranteed portions of SBA loans which accounted for the $3.3 million gain during 2006. The primary reason for the 2007 decrease was Managements decision to hold SBA loans for the loan yields and variable rate nature of these loans. Management will evaluate on a quarterly basis whether to sell SBA loans or hold them in the loan portfolio. While the decrease in the amount of loans sold factored into the increased gain on sale recognized in 2006, the primary cause for the increase was the larger percentage of unguaranteed portion sold in 2006 which was a substantial portion of the gain generated from the sale of the unguaranteed loans occurs from the recognition of the deferred gain that resulted from the sale of the guaranteed portion. As a result of the changes in volume and loan mix, combined with the $7.4 million decrease in 2007 and the $1.7 million increase in 2006 of total non-interest income, the gain on sale of loans amounted to 4.2% of total non-interest income for 2007, compared to 15.0% and 12.1% in 2006 and 2005, respectively.
Loan service fees decreased $122,000, or 6.6%, from 2006 to 2007, and decreased $172,000, or 8.5%, from 2005 to 2006. The decreases were due primarily to lower servicing fees earned as the amortization of the servicing assets increased from rising prepayments. As a result of these factors, combined with the $7.4 million decrease in 2007 and the $1.7 million increase in 2006 of total non-interest income, other loan related service fees amounted to 11.6% of total non-interest income for 2007, compared to 8.3% and 9.8% in 2006 and 2005, respectively.
Insurance settlementlegal fees represent a settlement with our insurance carrier regarding coverage of legal fees associated with our ongoing litigation with KEIC. The total settlement amounted to $3.75 million of which approximately $1.0 million was designated to offset future litigation expenses. Of the $1.0 million reserve, approximately $469,000 and $531,000 were recognized as a reduction of legal expenses in 2007 and 2006, respectively. Of the remaining $2.75 million, approximately $230,000 was utilized to recoup expenses incurred in the second quarter of 2006. The balance, approximately $2.5 million, was recognized as other income and represents reimbursement of legal fees expensed prior to the quarter ended June 30, 2006. The recovery of $3.3 million was reflected in the 2006 financial statements and the recovery of $469,000 was reflected in the 2007 financial statements.
Other income decreased $101,000, or 4.7%, from 2006 to 2007, and decreased $295,000, or 12.0%, from 2005 to 2006. The slight decrease in 2007 was attributable to the reduction of miscellaneous transaction fees during the year. The decrease in 2006 was attributable primarily to litigation settlements that approximated $850,000 in 2005 offset in part by an increase in fees earned from Travelers Express of approximately $350,000. As a result of these factors, combined with the $7.4 million decrease in 2007 and the $1.7 million increase in 2006 of total non-interest income, other income amounted to 13.8% of total non-interest for 2007, compared to 9.7% and 11.9% in 2006 and 2005, respectively.
The following table sets forth the non-interest expenses for the periods indicated:
Non-interest expense is comprised primarily of salary and employee benefits; occupancy; furniture, fixture, and equipment; data processing; professional service fees; business promotions and advertising; impairment loss of securities available for sale; and other operating expenses. Non-interest expense increased $3.7 million, or 8.2 % from 2006 to 2007 and $4.5 million, or 11.0% from 2005 to 2006. The 2007 increase in non-interest expense was due to increases in salaries and employee benefits, occupancy and impairment loss on securities available for sale. As a result of significant growth in average earning assets, combined with a lower growth rate in total non-interest expense, non-interest expense as a percentage of average earning assets decreased in 2007 to 2.72%, compared to 2.87% and 3.07% for 2006 and 2005, respectively.
The efficiency ratio, defined as the ratio of non-interest expense to the sum of net interest income before provision for loan losses and non-interest income, was 53.8% for the year ended December 31, 2007, compared with 48.4% and 48.7% for the years ended December 31, 2006 and 2005, respectively. While the efficiency ratios for 2006 and 2005 were relatively stable, the increase in the efficiency ratio from 2006 to 2007 from 48.4% to 53.8% was due primarily to higher increases in operating costs ($45.3 million in 2006 and $49.0 million in 2007, or 8.2%) as net interest income before provision for loan losses increased by $4.8 million, or 6.8% and the other than temporary impairment of $1.3 million in 2007.
Salaries and employee benefits increased $2.0 million, or 8.4%, from 2006 to 2007, and $2.8 million, or 14.2%, from 2005 to 2006. The increase in 2007 was due in part to (i) expenses associated with compensation of our former CEO including full salary as an officer through March 30, 2007 and lump sum payment of approximately $240,000, (ii) continued hiring activity of highly qualified personnel, and (iii) normal salary increases. The number of employees increased from 344 to 363 during 2007. The increase in 2006 was due in part to expenses associated with increased personnel to staff the Irvine, California and Seattle, Washington branches in addition to filling key management positions.
Occupancy expense increased $523,000, or 14.3%, from 2006 to 2007, and $279,000, or 8.3%, from 2005 to 2006. The increase in 2007 was due mainly to an increase in rent, property insurance and amortization of tenant improvements and the acquisition of a new Branch in Federal Way in Washington. The increase in 2006 was due mainly to increased operational costs (e.g., rent, property insurance costs and amortization of tenant improvements costs incurred over the past eighteen months) resulting from a full year of operational costs associated with the Irvine, California and Seattle, Washington branches.
Data processing expense decreased $38,000, or 1.8%, from 2006 to 2007, and increased $88,000, or 4.4%, from 2005 to 2006. These relatively minor changes in data processing costs reflect Managements efforts to contain these costs as the Companys branch system expanded and additional processing systems were implemented. As a result of these cost containment efforts, combined with the increase in total non-interest expense, data processing expenses as a percentage of total non-interest expense has declined to 4.2% in 2007, as compared to 4.6% and 4.9% in 2006 and 2005, respectively.
Professional service fees decreased $965,000, or 23.0%, from 2006 to 2007, and increased $416,000, or 11.0%, from 2005 to 2006. The decrease in 2007 was mainly due to non-recurring professional service fees related to the Companys BSA compliance program in 2006. The increase in 2006 was due mainly to consulting costs attributable to resolving issues identified with the Companys BSA compliance program offset in part by lower legal expenses. Professional service fees as a percentage of total non-interest expense have decreased to 6.6% for 2007 from 9.2% for both 2006 and 2005.
Business promotion and advertising expense decreased by $182,000, or 7.1%, from 2006 to 2007, and increased by $1.2 million, or 42.4%, from 2005 to 2006. The 2007 decrease was the result of the 20th anniversary and related costs incurred in 2006. The increase in 2006 was also due to increased promotional activity for the Companys products and expanding LPO production. As a result of the 2006 increase, combined with the increase in total non-interest expense, business promotion and advertising expense as a percentage of total non-interest expense decreased to 4.9% in 2007, as compared to 8.8% and 6.8% in 2006 and 2005, respectively.
The Company recorded a $1.3 million impairment loss in 2007 as a result of an other-than-temporary decline in market value with respect to Fannie Mae Series F preferred stock due to changes in interest rates. The Company holds these investment grade, high yielding, and floating-rate securities as part of its available-for-sale investment portfolio. The unrealized loss was deemed a permanent impairment and recognized in 2007. During the first quarter of 2008, the Companys investments in these securities were sold in its entirety with no additional loss from the December 31, 2007 adjusted book value.
The Company recorded a loss on interest rate swaps of $26,000 in 2006. The Companys only remaining interest rate swap matured in August 2006. During 2005, the Company terminated one of its longer maturity interest rate swaps and recorded a net loss of $306,000. There were no swaps in 2007.
Other operating expense increased $1.0 million, or 24.7%, from 2006 to 2007, and $175,000, or 4.4%, from 2005 to 2006. The 2007 increase was primarily attributable to the increase in FDIC assessment of $435,000 (see the related discussion in Item 1, Business Premiums for Deposit Insurance) during the year and a penalty of $126,000 paid in connection with inaccurate filing for our employee benefit plan in prior years. The 2006 increase was primarily attributable to increased corporate administrative costs (e.g., auto and travel and directors insurance), increased amortization of the Companys CRA investments and losses incurred on the disposal of fixed assets. As a percentage of total non-interest expense, other operating expense increased to 10.6% in 2007 from 9.2% and 9.7% for 2006 and 2005, respectively.
The remaining non-interest expenses include such items as furniture, fixtures and equipment, stationery and supplies, telecommunications, postage, courier service and security service expenses. For the years ended 2007 and 2006, these non-interest expenses remained unchanged at $5.0 million.
Provision for Income Taxes
For the years ended December 31, 2007, 2006 and 2005, the provision for income taxes was $13.6 million, $16.5 million and $15.1 million, representing effective tax rates of approximately 38%, 39% and 38%, 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 advantaged investments in low-income housing, municipal obligations and agency preferred stocks and California Enterprise Zone tax credit. The Company reduced taxes utilizing the tax credits from investments in the low-income housing projects in the amount of $744,000 for the year ended December 31, 2007 compared to $586,000 and $582,000 for the years ended December 31, 2006 and 2005, respectively.
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 returns. The Companys deferred tax assets were $13.1 million as of December 31, 2007 and $11.7 million as of December 31, 2006. As of December 31, 2007, the Companys deferred tax assets were primarily due to the allowance for loans losses, deferred loan fees and impairment losses on preferred stocks.
Total assets increased by $237.9 million, or 12.9%, to $2.1 billion as of December 31, 2007 compared to $1.8 billion at December 31, 2006. The increase in total assets was mainly due to a $252.4 million growth in net loans and a $5.0 million increase in investments in affordable housing partnerships offset by a $5.1 million reduction in cash and cash equivalents, and $18.9 million in investments. Net loans (including loans held for sale), investments, and money market and short-term investments as a percentage of total assets were 86.0%, 8.6% and 0.1%, respectively, as of December 31, 2007, as compared to 83.4%, 8.7% and 0.1%, respectively, at December 31, 2006. The growth in total assets was financed primarily by the increase in deposits of $173.0 million and FHLB borrowings of $70.0 million.
Total assets increased by $182.3 million, or 11.0%, to $1.8 billion as of December 31, 2006 compared to $1.7 billion at December 31, 2005. The increase in total assets was mainly due to a $318.0 million growth in net loans offset by a $70.0 million reduction in cash and cash equivalents and $77.6 million in investments. Net loans (including loans held for sale), investments, and money market and short-term investments as a percentage of total assets were 83.4%, 8.7% and 0.1%, respectively, as of December 31, 2006, as compared to 73.4%, 14.3% and 3.8%, respectively, at December 31, 2005. The growth in total assets was financed primarily by the increase in FHLB borrowings of $196.7 million.
The Companys loan portfolio represents the largest single portion of earning assets, substantially greater than the investment portfolio or any other asset 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, 2007 and 2006, gross loans represented 87.1% and 84.6%, respectively, of total assets. The largest volume increases among loan categories in 2007 were commercial real estate, commercial business loans, real estate construction, and consumer loans, which increased $154.5 million, $33.7 million, $24.6 million and $21.4 million, respectively. The loan portfolio composition table below reflects the gross and net amounts of loans outstanding as of December 31 for each year from 2003 to 2007.
As of December 31, 2007, 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:
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 County and Orange County, California.
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 1.20:1 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, 2007, commercial real estate loans totaled $1.2 billion, representing 66.0% of total loans, compared to $1.0 billion or 66.9% of total loans at December 31, 2006. The slight decrease in the percentage of commercial real estate loans to total loans in 2007 was a result of the increase in real estate construction loans from 2006 to 2007.
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 $68.1 million or 3.8% of total loans and $43.5 million or 2.8% of total loans at December 31, 2007 and 2006, respectively. The Companys real estate construction portfolio varies from year-to-year as Management is selective in financing construction projects given the unique credit risk associated with these types of loans and the timing of the completion of construction and associated loan payoffs. Of $68.1 million, $30.5 million was related to the residential real estate market. Based on the current situation related to subprime mortgage, the Company is closely monitoring these projects and deems them to be performing as expected at December 31, 2007.
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, 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 interest. 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 a specific industry.
As of December 31, 2007 and 2006, commercial business loans totaled $311.0 million and $277.3 million, respectively. Although commercial business loans increased in 2007 by $33.7 million, as a percentage of total loans they decreased slightly to 17.2% at December 31, 2007 from 17.8% at December 31, 2006.
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, 2007, trade finance loans totaled $67.0 million, compared to $66.9 million as of December 31, 2006. While management continues efforts to increase the Companys Asia Pacific trade, the Company has seen significant competition from larger financial institutions and peer banks. As a result of the lower trade finance volume, combined with the strong loan growth in the commercial real estate portfolio, these loans as a percentage of total loans declined to 3.7% in 2007 from 4.3% in 2006.
Small Business Administration (SBA) Loans. The Company provides 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.
During the years 2007 and 2006, the Company originated $99.9 million, and $138.5 million, respectively, in SBA loans. The Company sold $7.7 million of SBA loans in 2007, a decrease of 86.7% as compared to $57.9 million in 2006. The Company sold both the guaranteed and unguaranteed portion of the SBA loans and retained the loan servicing obligation, for a fee. The primary reason for the 2007 decrease was managements decision to hold SBA loans for the loan yields and variable rate nature of these loans. Management will evaluate on a quarterly basis whether to sell SBA loans or hold them in the loan portfolio. As of December 31, 2007, the Company was servicing $117.5 million of sold SBA loans, compared to $160.7 million as of December 31, 2006. SBA loans as a percentage of total loans have remained relatively stable, 3.9% in 2007 as compared to 3.2% in 2006, as the growth of the SBA portfolio has mirrored the overall growth of the Companys total loans.
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 defenses 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 at 5.5 % and 5.0% of total loans as of December 31, 2007 and 2006. Automobile loans are the largest component of consumer loans, representing 63% and 71% of total consumer loans as of December 31, 2007 and 2006, respectively.
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 extend credit were $281.8 million and $266.0 million at December 31, 2007 and 2006, respectively. Unused commitments represented 15.5% and 17.1% of outstanding gross loans at December 31, 2007 and 2006, respectively. The Companys standby letters of credit and commercial letters of credit at December 31, 2007 were $8.2 million and $19.6 million, respectively, as compared to $12.2 million and $28.2 million, respectively at December 31, 2006.
Loan Maturities and Sensitivity to Changes in Interest Rates
The following table shows the maturity distribution of the Companys outstanding loans as of December 31, 2007. In addition, the table shows the distribution of such loans with floating interest rates and those with fixed interest rates. The table includes nonperforming loans of $6.3 million.
Nonperforming assets are defined as loans on non-accrual status, loans 90 days or more past due but not on non-accrual status, Troubled Debt Restructurings, and Other Real Estate Owned (OREO). Management generally places loans on non-accrual 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 non-accrual 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.
The Company had one OREO property in the amount of $380,000, which is a residential property, at December 31, 2007 compared to none at December 31, 2006. The Company records the property at the lower of its carrying value or its fair value less anticipated disposal costs. Any write-down of OREO is charged to earnings. No write-down was necessary for the one OREO property as of December 31, 2007. 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 (SFAS No. 66), Accounting for Sales of Real Estate, 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:
The following table provides information with respect to the components of the Companys nonperforming assets as of the dates indicated:
Nonperforming loans totaled $6.3 million at December 31, 2007, an increase of $3.0 million as compared to $3.3 million at December 31, 2006. Nonperforming loans as a percentage of total loans increased to 0.35% at December 31, 2007 as compared to 0.21% at December 31, 2006. The increase in 2007 resulted from SBA loans that have become nonperforming during the year due to a weakening economy. At December 31, 2007, SBA non-accrual loans represented 64% of total nonperforming loans. Nonperforming assets as a percentage of total loans and other real estate owned increased to 0.37% at December 31, 2007 as compared to 0.21% at December 31, 2006. However, $2.7 million of the total $4.0 million in nonperforming SBA loans consisted of the guaranteed portion of such loans. At December 31, 2007, total nonperforming assets, net of the SBA guaranteed portion, were $3.9 million, representing 0.22% of both total loans and total loans and other real estate owned. There have been no nonperforming commercial real estate loans over the past five years.
Nonperforming loans increased by $318,000 to $3.3 million at December 31, 2006, as compared to $2.9 million in 2005. The slight increase in 2006 resulted from the sale of a real estate construction non-accrual loan in the amount of $1.6 million offset by additional loans placed on non-accrual status in the Companys commercial real estate, commercial loan and SBA portfolios that are sensitive to rising interest rates. The federal government currently guarantees SBA loans at 75% to 85% of the principal amount and, accordingly, the amount included in the SBA category includes only the unguaranteed portion of the loan.
The following table provides information on impaired loans for the periods indicated:
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. The amount of impairment is based on the present value of expected future cash flows discounted at the loans effective interest rate, a loans observable market price, or the fair value of the collateral if the loan is collateral dependent. Loans are identified for specific allowances from information provided by several sources including asset classification, third party reviews, delinquency reports, periodic updates to financial statements, public records, and industry reports. All loan types are subject to specific allowances once identified as impaired.
During the first quarter of 2007, the impaired loans outstanding were $21.3 million. During the second quarter, two loan relationships which were deemed impaired totaling $20.5 million at March 31, 2007 were removed from that status as a result of a payoff and a loan sale relating to these two loan relationships. For these reasons, the average total recorded investment in impaired loans was higher than the impaired loan balance at year-end.
Allowance for Loan Losses
The following table sets forth the composition of the allowance for loan losses as of dates indicated:
The Companys allowance for loan loss methodologies incorporates 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 the Companys 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 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 the Companys 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 its methodologies. As the Company adds new products, increases the complexity of the loan portfolio, and expands the geographic coverage, the Company will enhance the 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. The Company believes that its methodologies continue to be appropriate given its size and level of complexity.
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 date of the consolidated statements of financial condition. On a quarterly 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 and an allocated allowance for large groups of smaller balance homogenous loans.
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. The Company measures impairment based on the fair value of the collateral, adjusted for the cost related to liquidation of the collateral.
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, the Company relies 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, the Company classifies groups of homogenous loans based on the number of days delinquent and other qualitative factors and trends.
The table below summarizes the activity in the Companys allowance for loan losses for the periods indicated.
The process of assessing the adequacy of the allowance for loan losses involves judgmental discretion, and eventual losses may therefore differ from 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 balance of the allowance for loan losses increased to $20.5 million as of December 31, 2007 compared to $17.4 million as of December 31, 2006. This increase was mainly due to the growth of the portfolio, and Managements assessment of credit risk inherent in the portfolio.
Total charge-offs of $3.6 million for 2007 were primarily comprised of following industries: general merchandise wholesalers for 50.7%, dry cleaning businesses for 17.1%, clothing stores for 7.4%, and garment industry for 6.2%. The Company continued to record loss provisions to compensate for both the continued growth in the Companys loan portfolio, continued change in the composition of the overall loan portfolio (reflecting a steady shift toward commercial real estate and commercial loans) and net write-offs. The Company provides an allowance for the new credits based on the migration analysis and other qualitative factors and trends. The ratio of the allowance for loan losses to nonperforming loans decreased to 327% at December 31, 2007 as compared to 534% and 471% in 2006 and 2005, respectively.
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 quarterly, Management performs an ongoing assessment of the risks inherent in the portfolio. As of December 31, 2007, 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 and other qualitative factors and trends.
However, no assurance can be given that economic conditions, which adversely affect the Companys service areas or other circumstances, will not be reflected in an increase in the loan loss provision or loan losses. Nonperforming assets were $6.6 million as of December 31, 2007 compared to $3.3 million as of December 31, 2006. The 2007 increase was primarily due to growth in the loan portfolio and the weakening economic trends in our markets.
The provision for loan losses in 2007, 2006, and 2005 was $6.5 million, $5.7 million, and $3.4 million, respectively. The increase in 2006 and 2005 was due to the expansion in the Companys loan portfolio and net charge-offs. Total charge-offs in 2007, 2006 and 2005 were $3.6 million, $2.7 million and $887,000, respectively. The largest single charge-off during 2007 and 2006 was $328,000 and $411,000, respectively. Net charge-offs were $3.4 million, $2.1 million and $726,000 in 2007, 2006 and 2005, respectively.
Allocation of Allowance for Loan Losses
The following table provides a breakdown of the allowance for loan losses by category as of the dates indicated:
The allocated allowance for other commercial business loans increased by $397,000, or 10.5%, to $4.2 million at December 31, 2007, compared to $3.8 million as of the December 31, 2006. Commercial business loans represented 17.2% of the loan portfolio and 20.5% of the allocated loan loss allowance at December 31, 2007. This disproportional allocation of the allowance for losses is based on historical information and analysis, since these types of loans have typically had the highest charge-off percentage.
The allocated allowance for SBA loans inclusive of SBA 504 loans decreased $247,000, or 20.8%, to $943,000 at December 31, 2007, compared to $1.2 million as of December 31, 2006. SBA loans represented 3.89% of the loan portfolio and 4.6% of allocated loan loss allowance at December 31, 2007.
The allocated allowance for other trade finance loans decreased $28,000, or 3.7%, to $754,000 at December 31, 2007, compared to $762,000 as of December 31, 2006. Trade finance loans represented 3.7% of the loan portfolio and 3.9% of allocated loan loss allowance at December 31, 2007.
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 summarizes the amortized cost, fair value, and distribution of the Companys investment securities as of the dates indicated:
The Companys investment securities portfolio is classified into two categories: Held-to-Maturity or Available-for-Sale. Statement of Financial Accounting Standards No. 115 (SFAS No. 115), Accounting for Certain Investments in Debt and Equity Securities, also provides for a trading portfolio classification, but the Company had no investment securities in this category for any of the reported periods. The Company classifies securities that it has the ability and intent to hold to maturity as held-to-maturity securities, to be sold only in the event of concerns with an issuers credit worthiness, a change in tax law that eliminates their tax-exempt status or other infrequent situations as permitted by SFAS No. 115. All other securities are classified as available-for-sale. The securities classified as held-to-maturity are presented at net amortized cost and available-for-sale securities are carried at their estimated fair values.
The Company aims to maintain an investment portfolio with an adequate mix of fixed-rate and adjustable-rate securities with relatively short maturities to minimize overall interest rate risk. The companys investment securities portfolio consists of U.S. Treasury securities, U.S. Government agency securities, U.S. Government sponsored enterprise debt securities, mortgage-backed securities, corporate debt, and U.S. Government sponsored enterprise equity securities. The mortgage backed securities and collateralized mortgage obligations (CMO) are all agency-guaranteed residential mortgages. The company regularly models, evaluates and analyses each agency CMOs to capture its unique allocation of principal and interest. The company currently classifies the investment portfolio as available-for-sale or held-to-maturity. Accordingly, available-for-sale securities are carried at their estimated fair values and held-to-maturity securities are carried at their net amortized cost.
The Company performs regular impairment analyses on the investment securities portfolio. If the Company determines that a decline in fair value is other-than-temporary, an impairment write-down is recognized in current earnings. Other-than-temporary declines in fair value are assessed based on the duration the security has been in a continuous unrealized loss position, the severity of the decline in value, the rating of the security and the Companys ability and intent on holding the securities until the fair values recover. The securities that have been in a continuous unrealized loss position for twelve months or longer at December 31, 2007 had investment grade ratings upon purchase. The issuers of these securities have not, to the Companys knowledge, established any cause for default on these securities and the various rating agencies have reaffirmed these securities long-term investment grade status at December 31, 2007. These securities have fluctuated in value since their purchase dates as market interest rates have fluctuated. However, the Company has the ability and the intention to hold these securities until their fair values recover to cost. Because the Company has the ability and the intent to hold these investments until recovery of fair value, which may be at maturity, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2007.
As a result of the Companys periodic reviews for impairment, the Company recorded $1.3 million in OTTI (Other-Than-Temporary-Impairment) charges on certain investment-grade FNMA agency perpetual preferred stocks held in the available-for-sale investment portfolio where the reduction in fair value was deemed to be other than temporary at December 31, 2007. On January 10th, 2008, the agency preferred stocks were sold without incurring additional loss beyond the impairment booked at December 31, 2007.
As of December 31, 2007, investment securities totaled $139.7 million or 6.7% of total assets, compared to $159.5 million or 8.7% of total assets at December 31, 2006. The decrease in the investment portfolio was mainly due to the reinvestment of proceeds from investment maturities and principal pay-downs into new loan originations.
As of December 31, 2007, available-for-sale securities totaled $128.8 million, compared to $148.9 million as of December 31, 2006. Available-for-sale securities as a percentage of total assets decreased to 6.2% as of December 31, 2007 from 8.1% as of December 31, 2006, as maturities and principal pay-downs were reinvested into new loans. Held-to-maturity securities increased to $10.9 million as of December 31, 2007, from $10.6 million as of December 31, 2006. This increase was due to additional investments in Community Reinvestment Act (CRA) qualified securities. The composition of available-for-sale and held-to-maturity securities was 92.2% and 7.8% as of December 31, 2007, compared to 93.4% and 6.6% as of December 31, 2006, respectively. For the year ended December 31, 2007, the yield on the average investment portfolio was 4.88%, representing an increase of 45 basis points as compared to 4.43% for 2006.
As of December 31, 2007 the Company had total fair value of $49.2 million of securities with unrealized losses of $1.0 million. Management believes these unrealized losses are due to temporary conditions, namely fluctuations in interest rates, and do not reflect a deterioration of credit quality of the issuer. The market value of securities with unrealized losses (for a period of twelve months or more) totaled $28.9 million, with related unrealized losses of these securities totaling $223 thousand.
The following table summarizes, as of December 31, 2007, the contractual maturity characteristics of the investment portfolio, by investment category. Expected remaining maturities may differ from remaining contractual maturities because obligors may have the right to prepay certain obligations with or without penalties.
Interest Earning Short-Term Investments
The Company invests its short-term excess available funds in overnight Fed Funds and money market funds. As of December 31, 2007 and 2006 the Company had $7.1 million and none invested in overnight Fed Funds. As of December 31, 2007 and 2006, the amounts invested in money market funds and interest-bearing deposits in other banks were $2.8 million and $1.9 million, respectively. The investment in Fed Funds averaged $4.6 million and $33.3 million for the year ended December 31, 2007 and 2006, respectively. Interest earned on these funds was 5.53% and 4.73% in 2007 and 2006, respectively.
The Companys investment in the FHLB stock totaled $15.2 million and $11.0 million as of December 31, 2007 and 2006, respectively. FHLB stock is required in order to utilize a borrowing facility when needed. The Company purchased $9.7 million of additional shares of FHLB stock during 2007 due to the FHLBs minimum capital stock requirement for its member banks based on the members December 31 regulatory financial data and on current advances outstanding.
Other investments, totaling $11.9 million and $6.9 million as of December 31, 2007 and 2006, respectively, are comprised of limited partnership interests owned by the Company in affordable housing projects for lower income tenants. Investments in these projects enable the Company to obtain CRA credit and federal and state income tax credits, as previously discussed in Provision for Income Taxes. In addition, the Company invested $10.0 million in bank owned life insurance (BOLI) in December 2003. BOLI is an insurance policy with a single premium paid at policy commencement. Its initial cash surrender value is equivalent to the premium paid, and the value grows through non-taxable increases in its cash surrender value through interest earned on the policy, net of the cost of insurance plus any death benefits ultimately received by the Company. The cash surrender value of BOLI as of December 31, 2007 and 2006 was $11.6 million and $11.2 million, respectively. Even though BOLI and the investment in affordable housing partnerships generally enhance profitability, they are not classified as interest-earning assets.
Cash on hand and balances due from correspondent banks represent the largest component of the Companys non-earning assets. Cash on hand and balances due from correspondent banks represented 2.8% and 3.9% of total assets for December 31, 2007 and 2006, respectively. The outstanding balance of cash and due from banks was $58.3 million and $71.5 million as of December 31, 2007 and 2006, respectively. The ratio of average cash and due from banks to average total assets declined to 3.5% for 2007 as compared to 4.5% for 2006. The Company maintained balances at correspondent banks to cover daily in-clearings and other activities. The average reserve balance requirements were approximately $12.5 million and $6.4 million as of December 31, 2007 and 2006, respectively, most of which was covered by cash on hand and vault cash held (no additional balances were maintained with the Federal Reserve Bank for this purpose).
A significant component of non-earning assets is Premises and Equipment, which is stated at cost less accumulated depreciation and amortization. Depreciation is charged to income over the estimated useful lives of the assets and leasehold improvements are amortized over the terms of the related leases, or the estimated useful lives of the improvements, whichever is shorter. Depreciation expense was $1.9 million in both 2007 and 2006. The net book value of the Companys premises and equipment totaled $13.6 million at December 31, 2007, an increase of $300,000, compared to $13.3 million at December 31, 2006.
Other assets decreased by $556,000 to $3.5 million as of December 31, 2007 compared to $4.1 million at December 31, 2006. The decrease principally reflects reductions in the Companys servicing assets due to prepayments.
The composition and cost of the Companys deposit base are important components in analyzing its net interest margin and balance sheet liquidity characteristics, both of which are discussed in greater detail in other sections herein. Net interest margin is improved to the extent that growth in deposits can be concentrated in historically lower-cost core deposits, namely non-interest-bearing demand, NOW accounts, savings accounts and money market deposit accounts. Liquidity is impacted by the volatility of deposits or other funding instruments, or in other words their propensity to leave the institution for rate-related or other reasons. Potentially, the most volatile deposits in a financial institution are large certificates of deposit (e.g., generally time deposits with balances exceeding $100,000). Because these deposits (particularly when considered together with a customers other specific deposits) may exceed FDIC insurance limits, depositors may select shorter maturities to offset perceived risk elements associated with deposits over $100,000.
The Company offers a wide variety of retail deposit account products to both consumer and commercial deposit customers. Time deposits, which are the Companys highest cost deposits, consist primarily of retail fixed-rate certificates of deposit, and comprised 58.1% and 54.1% of the deposit portfolio at December 31, 2007 and 2006, respectively. The ratio of non-interest-
bearing deposits to total deposits was 23.0% and 27.2% at December 31, 2007, and 2006, respectively. All other deposits, which include interest-bearing checking accounts (NOW), savings and money market accounts, accounted for the remaining 19.0% and 18.7% of the deposit portfolio at December 31, 2007 and 2006, respectively.
Deposit growth remains challenging as the Company continues to experience heightened market competition. Deposits increased 10.4% to $1.58 billion at December 31, 2007, from $1.43 billion at December 31, 2006, largely due to $70.3 million in deposits acquired through broker deposits. Deposit growth was comprised of increases in money market accounts of $53.8 million or 28.2% and time deposits of $141.2 million or 18.2%. These increases were partially offset by decreases in savings accounts of $22.0 million or 28.6%, and non-interest-bearing demand deposits of $24.7 million or 6.4%. Core deposits, or non-time jumbo deposit accounts, amounted to $775.2 million at December 31, 2007, representing 49.1% of total deposits, with jumbo time deposits representing the remaining 51.9%. This is lower than the Companys core deposit ratio of 52.3% at December 31, 2006.
As of December 31, 2007 and 2006, time deposits of $100,000 or more totaled $802.5 million and $682.1 million, respectively, representing 50.9% and 47.7%, respectively, of the total deposit portfolio. These accounts, consisting primarily of consumer deposits and deposits from the State of California, had a weighted average interest rate of 4.33% and 4.97% at December 31, 2007 and 2006, respectively.
The following table provides the remaining maturities of the Companys time deposits in denominations of $100,000 or greater as of December 31, 2007 and 2006:
The Companys average deposit cost increased to 3.59% during 2007 from 3.25% in 2006.
Information concerning the average balance and average rates paid on deposits by deposit type for the past three fiscal years is contained in the Distribution, Rate, and Yield table in the previous section entitled Results of OperationsNet Interest Margin.
Other Borrowed Funds
As of December 31, 2007, the Company borrowed $298.5 million as compared to $223.8 million at December 31, 2006 from the Federal Home Loan Bank of San Francisco with note terms from less than 1 year to 15 years. Notes of 10-year and 15-year terms are amortizing at the predetermined schedules over the life of the notes. Of the $298.5 million outstanding, $145.0 million is composed of six fixed rate term advances, each with an option to be called by the FHLB after the lockout dates varying from 6 months to 2 years. If market interest rates are higher than the advances stated rates at that time, the advances will be called by the FHLB and the Company will be required to repay the FHLB. If market interest rates are lower after the lockout period, then the advances will not be called by the FHLB. If the advances are not called by the FHLB, then they will mature on the maturity date ranging from 4 years to 10 years. The Company may repay the advances with a prepayment penalty at any time. If the advances are called by the FHLB, there is no prepayment penalty.
Under the FHLB borrowing agreement, the Company has pledged under a blanket lien all qualifying commercial and residential loans as collateral with a total carrying value of $1.2 billion at December 31, 2007 as compared to $1.1 billion at December 31, 2006
Total interest expense on FHLB borrowings was $11.2 million and $4.4 million for the years ended December 31, 2007 and 2006, respectively, reflecting average interest rates of 5.01% and 5.27%, respectively.
The Company also regularly uses short-term borrowing from the U.S. Treasury to manage Treasury Tax and Loan payments. Notes issued to the U.S. Treasury amounted to $1.1 million as of December 31, 2007 compared to $675,000 as of December 31, 2006. Interest expense on these borrowings was $25,000 and $31,000 in 2007 and 2006, respectively, reflecting average interest rates of 2.23% and 3.68%, respectively. The details of these borrowings for the years 2007, 2006, and 2005 are presented in Note 9 to the Consolidated Financial Statements in Item 8 herein.
In addition, the issuance of a long-term subordinated debenture at the end of 2004 in connection with the issuance of $18.6 million in pass-through trust preferred securities provided an additional source of funding. (See Note 11 to the Financial Statements in Item 8 herein).
Short-term borrowings principally include overnight fed funds purchased and advances from the FHLB. The details of these borrowings for the years 2007, 2006, and 2005 are presented below:
The following table presents, as of December 31, 2007, the Companys significant fixed and determinable contractual obligations, within the categories described below, by payment date. These contractual obligations, except for the operating lease obligations, are included in the Consolidated Statements of Financial Condition. The payment amounts represent those amounts contractually due to the recipient.
Off-Balance Sheet Arrangements
The Company may also have liabilities under certain contractual agreements contingent upon the occurrence of certain events.
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 extend credit were $281.8 million and $266.0 million at December 31, 2007 and 2006, respectively. Unused commitments represented 15.5% and 17.1% of outstanding gross loans at December 31, 2007 and 2006, respectively. The Companys standby letters of credit and commercial letters of credit at December 31, 2007 were $8.2 million and $19.6 million, respectively, as compared to $12.2 million and $28.2 million, respectively at December 31, 2006.
Liabilities for losses on outstanding commitments of $317,000 and $319,000 were reported separately in other liabilities at December 31, 2007 and 2006.
A discussion of significant contractual arrangements under which the Company may be held contingently liable, including guarantee arrangements, is included in Note 13Commitments and Contingencies and Note 17Financial Instruments with Off-Balance Sheet Risk to the Consolidated Financial Statements Item 8 herein.
Impact of Inflation
The primary impact of inflation on the Company is its effect on interest rates. The Companys primary source of income is net interest income, which is affected by changes in interest rates. The Company attempts to mitigate the impact of inflation on its net interest margin through the management of rate-sensitive assets and liabilities and the analysis of interest rate sensitivity. The effect of inflation on premises and equipment as well as non-interest expenses has not been significant for the periods covered in this Annual Report.
Market Risk and Asset Liability Management
Market risk is the risk of loss from adverse changes in market prices and rates. The Companys market risk arises primarily from interest rate risk inherent in its lending, investment and deposit taking activities. The Companys profitability is affected by fluctuations in interest rates. A sudden and substantial change in interest rates may adversely impact the Companys earnings to the extent that the interest rates borne by assets and liabilities do not change at the same speed, to the same extent or on the same basis. To that end, Management actively monitors and manages its interest rate risk exposure.
The Companys strategy for asset and liability management is formulated and monitored by the Companys Asset/Liability Board Committee (the Board Committee). This Board Committee is composed of four non-employee directors and the President. The Board Committee meets quarterly to review and adopt recommendations of the Asset/Liability Management Committee.
The Asset/Liability Management Committee consists of executive and manager level officers from various areas of the Company including lending, investment, and deposit gathering, in accordance with policies approved by the board of directors. The primary goal of the Companys Asset/Liability Management Committee is to manage the financial components of the Companys balance sheet to optimize the net income under varying interest rate environments. The focus of this process is the development, analysis, implementation, and monitoring of earnings enhancement strategies, which provide stable earnings and capital levels during periods of changing interest rates.
The Asset/Liability Management Committee meets regularly to review, among other matters, the sensitivity of the Companys assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, and maturities of investments and borrowings. The Asset/Liability Management Committee also approves and establishes pricing and funding decisions with respect to overall asset and liability composition, and reports regularly to the Board Committee and the board of directors.
Interest Rate Risk
Interest rate risk occurs when assets and liabilities reprice at different times as interest rates change. In general, the interest the Company earns on its assets and pays on its liabilities are established contractually for specified periods of time. Market interest rates change over time and if a financial institution cannot quickly adapt to changes in interest rates, it may be exposed to volatility in earnings. For instance, if the Company were to fund long-term fixed rate assets with short-term variable rate deposits, and interest rates were to rise over the term of the assets, the short-term variable deposits would rise in cost, adversely affecting net interest income. Similar risks exist when rate sensitive assets (for example, prime rate based loans) are funded by longer-term fixed rate liabilities in a falling interest rate environment.
The Companys overall strategy is to minimize the adverse impact of immediate incremental changes in market interest rates (rate shock) on net interest income and economic value of equity. Economic value of equity is defined as the present value of assets, minus the present value of liabilities and off-balance sheet instruments. The attainment of this goal requires a balance between profitability, liquidity and interest rate risk exposure. To minimize the adverse impact of changes in market interest rates, the Company simulates the effect of instantaneous interest rate changes on net interest income and economic value of equity on a quarterly basis. The table below shows the estimated impact of changes in interest rates on our net interest income and market value of equity as of December 31, 2007 and 2006, respectively, assuming a parallel shift of 100 to 300 basis points in both directions.
All interest-earning assets and interest-bearing liabilities are included in the interest rate sensitivity analysis at December 31, 2007 and 2006, respectively. At December 31, 2007 and 2006, respectively, our estimated changes in net interest income and economic value of equity were within the ranges established by the Board of Directors, with the exception of up 200 basis points and 300 basis points scenarios in the economic value of equity at December 31, 2007. The increase in fixed rate loans as a percentage of the total loan portfolio from 48% at December 31, 2006 to 61% at December 31, 2007 had the most significant impact on the change in EVE. The Company will continue its efforts to bring the EVE back into compliance by actively managing assets and liabilities. The company can lengthen the duration of its liabilities and/or reposition the balance sheet by changing the interest rate composition of the companys asset portfolio.
The primary analytical tool used by the Company to gauge interest rate sensitivity is a simulation model used by many community banks, which is based upon the actual maturity and repricing characteristics of interest-rate-sensitive assets and liabilities. The model attempts to forecast changes in the yields earned on assets and the rates paid on liabilities in relation to changes in market interest rates. As an enhancement to the primary simulation model, other factors are incorporated into the model, including prepayment assumptions and market rates of interest provided by independent broker/dealer quotations, an independent pricing model, and other available public information. The model also factors in projections of anticipated activity levels of the Companys product lines. Management believes that the assumptions it uses to evaluate the vulnerability of the Companys operations to changes in interest rates approximate actual experience and considers them reasonable; however, the interest rate sensitivity of the Companys assets and liabilities and the estimated effects of changes in interest rates on the Companys net interest income and EVE could vary substantially if different assumptions were used or if actual experience were to differ from the historical experience on which they are based.
The Companys historical strategies in protecting both net interest income and the economic value of equity from significant movements in interest rates have involved using various methods of assessing existing and future interest rate risk exposure and diversifying and restructuring its investment portfolio accordingly. The Company may use off-balance sheet instruments, such as interest rate swaps, as part of its overall goal of minimizing the impact of interest rate fluctuations on the Companys net income, shareholders equity and cash flows. As of December 31, 2005 the Company had one outstanding swap contract with a notional value of $25.0 million. This swap contract expired in August 2006 and no new swap contracts were entered into during 2006 or 2007.
Net interest settlements of $255,000 (payments) and $26,000 (receipts) were recorded for the years ended December 31, 2006 and 2005, respectively, in non-interest expense. Since the Company does not apply hedge accounting treatment for its interest rate swaps, market value adjustments of the swaps are included in other assets and recorded through current earnings. The total market value adjustment was a loss of $26,000 for 2006 compared to a loss of $586,000 in 2005.
The objective of liquidity risk management is to ensure that the Company has the continuing ability to maintain cash flows that are adequate to fund operations and meet its other obligations on a timely and cost-effective basis in various market conditions. Changes in each of the composition of its balance sheet, the ongoing diversification of its funding sources, risk tolerance levels and market conditions are among the factors that influence the Companys liquidity profile. The Company establishes liquidity guidelines and maintains contingency liquidity plans that provide for specific actions and timely responses to liquidity stress situations.
As a means of augmenting the liquidity sources, the Company has available a combination of borrowing sources comprised of FHLB advances, federal funds lines with various correspondent banks, and access to the wholesale markets. The Company believes these liquidity sources to be stable and adequate. At December 31, 2007, the Company was not aware of any information that was reasonably likely to have a material adverse effect on our liquidity position.
The liquidity of the Company is primarily dependent on the payment of cash dividends by its subsidiary, Center Bank, subject to limitations imposed by the laws of the State of California.
As part of the Companys liquidity management, the Company utilizes FHLB borrowings to supplement our deposit source of funds. Therefore, there could be fluctuations in these balances depending on the short-term liquidity and longer-term financing need of the Company. The Companys primary sources of liquidity are derived from financing activities, which include customer and broker deposits, federal funds facilities, and advances from the Federal Home Loan Bank of San Francisco.
Because the Companys primary sources and uses of funds are deposits and loans, respectively, the relationship between net loans and total deposits provides one measure of the Companys liquidity. Typically, if the ratio is over 100%, the Company relies more on borrowings, wholesale deposits and repayments from the loan portfolio to provide liquidity. Alternative sources of funds such as FHLB advances and brokered deposits and other collateralized borrowings provide liquidity as needed from liability sources are an important part of the Companys asset liability management strategy.