Pacific Capital Bancorp 10-Q 2005
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
For the quarterly period ended June 30, 2005
For the transition period from to
Commission File No.: 0-11113
PACIFIC CAPITAL BANCORP
(Exact Name of Registrant as Specified in its Charter)
(Registrants telephone number, including area code)
Former name, former address and former fiscal year,
if changed since last report.
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨
Common Stock - As of August 4, 2005 there were 45,944,737 shares of the issuers common stock outstanding.
PART 1 FINANCIAL INFORMATION
Consolidated Balance Sheets (Unaudited)
(dollars and share amounts in thousands except per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
Consolidated Statements of Income (Unaudited)
(dollar and share amounts in thousands except per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
Consolidated Statements of Cash Flows (Unaudited)
(dollars in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
Consolidated Statements of Comprehensive Income (Unaudited)
(dollars in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
Notes to Consolidated Condensed Financial Statements
June 30, 2005
Consolidation and Basis of Presentation
The consolidated financial statements include the parent holding company, Pacific Capital Bancorp (Bancorp), and its wholly owned subsidiaries, Pacific Capital Bank, N.A. (the Bank or PCBNA), two service corporations, and two securitization subsidiaries. The activities of one of the service corporations are minimal; the other is inactive. The securitization subsidiaries are or have been used for the transactions described in Note 8, Transfers and Servicing of Financial Assets. One is used only in the first quarter of each year and the other is currently inactive. All references to the Company apply to Pacific Capital Bancorp and its subsidiaries. Bancorp will be used to refer to the parent company only. Material intercompany balances and transactions have been eliminated.
On March 5, 2004, the Company acquired Pacific Crest Capital, Inc. (PCCI) and its wholly owned subsidiaries, Pacific Crest Bank, Pacific Crest Capital Trust I (PCC Trust I), Pacific Crest Capital Trust II (PCC Trust II), and Pacific Crest Capital Trust III (PCC Trust III). PCCI was merged into Bancorp, while Pacific Crest Bank was merged into PCBNA. PCC Trust I, PCC Trust II, and PCC Trust III were created by PCCI for the exclusive purpose of issuing trust preferred securities. These three entities remain stand-alone subsidiaries of Bancorp but are not consolidated in the Companys financial statements (see Variable Interest Entities in this Note regarding the nonconsolidation of these subsidiaries and Note 2, Business Combinations for more information on the PCCI acquisition).
Under a definitive agreement announced February 28, 2005, Pacific Capital Bancorp agreed to acquire First Bancshares, Inc. (FSLO) in an all cash transaction valued at approximately $60.8 million or $48 per each diluted share of FSLO common stock. On July 13, 2005 the company received all necessary regulatory approvals related to the acquisition and closed the transaction on August 1, 2005. First Bancshares is a San Luis Obispo, California based bank holding company with $302.1 million in assets and $257.9 million in deposits at June 30, 2005. It conducts business through its wholly owned subsidiary, First Bank of San Luis Obispo. First Bank will become an additional brand of Pacific Capital Bank, N.A., and will continue to operate under the same name following the close of the transaction.
PCBNA uses the brand names of Santa Barbara Bank & Trust, First National Bank of Central California, South Valley National Bank, and San Benito Bank in its various retail market areas. Bank also includes the operations of Pacific Crest Bank, which was merged into PCBNA as part of the March 5, 2004 acquisition of PCCI. The Bank uses the brand name Pacific Capital Bank for the operations acquired with PCCI.
The accompanying unaudited consolidated financial statements have been prepared in a condensed format, and therefore do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America (GAAP) for complete financial statements. In the opinion of Management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair statement have been reflected in the financial statements. However, the results of operations for the three-month and six-month periods ended June 30, 2005 are not necessarily indicative of the results to be expected for the full year.
Cash and Cash Equivalents
For the purposes of reporting cash flows, cash and cash equivalents include cash and due from banks, money market funds, Federal funds sold, and securities purchased under agreements to resell.
Securities may be classified as held-to-maturity, available-for-sale, or trading securities. Securities for which an investor has positive intent and ability to hold until maturity are classified as held-to-maturity. Securities that might be sold prior to maturity because of interest rate changes, to meet liquidity needs, or to better match the repricing characteristics of funding sources are classified as available-for-sale. If an investor were to purchase securities principally for the purpose of selling them in the near term, they would be classified as trading securities. The Company holds no securities that should be classified as trading securities and has decided that all securities could be sold prior to maturity
for any of the reasons noted above. Consequently, it classifies all securities as available-for-sale. On determining gain or loss on securities, cost is determined by specific identification.
A Security is impaired if its fair value is less than its cost adjusted for accretion of discount or amortization of premium. In the last several months, there have been extensive discussions by accounting authorities regarding securities that might be other than temporarily impaired. This issue is discussed in the sub-section of this note titled, New Accounting Pronouncements. The Company has not purchased any securities arising out of highly leveraged transactions, and its investment policy prohibits the purchase of any securities of less than investment grade.
Nonaccrual LoansWhen a borrower is not making payments as contractually required by the note, the Company must decide whether it is appropriate to continue to accrue interest income. Generally, the Company stops accruing interest when the loan has become delinquent by more than 90 days, or in the case of individually analyzed large loans, when either an event of default has occurred or when analysis suggests that it is unlikely that the obligor will continue to pay according to the agreed terms of the credit.
Neither delinquency nor default is a requirement for nonaccrual status. Once reasonable doubt about the collectibility exists, the loan is put on nonaccrual. In the case of consumer loans, it is usually an event of delinquency or default that raises the doubt of collectibility, but in the case of commercial loans, doubt may be raised by other events. For example, the financial statements required to be provided by these borrowers may show a deterioration in their financial condition, or a borrower may begin borrowing under a line of credit to make payments on another loan.
Impaired LoansSpecific kinds of loans are identified as impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreements. Because this definition is very similar to that used by Management to determine on which loans interest should not be accrued, the Company expects that most impaired loans will also be on nonaccrual status. Therefore, in general, the accrual of interest on impaired loans is discontinued, and any uncollected interest is written off against interest income in the current period. No further income is recognized until all recorded amounts of principal are recovered in full or until circumstances have changed such that the loan is no longer regarded as impaired.
Impaired loans are reviewed each quarter or more frequently upon receipt of material information, to determine whether a valuation allowance for loan loss is required. The amount of the valuation allowance for impaired loans is determined by comparing the recorded investment in each loan with its value measured by one of three methods. The first method is to estimate the expected future cash flows and then discount them at the effective interest rate of the loan. The second method is to use the loans observable market price if the loan is of a kind for which there is a secondary market. The third method is to use the value of the underlying collateral. A valuation allowance is established for any amount by which the recorded investment exceeds the value of the impaired loan. If the value of the loan as determined by the selected method exceeds the recorded investment in the loan, and certain other factors suggest that the recorded investment is or would be reasonably realizable within the contractual term of the loan or within a reasonable period of time using methods available to the bank, then no valuation allowance for that loan is established.
GAAP recognizes that some impaired loans may have risk characteristics that are unique to the individual borrower while others may share common risk characteristics. In the former case, the creditor is expected to apply the measurement methods mentioned in the preceding paragraph on a loan-by-loan basis. In the latter case, the creditor is allowed to aggregate those loans and use historical statistics in measuring the amount of the valuation allowance needed. Because the loans currently identified as impaired by the Company have unique risk characteristics, the valuation allowance disclosed in Note 5, Loans and the Allowance for Credit Losses, for impaired loans is determined on a loan-by-loan basis.
The amount of impaired loans and the allowance provided for them are disclosed in Note 5.
Allowance for Other LoansThe Company also provides an allowance for credit losses for other loans. These include: (1) groups of loans for which the allowance is determined by historical loss experience ratios for similar loans; (2) specific loans that are not included in one of the types of loans covered by the concept of impairment but for which repayment is nonetheless uncertain; and (3) probable losses incurred in the various loan portfolios, but which have not been specifically identified as of the period end. The amounts of the various components of the allowance for credit losses are based on review of individual loans, historical trends, current economic conditions, and other factors. This process is explained in detail in the notes to the Companys Consolidated Financial Statements in its Annual Report on Form 10-K for the year ended December 31, 2004 (2004 10-K).
Loans that are deemed to be uncollectible are charged-off against the allowance for credit losses. Uncollectibility is determined based on the individual circumstances of the loan and historical trends. Additions and reductions to the allowance for credit loss for the three-month and six-month periods ended June 30, 2004 and 2005, and the balances as of those dates are disclosed in Note 5.
Origination Fees and CostsThe Company defers and amortizes loan fees collected and origination costs incurred over the lives of the related loans. For each category of loans, the net amount of the unamortized fees and costs are reported as a reduction or addition, respectively, to the balance reported. Because the fees collected are generally less than the origination costs incurred for consumer loans, the total net deferred or unamortized amount for this category is an addition to the loan balances.
Property acquired as a result of defaulted loans is included within other assets on the balance sheets. Property from defaulted loans is carried at the lower of the outstanding balance of the related loan at the time of foreclosure or the estimate of the market value of the assets less disposal costs. During the second quarter of 2004, the Company received a real estate property in satisfaction of a delinquent loan. The property was recorded at an estimate of its fair value less cost of disposal, $2.9 million. As of June 30, 2005, the Company still held the $2.9 million property.
Goodwill and Other Intangible Assets
Goodwill is recorded on the balance sheets in connection with acquisitions of other financial institutions. The Company recognized the excess of the purchase price over the estimated fair value of the assets received and liabilities assumed as goodwill. The goodwill recognized in connection with the March 5, 2004 PCCI acquisition as well as the remainder of the Companys goodwill is recorded within the Community Banking segment in Note 14, Segment Disclosure. The acquisition of FSLO is a third quarter 2005 event and, aside from disclosure, is not included in this report. Customer deposits with financial institutionsespecially the deposits other than certificatesare generally the result of long-term customer relationships. These deposits are therefore more valuable to a purchaser than simply their outstanding amount would indicate because financial institutions have to spend marketing and other acquisition costs to generate these customer relationships. Therefore, when deposits are purchased, the seller demands an acquisition cost representing the value of the relationship. In the sale of deposits, because the buyer is actually assuming a liability from the seller, this acquisition cost is represented by the amount that the liability assumed exceeds the cash paid by the seller to the buyer to assume the liability. This acquisition cost is termed a Core Deposit Intangible (CDI). The Company records this CDI as an asset and amortizes it against other expense over the expected average life of the deposit relationships acquired. For any particular acquisition, the amount of the CDI and the expected average life of the relationship will differ depending on the nature of the deposits and the customers.
Intangible assets, including goodwill, have been and will be reviewed each year to determine if circumstances related to their valuation have been materially affected. In the event that the current market values are determined to be less than the current book values (impairment), a charge against current earnings will be recorded. No such impairment existed at June 30, 2005 or December 31, 2004.
See Note 2, Business Combinations, for information regarding the March 5, 2004 acquisition of PCCI.
Loan Sales and Loan Servicing Rights
The Company sells some of the residential real estate loans that it originates. Whether it sells loans during any particular period and how much are sold depends on a number of factors, including the Companys interest rate risk profile, the fees and gains available from selling, the amount of loans originated, and the coupon rates. Some of the residential loans sold are sold servicing released and the purchaser takes over the collection of the payments. However, most are sold with servicing retained and the Company continues to receive the payments from the borrower and forwards the funds to the purchaser. The Company earns a fee for this service. The sales are made without recourse, that is, the purchaser cannot look to the Company as a source of repayment in the event the borrower does not perform according to the terms of the note. GAAP requires companies engaged in mortgage banking activities to recognize the rights to service mortgage loans for others as separate assets. For loans sold, a portion of the investment in the loan is allocated to the right to receive this fee for servicing and this value is recorded as a separate asset. This allocation is based on an estimate of the fair value of the servicing rights.
The Company originates some of the SBA loans with the intention of selling the guaranteed portion. As with the residential loans that are sold, these loans are sold promptly after origination. The Company does not hold them for some period of time to assemble groups or pools for sale. Consequently, the amount at any particular time and any adjustment to the market value from changes in interest rates are immaterial.
Most of the leases on the buildings the Company rents provide for periodic cost of living rent increases based on the consumer price index. However, some provide for either fixed dollar or minimum percentage increases. For these latter leases, as required by GAAP, the monthly rent expense is computed by dividing the total minimum rent to be paid over the term of the lease by the number of months in the term. During the early years of the lease term, rent expense will be more than the monthly payment and a liability will be recognized. During the later years of the lease term, the payment will be more than the rent expense recognized and the liability will be gradually reduced to zero at the end of the lease term.
The balances in the equity accounts of the Company are impacted by transactions with shareholders. These impacts would include increases from the sale of new stock or the issuance of new stock upon the exercise of stock options. They would also include decreases arising from distributions to shareholders in the form of either dividends or share repurchases. Changes in the equity accounts other than those changes resulting from investments by owners and distributions to owners are called comprehensive income. Net income is the primary component of comprehensive income. For the Company, the only component of comprehensive income other than net income is the unrealized gain or loss on securities classified as available-for-sale. The aggregate amount of such changes to equity that have not yet been recognized in net income are reported in the equity portion of the Consolidated Balance Sheets net of income tax effect as Accumulated other comprehensive income.
When an available-for-sale security is sold, a realized gain or loss will be included in net income and, therefore, in comprehensive income. Consequently, the recognition of any unrealized gain or loss for that security that had been included in comprehensive income in an earlier period must be reversed in the current period to avoid including it twice. These adjustments are reported in the Consolidated Statements of Comprehensive Income as a reclassification adjustment for gains or losses included in net income.
While the Companys products and services are all of the nature of commercial banking, the Company has five reportable segments. There are four specific segments: Community Banking, Commercial Banking, Refund Programs, and Fiduciary. The remaining activities of the Company are reported in a segment titled All Other.
Information regarding how the Company determines its segments is provided in Note 26, Segment Reporting, to the Consolidated Financial Statements included in the Companys 2004 10-K. This information includes descriptions of the factors used in identifying these segments, the types and services from which revenues for each segment are derived, charges and credits for funds obtained from or provided to other segments, and how the specific measure of profit or loss was selected. Readers of these interim statements are referred to that information to better understand the disclosures for each of the segments in Note 14, Segment Disclosure. There have been no changes in the basis of segmentation or in the measurement of segment profit or loss from the description given in the 2004 10-K, but there has been a change in the segments as discussed in Note 14.
GAAP permits the Company to use either of two methods for accounting for compensation cost in connection with employee stock options. The first methodtermed the fair value methodrequires issuers to record compensation expense over the period the options are expected to be outstanding prior to exercise, expiration, or cancellation. The amount of compensation expense to be recognized over this term is the fair value of the options at the time of the grant as determined by an option pricing model. The option pricing model computes fair value for the options based on the length of their term, the volatility of the stock price in past periods, and other factors. Under this method, the issuer recognizes compensation expense regardless of whether the officer or director eventually exercises the options.
The second method is termed the intrinsic value method. Under this accounting method, if options are granted at an exercise price equal to the market value of the stock at the time of the grant, no compensation expense is recognized. GAAP requires that issuers that elect the second
method must present pro forma disclosures of net income and earnings per share as if the first method had been elected. The Company uses this second method.
Had the Company recognized compensation expense over the expected life of the options based on the fair value method as discussed above, the Companys pro forma salary expense, net income, and earnings per share for the three and six-month periods ended June 30, 2005 and 2004 would have been as follows:
For purposes of the 2005 computation, the significant assumptions used, computed on a weighted average basis, were:
During the second quarter of 2005, the Company granted approximately 215,000 shares of restricted stock to employees and directors. The stock granted to employees vests in annual increments of 5%, 10%, 15%, 30%, and 40%. The stock granted to directors vests at the end of one year. Compensation expense is measured based on the closing price of the stock on the day of the grant. The compensation expense is recognized over the vesting period. Compensation expense related to the second quarter of 2005 was approximately $134,000. While not vested, a portion of the restricted stock must still be included in the period end balance of outstanding shares on the balance sheet as of June 30, 2005 and the average shares outstanding for the second quarter and year-to-date for the computation of earnings per share as explained in Note 3.
The Company has established policies and procedures to permit limited types and amounts of derivative instruments to help manage its interest rate risk. At various times under this authority, the Company has entered into interest rate swaps to mitigate interest rate risk. Under the terms of these swaps, the Company paid a fixed rate of interest to the counterparty and received a floating rate of interest. Such swaps have the effect
of converting fixed rate financial instruments into variable or floating rate instruments. Such swaps may be related to specific instruments or specifically identified pools of instrumentsloans, securities, or deposits with similar interest rate characteristics or terms.
The Company has also established policies and procedures to sell derivatives, specifically interest rate swaps, to customers to assist them in managing their interest rate risk. Generally these customers have wanted to protect themselves from rising rates. Depending on the notional amount of the swap, the Company may cover its position with an interest rate swap purchased from another counterparty with equal but opposite terms, thereby covering its position, so as not to incur any additional interest rate risk. With smaller transactions that mitigate the Companys current interest rate risk position, the Company may elect to not cover its position. The Companys policy limits both the individual notional amount and the aggregate notional amount of these covered and uncovered derivatives.
The Company engages in a very small number of foreign exchange contracts with customers. These may be either spot or futures contracts. Futures contracts are always covered by an offsetting contract with another counterparty so that there is no risk of loss to the Company from changes in the relative price of currencies over the term of the contract.
Other types of derivatives are permitted by the Companys policies, but have not been utilized.
All derivatives are required to be recorded on the balance sheet at their current fair value. Certain derivatives may be designated as either fair value or cash flow accounting hedges and qualify for the deferral of gain or loss recognition. A qualifying hedge may defer all or a part of changes in their fair value in the basis of the item being hedged or in accumulated other comprehensive income. Changes in the fair value of derivatives that are not related to specific instruments and do not meet the criteria for hedge accounting are included in net income, within other income or other expense as appropriate.
Swaps sold to customers are not intended to act as a hedge for the Companys interest rate risk position with respect to the loan. They are intended only to be a hedge by the customer for the customers position. Consequently, they do not meet the requirement for hedge accounting for the Company. Consequently, changes in the fair value of these hedges are included in the Companys net income in the period in which the changes occur. Because a derivative may not be used to hedge another derivative, any changes in the fair value of swaps entered into to cover the Companys position on the customer swaps are also included in net income in the period in which they occur. Because the covering swap will have the same terms as the Companys swap with the customer, gains and losses will net to no income impact for these swaps.
Variable Interest Entities
In December 2003, the FASB issued Interpretation No. 46R, Consolidation of Variable Interest Entities (FIN 46R). In effect, FIN 46R applies broader criteria than just ownership percentage or voting rights in determining whether a controlling financial interest in one entity by another exists. Specifically, if by design the owners of the entity have not made an equity investment sufficient to absorb its expected losses and the owners lack any one of three essential characteristics of controlling financial interest, the entity is to be consolidated in the financial statements of its primary beneficiary. The three characteristics are the ability to make decisions about the entitys activities, the obligation to absorb the expected losses of the entity, and the right to receive the expected residual returns of the entity.
The Company has two special-purpose entities used for the securitizations described in Note 8, Transfers and Servicing of Financial Assets. The special-purpose entity that was used for the indirect auto loan securitization was exempt from this pronouncement because it is a qualifying special-purpose entity (QSPE) as described in Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (SFAS 140). If this entity were now active, instead of disclosing its rights and obligations related to this QSPE under the provisions of FIN 46, the Company would disclose them under the provisions of SFAS 140.
The special-purpose entity used for the tax refund loan securitization is a variable interest entity within the scope of FIN 46R, and is consolidated with the Company. In the structure of this securitization, the loans are sold by the special-purpose entity directly to other financial institutions or to securitization conduits established by one or more financial institutions. These conduits, which are different from the special purpose entity, are variable interest entities within the scope of FIN 46R. However, these conduits hold refund anticipation loans (RALs) originated by the Company only during a 30 day period of each year. They continue to function during the eleven months of the year holding other types of loans purchased from other financial institutions. Therefore, because it is not the primary beneficiary of them and because it exercises no control over the other assets purchased or held, the Company has concluded that consolidation of these conduits with the Company is not required by FIN 46R. While used only during the first quarter of each year, the special purpose entity for RALs remains in place from year to year.
In connection with the March 5, 2004 PCCI acquisition, Bancorp added three business trust subsidiaries which had been originally created by PCCI for the exclusive purpose of issuing trust preferred securities. The three subsidiaries are PCC Trust I, PCC Trust II, and PCC Trust III.
The purchasers of the securities are the primary beneficiaries of these entities. Because Bancorp is not the primary beneficiary of these entities, in accordance with FIN 46 they are not consolidated with the Company. However, the Company has included the investments in these subsidiaries in Other assets and the subordinated debt owed by the Company to these subsidiaries is included in Long-term debt and other borrowings on its Consolidated Balance Sheets. This subordinated debt has exactly the same terms as the trust preferred securities owed by the trusts. In its Consolidated Statements of Income, the Company has reported dividend income from the subsidiaries in Other income and interest expense on the subordinated debt in Other borrowed funds.
The Company has invested in several partnerships that promote the development of low cost housing by providing incentives in the form of tax credits. These partnerships also help the Company meet its obligations under the Community Reinvest-ment Act. These partnerships are variable interest entities within the scope of FIN 46 because, as a group, the holders of the equity interests in these entities do not have the direct or indirect ability to make decisions about the entities activities through voting rights or similar rights. The Company owns more than 50% of the partnership interests in one of these partnerships. The Company has therefore consolidated the assets, liabilities, and operating results of that partnership with the assets, liabilities and operating results of the Company. Consolidation resulted in an additional $3.1 million in assets and a liability for the minority interest of $3.1 million. The Company recognized the whole amount of the operating losses of this partnership which decreased noninterest revenue by $49,000 for the second quarter of 2005 and $122,000 for the first six months of 2005. The Company recognized corresponding reductions of other expense for the same periods for the other partners share of the losses.
Management does not believe that the Company is the primary beneficiary of any other comparable entities such that consolidation with the Companys financial statements would be required by GAAP.
New Accounting Pronouncements
Statement of Financial Accounting Standards No. 123R, Share-Based Payment (SFAS 123R) was issued in December 2004. It requires that the Company recognize in the income statement the fair value of stock options and other equity-based compensation issued to employees. The fair value is determined as of the date these equity instruments are granted. The compensation expense will be recognized as a charge against earnings over the requisite service period.
SFAS 123R permits two alternative transition methods; the modified prospective method and the modified retrospective transition method. Under the modified prospective method, awards that are granted, modified, or settled after the date of adoption should be measured and accounted for in accordance with SFAS 123R. Unvested equity-classified awards that were granted prior to the effective date should continue to be accounted for in accordance with SFAS 123 except that amounts must be recognized in the income statement. Under the modified retrospective approach, the previously reported amounts are restated, either to the beginning of the year of adoption or for all periods presented, to reflect the SFAS 123 amounts in the income statement.
The Statement was to be effective for interim periods beginning after June 15, 2005. In April 2005, the Securities Exchange Commission amended the effective date to be the start of the first fiscal year following June 15, 2005. Under this amendment, the Company will need to adopt SFAS 123R beginning with the first quarter of 2006. The Company has not, as yet, decided which of the two transition methods to use. Management expects the adoption of this statement will have an effect on its annual earnings approximately equivalent to the proforma adjustments disclosed above in this note for SFAS 123, i.e. a reduction of $1.2 million or $0.03 per share. Based on Managements current expectations for net income for 2005, this would represent a reduction of approximately 1.10%.
In December 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position 03-3 (SOP 03-3). SOP 03-3 requires loans that are acquired in a transfer or business combination, the credit quality of which has deteriorated since origination, to be accounted for at fair value. No allowance for loan losses or other valuation allowance is permitted at the time of acquisition. Valuation allowances should reflect only losses incurred after the acquisition. Provisions of the SOP are required to be adopted for fiscal years beginning after December 15, 2004. The Company adopted SOP 03-3 on January 1, 2005 with no financial impact.
The Emerging Issues Task Force (EITF) was established by the FASB to provide prompt resolution of certain specialized accounting issues. In 2003, the EITF addressed the issue of how to measure and account for the other than temporary impairment of securities. The EITF reached a consensus that was described in a document entitled, Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (Issue 03-1). Issue 03-1 defined impairment as the amount by which the cost of an investment (adjusted for the amortization of premium and the accretion of discount) exceeded the fair value of the investment.
Issue 03-1 requires that an investor write-down through a charge to income any other than temporary impairment of a security unless the investor has both the ability and intent to hold the maturity until recovery of the cost of the investment is assured. No distinction was made by the EITF between the treatment of other than temporary impairment due to credit concerns and that due to changes in interest rates. It also
indicated that a pattern of sales of securities that were impaired because of interest rate reasons would taint the assertion by management that it had the intent to hold until recovery.
In October 2004, the FASB delayed the effective date for the recognition and measurement guidance of EITF 03-1 to obtain additional comments from preparers and users of financial statements on the impact of that guidance. The FASB stated that after further consideration of the issue, it would issue final guidance.
In June 2005, the FASB issued a pronouncement that it would provide guidance on accounting for securities that were other than temporarily impaired that would reiterate existing guidance regarding recognition and measurement. The guidance would replace EITF 03-1 and would not include the tainting of the assertion by management because of a pattern of sales of securities that were impaired prior to maturity.
The Company will consider how its practice will be impacted by the provisions of whatever pronouncement is issued by the FASB.
On February 28, 2005, the Company entered into a definitive agreement with First Bancshares, Inc. (FSLO) under which the Company will acquire FSLO in an all-cash transaction. The FSLO transaction closed on August 1, 2005. See Note 1 for further discussion.
On March 5, 2004, the Company acquired Pacific Crest Capital, Inc. (PCCI) in an all cash transaction valued at $136 million, or $26 per each diluted share of Pacific Crest Capital common stock. PCCI was an Agoura Hills, California-based bank holding company that conducted business through its wholly-owned subsidiary, Pacific Crest Bank, which had three branches located in Beverly Hills, Encino and San Diego. Since its establishment in 1974, Pacific Crest Bank had operated as a specialized business bank serving small businesses, entrepreneurs and investors. Its products include customized loans on income producing real estate, business loans under the U.S. Small Business Administration (SBA) 7(a) and 504 programs, lines of credit and term loans to businesses and professionals, and savings and checking account programs. Pacific Crest Bank was an SBA-designated Preferred Lender in California, Arizona and Oregon. In addition to three branches, it operated six loan production offices in California and Oregon. The Company acquired PCCI primarily for its commercial real estate and SBA commercial business lending operations. The Companys Consolidated Statement of Income for the three-month period ended March 31, 2004 includes the operations of PCCI from March 6, 2004 through March 31, 2004. The Company acquired $121 million in investment securities, $419 million in loans, $291 million in deposits, and other assets and liabilities in this transaction. The excess of the purchase price over the net fair value of the assets and liabilities, $80 million, was recognized as goodwill as discussed in Note 7, Goodwill and Other Intangible Assets.
The following table presents pro forma combined information about results of operation as though the acquisition had occurred on January 1, 2004.
There were no extraordinary items or cumulative effects of accounting changes in the periods reported above for either company. The following items related to the acquisition (pre-tax) are included in the Pacific Crest column in the above table for the period of January 1 through March 5, 2004 (in thousands):
There were no material items included in the Company operating results for the first three months of 2004 related to the acquisition other than the payment of the consideration.
Earnings per share for all periods presented in the Consolidated Statements of Income are computed based on the weighted average number of shares outstanding during each period. Diluted earnings per share include the effect of the potential issuance of common shares. For the Company, these include only shares issuable on the exercise of outstanding stock options and shares related to restricted stock awards. Stock options with an exercise price greater than the average market price during the period have been excluded from the computations below because they are anti-dilutive.
As mentioned in the section titled Stock-based Compensation in Note 1, during the second quarter of 2005, the Company issued approximately 215,000 shares of restricted stock to directors and employees. The grant dates were April 25, 2005 and May 27, 2005 respectively.
The computation of basic and diluted earnings per share for the three and six-month periods ended June 30, 2005 and 2004, was as follows (share, option, and net income amounts in thousands):
The amortized historical cost, market values and gross unrealized gains and losses of securities are as follows:
Gains or losses may be realized on securities in the available-for-sale portfolio if the Company sells any of these securities in response to changes in interest rates or for other reasons related to the management of the components of the balance sheet.
The fair value of securities can change due to credit concerns, i.e. whether the issuer will in fact be able to pay the obligation when due, and due to changes in interest rates. All of the securities held by the Company are classified as available for sale, and all are therefore carried at their fair value. However, as required by GAAP, adjustments to the carrying amount for changes in fair value for securities classified as available-for-sale are not recorded in the Companys income statement. Instead, the after-tax effect of the change is shown in a separate component of capital. Consequently, as shown in the first table in this note, there are unrealized gains and losses related to the securities held by the Company.
The following table discloses securities balances by category that are at an unrealized loss at June 30, 2005 and December 31, 2004 and the range of duration of the loss. Included in the table are 72 securities that have been in an unrealized loss position for less than a year and 95 securities that have been in an unrealized loss position for more than one year. The amount of unrealized losses at June 30, 2005 has decreased $1.4 million from December 31, 2004 and decreased $11.9 million since March 31, 2005. The Company realized $621,000 of losses in the second quarter of 2005 and $730,000 in the first half of 2005. The remainder of the decrease in unrealized losses is due to changes in interest rates. The Company sold these securities because Management believes that such sales prevent a large build up of embedded losses that would reduce liquidity and income. The Company does not hold any securities that it believes to be other than temporarily impaired where the impairment is due to credit concerns as described in Securities and Exchange Commission Staff Accounting Bulletin #59 and consequently the Company has no reason to believe that the full par value of the securities will not be received.
The Company has concluded that none of its securities is other than temporarily impaired.
The amortized historical cost and estimated market value of debt securities by contractual maturity are shown below. The issuers of certain of the securities have the right to call or prepay obligations before the contractual maturity date. Depending on the contractual terms of the security, the Company may receive a call or prepayment penalty in such instances.
The balances in the various loan categories are as follows:
The loan balances at June 30, 2005, December 31, 2004 and June 30, 2004 are net of approximately $6.5 million, $7.1 million, and $6.3 million respectively, in deferred net loan fees. The leases reported in the table above are fully financed capital leases of commercial equipment. The Company is not in the business of automobile leasing.
Included among the loans reported in the table above are tax-exempt loans to cities and special districts. These obligations are not bonded as are the municipal obligations in the securities portfolio.
Market Value Adjustment for PCCI Loans
Included in the total for loans is the market value adjustment related to the loans acquired from PCCI in the March 2004 acquisition. The amount of this adjustment was $6.4 million at the time of the acquisition. Because the amount that will be collected on these loans is not impacted by this adjustment, it must be amortized against interest income over the estimated lives of the loans so that the amount of the loans reported as outstanding at the time of payment equals the amount to be paid. Amortization expense on this adjustment through the end of the second quarter of 2005 was $528,000. Estimated amortization expense for the remainder of 2005, for the next three years, and thereafter is as follows:
Impaired Loan Information
The following table discloses balance information about the impaired loans and the related allowance as of June 30, 2005, December 31, 2004 and June 30, 2004:
The following table discloses additional information about impaired loans for the three and six-month periods ended June 30, 2005 and 2004:
The valuation allowance for impaired loans of $1.3 million as of June 30, 2005 is included within the allowance for credit losses of $49.9 million in the All Other Loans column in the statement of changes in the allowance account as of June 30, 2005 shown below. The amounts related to tax refund anticipation loans and to all other loans are shown separately.
Included in Other assets on the Consolidated Balance Sheets at June 30, 2005 and December 31, 2004, are deferred tax assets net of deferred tax liabilities of $9.4 million and $12.2 million, respectively. Deferred tax assets represent the tax impact of expenses recognized as tax deductible for the financial statements that have not been deducted in the Companys tax returns or taxable income reported on a return that has not been recognized in the financial statements as income. Changes in the amount are primarily related to provision for credit losses expense and to changes in the unrealized gain or loss on securities. The Company cannot necessarily deduct its provision for credit losses expense in its tax return in the same year in which it is recognized for financial statements. Provision for credit losses expense is deductible for income tax purposes only as loans are actually charged-off.
The balance of goodwill at June 30, 2005 was $109.7 million, that is comprised of $79.7 million related to the PCCI March 5, 2004 acquisition and $30.0 million related to previous acquisitions as explained in Note 1. Goodwill is allocated to the unit(s) of the acquired company that are deemed by Management to have provided the value in the acquisition. PCCI was acquired primarily for the lending units. In the case of the prior purchases, the perceived value was in the deposit relationships and the consumer and small business lending. Because of the change in reporting segments discussed in Note 14, the goodwill arising from the PCCI acquisition as well as all other goodwill is recorded on the Community Banking segment which includes the Companys deposit activities and consumer and small business lending. Goodwill is not amortized but is periodically reviewed for impairment as discussed in Note 1.
Also recorded on the Consolidated Balance Sheets at June 30, 2005 is approximately $4.3 million in other intangible assets. This figure includes $1.5 million in loan servicing rights, some of which are related to the PCCI acquisition, as discussed in Note 8, Transfers and Servicing of Financial Assets, and an intangible asset of $2.8 million related to both the purchase of certain of the assets and liabilities of two branches from another financial institution and to the value of core deposits acquired with PCCI. The $4.3 million is recorded in the Community Banking segment. The portion related to PCCI is being amortized over 5 years. The portion related to the two branches is also being amortized over 5 years.
Amortization expense for the remainder of 2005, over the next three years, and thereafter on all core deposit intangible and the other minor intangibles is expected to be:
Refund Anticipation Loan Securitization
The Company established a special purpose subsidiary corporation in November 2000 named SBB&T RAL Funding Corporation. During the first quarters of 2004 and 2005 the Company sold RALs through this special purpose entity into multi-seller conduits owned by other financial institutions. The conduits are backed by commercial paper. The Company acted as the servicer for all such RALs during the securitization periods. By March 31, 2004 and 2005, all loans sold into the securitization earlier in the respective quarters were either repaid or charged-off, and no securitization-related balances remain during the subsequent quarters of these years. The potential existed at March 31 of each year for subsequent recoveries on loans charged-off in the securitization during the remainder of the year. The Company believes the impact of these recoveries are immaterial to the financial statements and has recognized such recoveries in the second quarter and will recognize any further recoveries in subsequent quarters along with recoveries of other charged-off RALs as they are realized.
Mortgage and Other Loan Servicing Rights
The Company sells some of the residential mortgages it originates and, for most of these sold loans, servicing is retained. As of June 30, 2005, the Company serviced $60.0 million in residential loans for investors. The Company receives a fee for this service. The right to receive this fee for performing servicing (mortgage servicing rights or MSR) is of value to the Company and could be sold should the Company choose to do so. The rights are recorded at the net present value of the fees that will be collected, less estimated servicing costs, which approximates fair value. The capitalized fees are amortized against noninterest revenue over the expected lives of the loans. The longer the period of time over which the fees will be collected, the more valuable they are. Prepayment by the borrowers of these loans reduces the value of the MSR because the Company will not receive servicing fees for as long as it would if the loans were paid back over the original terms.
Because the rate at which consumers prepay their loans is impacted by changes in interest ratesprepayments increase as rates fall, and decrease as rates risethe value of the servicing right changes with changes in interest rates. Changes in the value are reflected in the financial statements by adjustments to a valuation allowance, which offsets the asset, and by changes or credits to noninterest revenue. Changes to the valuation allowance are only made to reflect impairment or increases in value up to the amount of previously recognized impairments. Adjustments have been made to the valuations allowance almost each quarter since then. The value of the MSR at June 30, 2005 was $472,000, net of an allowance of $39,000.
In connection with the March 5, 2004 PCCI acquisition, the Company obtained a non-mortgage servicing asset of $866,000. This asset was created by PCCIs sales of SBA 7(a) commercial business loans, whereby PCCI sold the guaranteed portion of such loans and retained the servicing, for which it received servicing fees. The servicing asset was recorded at the present value of the excess of the contractual fees that will be collected over the estimated cost of servicing the loans. The Company has continued this activity subsequent to the acquisition. The servicing asset is amortized against noninterest revenue over the expected lives of the underlying loans. As with servicing rights on mortgages, prepayments by the borrowers on these SBA loans reduce the value of the servicing asset. The amount of the SBA 7(a) loans sold and serviced by the Company at June 30, 2005 was $51.0 million, and the amount of the unamortized servicing rights was $1.01 million.
The following table shows the activity in the servicing rights account and the valuation allowance. Servicing rights may be purchased from another institution that originates loans or from another entity that services loans. Aside from the rights acquired as part of the acquisition of PCCI, the Company does not, in the normal coarse of business, purchase such rights.
Long-term debt and other borrowings and obligations include the following items:
As of June 30, 2005, the Federal Home Loan Bank (FHLB) advances had the following maturities: $295 million in 1 year or less; $244 million in 1 to 3 years, and $141 million in more than 3 years. The senior debt is due in July 2006. Of the subordinated debt issued by the Bank, $36 million is due in July 2011, $35 million is due in December 2013, and $50 million is due in 2014. The Treasury Tax and Loan notes are due on demand.
The Subordinated debt issued by Bancorp was assumed in connection with the March 5, 2004 PCCI acquisition. This debt is owed to the three business trust subsidiaries of Bancorp that were obtained in the PCCI acquisition and is comprised of the following: $13,750,000 owed to PCC Trust I, $6,190,000 owed to PCC Trust II, and $10,310,000 owed to PCC Trust III. The difference between these three amounts and the amount shown in the table above represents the fair value adjustment related to the debt which was recorded at the acquisition of PCCI, less subsequent amortization. Each of the three pieces of this subordinated debt will mature in 2033, but is callable by the Company in part or in total in 2008. Each has a fixed rate of interest until 2008 after which the interest rate will float and reset quarterly at the three-month LIBOR rate plus a spread.
The capital lease obligation was incurred when the Company obtained the master lease on a shopping center in which one of its branch offices is located. The lease calls for monthly payments through 2038. The implied interest rate is 5.89%. The capital lease obligation is for the buildings on the property. The Company also leases the land under an operating lease. The amortization of these buildings is included with depreciation expense. Rather than providing for contingent adjustments based on the consumer price index, the lease provides for specific increases during its term.
All eligible retirees may obtain health insurance coverage through the Companys Retiree Health Plan (the Plan). The coverage is provided through the basic coverage plan provided for current employees. Based on a formula involving date of retirement, age at retirement, and years of service prior to retirement, the Plan provides that the Company will pay a portion of the health insurance premium for the retiree. Though the premiums for a retirees health coverage are not paid until after the employee retires, the Company is required to recognize the cost of those benefits as they are earned rather than when paid. The Plan is described in detail in Note 14 to the Companys Consolidated Financial Statements in the 2004 10-K.
The commitment the Company has made to provide these benefits results in an obligation that must be recognized in the financial statements. This obligation, termed the accumulated postretirement benefit obligation (APBO), is the actuarial net present value of the obligation for: (1) already retired employees expected postretirement benefits; and (2) the portion of the expected postretirement benefit obligation earned to date by current employees. The net present value is that amount which if compounded at an assumed interest rate would equal the amount expected to be paid in the future.
The increase in the APBO for the benefits being earned each year, is recognized through a charge to income called the Net Periodic Postretirement Benefit Cost (the NPPBC). The various components of the NPPBC are explained in the 2004 10-K.
The Medicare Prescription Drug, Improvement and Modernization Act was enacted in 2003. The APBO and the NPPBC recognized by the Company do not reflect any amount associated with the federal subsidy provided by the act because the Company is as yet unable to conclude whether the benefits provided by the Plan are actuarially equivalent to those provided by the act.
The amount of NPPBC recognized in the three and six-month periods ending June 30, 2005 and 2004 are disclosed in the following table.
The Company has been a defendant in a class action lawsuit brought on behalf of persons who entered into a refund anticipation loan application and agreement (the RAL Agreement) with the Company from whose tax refund the Company deducted a debt owed by the applicant to another RAL lender. The lawsuit was filed on March 18, 2003 in the Superior Court in San Francisco, California as Canieva Hood and Congress of California Seniors v. Santa Barbara Bank & Trust, Pacific Capital Bank, N.A., and Jackson-Hewitt, Inc. The Company is a
party to a separate cross-collection agreement with each of the other RAL lenders by which it agrees to collect sums due to those other lenders on delinquent RALs by deducting those sums from tax refunds due to its RAL customers and remitting those funds to the RAL lender to whom the debt is owed. This cross-collection procedure is disclosed in the RAL Agreement with the RAL customer and is specifically authorized and agreed to by the customer. The plaintiff does not contest the validity of the debt, but contends that the cross-collection is illegal and requests damages on behalf of the class, injunctive relief against the Company, restitution of sums collected, punitive damages and attorneys fees. Venue for this suit was changed to Santa Barbara. The Company filed an answer to the complaint and a cross complaint for indemnification against the other RAL lenders. On May 4, 2005, a superior court judge in Santa Barbara granted a motion filed by the Company and the other RAL lenders, which resulted in the entry of a judgment in favor of the Company dismissing the suit. The plaintiffs have filed an appeal, but the Company continues to believe that there is no merit to the claims made in this action and intends to vigorously defend itself during any appellate process.
The Company is a defendant in a class action lawsuit brought on behalf of persons who entered into a refund transfer application and agreement (the RT Agreement) with the Company from whose tax refund the Company deducted a debt owed by the applicant to another RAL lender. The lawsuit was filed on May 13, 2003 in the Superior Court in San Francisco, California as Alana Clark, Judith Silverstine, and David Shelton v. Santa Barbara Bank & Trust. The cross-collection procedures mentioned in the description above of the Hood case is also disclosed in the RT Agreement with each RT customer and is specifically authorized and agreed to by the customers. The plaintiffs do not contest the validity of the debt, but contend that the cross-collection is illegal and request damages on behalf of the class, injunctive relief against the Company, restitution of sums collected, punitive damages and attorneys fees. The Company filed a motion for a change in venue from San Francisco to Santa Barbara. The plaintiffs legal counsel stipulated to the change in venue. Thereafter, the plaintiffs dismissed the complaint without prejudice. The plaintiffs filed a new complaint in San Francisco limited to a single cause of action alleging a violation of the California Consumer Legal Remedies Act. The Company filed an answer to the complaint and a cross complaint for indemnification against the other RAL lenders. The Company believes that there is no merit to the claims made in this action and intends to vigorously defend itself.
The Company is a defendant in a class action law suit brought on behalf of residents of the State of New York who engaged Jackson Hewitt, Inc (JHI) to provide tax preparation services and who through JHI entered into an agreement with the Company to receive a RAL. JHI is also a defendant. The lawsuit was filed on June 18, 2004, in the Supreme Court of the State of New York, County of New York as Myron Benton v. Jackson Hewitt, Inc. and Santa Barbara Bank & Trust Co. As part of the RAL documentation, the customer receives and signs a disclosure form which discloses that the Company may share a portion of the federal refund processing fee and finance charge with JHI. The plaintiffs allege that the failure of JHI and the Company to disclose the specific amount of the fee that JHI receives is unlawful and request damages on behalf of the class, injunctive relief, punitive damages and attorneys fees. The Company filed a motion to dismiss the complaint. In response to the complaint, on December 22, 2004, the plaintiffs filed an amended complaint. The amended complaint added three new causes of action: 1) a cause of action for an alleged violation of California Business and Professions Code Sections 17200 and 17500, et seq, as a result of alleged deceptive business practices and false advertising; 2) a cause of action for an alleged violation of California Consumer Legal Remedies Act, California Civil Code Section 1750, et seq; and 3) a cause of action for alleged negligent misrepresentation. The Company has filed a motion to dismiss the amended complaint. The Company believes that there is no merit to the claims made in this action and intends to vigorously defend itself.
The Company is involved in various litigation of a routine nature that are being handled and defended in the ordinary course of the Companys business. Expenses are being incurred in connection with defending the Company, but in the opinion of Management, based in part on consultation with legal counsel, the resolution of this litigation will not have a material impact on the Companys financial position, results of operations, or cash flows.
Securities and Loans Pledged as Collateral
Securities totaling approximately $1.31 billion and $1.37 billion at June 30, 2005 and December 31, 2004, respectively, were pledged to secure public funds, trust deposits, bankruptcy deposits, treasury tax and loan deposits, FHLB advances, customer repurchase agreements, and other borrowings as required or permitted by law.
Loans secured by first trust deeds on residential and commercial property of $878.8 million and $792.6 million at June 30, 2005 and December 31, 2004, respectively, were pledged to the FHLB as security for borrowings.
Letters of Credit and Other Contractual Commitments
In order to meet the financing needs of its customers in the normal course of business, the Company is a party to financial instruments with off-balance sheet risk. These financial instruments consist of commitments to extend credit and standby letters of credit.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of material covenants indicating economic deterioration inconsistent with further lending. The Company sometimes charges fees in connection with loan commitments. Standby letters of credit are irrevocable commitments issued by the Company to guarantee the performance or support the debt of a customer to a third party. The Company charges a fee for these letters of credit.
The standby letters of credit involve, to varying degrees, exposure to credit risk in excess of the amounts recognized in the consolidated balance sheets. This risk arises from the possibility of the failure of the customer to perform according to the terms of a contract or to pay contracted amounts to the third party. In such a situation the third party might draw on the standby letter of credit to pay for completion of the contract or the payment of the contracted amount and the Company would have to look to its customer to repay these funds to the Company with interest. To minimize the risk, the Company uses the same credit policies in making commitments and conditional obligations as it would for a loan to that customer. The decision as to whether collateral should be required is based on the circumstances of each specific commitment or conditional obligation. Because of these practices, Management does not anticipate that any unplanned for and unprovided for losses will arise from such draws, unless there are significant changes in the financial condition of the customers since the evaluation of the condition was performed by the Bank.
Changes in market rates of interest for commitments and undisbursed loans that have fixed rates of interest represent a possible cause of loss because of the contractual requirement to lend money at a rate that is no longer as great as the market rate at the time the loan is funded. To minimize this risk, if rates are quoted in a commitment, they are generally stated in relation to the Companys prime or base lending rate, or to another external index. These rates and indices vary with prevailing market interest rates. Fixed-rate loan commitments are not usually made for more than three months.
Consumer lines of credit consist primarily of home equity lines of credit and overdraft protection lines.
The maximum non-discounted exposure to credit risk is represented by the contractual notional amount of those instruments. The majority of the commitments are for one year or less. The majority of the credit lines and commitments may be with-drawn by the Company subject to applicable legal requirements. As of June 30, 2005 and December 31, 2004, the contractual notional amounts and the maturity of these instruments are as follows:
The Company anticipates that a majority of the above commitments will not be fully drawn by customers. Consumers do not tend to borrow the maximum amounts available under their home equity lines (the Company does not make credit card loans) and businesses typically arrange for credit lines in excess of their expected needs to handle contingencies.
The Company has established a liability for estimated credit losses on letters of credit and other credit commitments. In accordance with GAAP, this liability is not included as part of the allowance for credit loss reported on the consolidated balance sheets for outstanding loans. Instead, the liability is included in other liabilities. The expense to establish and maintain this liability is included in other expense rather than in provision for credit loss. The balance of the liability at June 30, 2005 was $1.1 million.
The following table shows the activity in this reserve account for the three and six-month periods ended June 30, 2005 and 2004:
Other Contractual Obligations
The following table discloses cash amounts contractually due from the Company under specific categories of obligations as of June 30, 2005 and December 31, 2004:
Non-cancelable leases: The Company leases most of its office locations and substantially all of these office leases contain multiple five-year renewal options and provisions for increased rentals, principally for property taxes and maintenance. As of June 30, 2005, the minimum rentals under non-cancelable leases for the next five years and thereafter are shown in the above table. Contractual obligations of sub-tenants have not been netted against the amounts in the above table for minimum rentals. Sub-tenants leasing space from the Company are contractually obligated to the Company for approximately $2.3 million. Approximately 53% of these payments are due to the Company over the next three years.
The capital lease obligation is explained in Note 9.
The Company had no swaps in place at the end of the second quarter of 2005 for managing its own interest rate risk.
The Company has entered into interest rate swaps and foreign exchange transactions with some of its customers to assist them in managing their interest rate and foreign currency risks. As of June 30, 2005, these swaps had a notional amount of $47.8 million and a fair value of $375,000. To avoid increasing its own interest rate or foreign exchange risk from entering into these swap agreements, the Company has entered into offsetting swap agreements with other larger financial institutions that cover most of these customer swaps. These covering swaps had a notional value of $47.8 million and a fair value of negative $375,000. The effect of the offsetting swaps to the Company is to neutralize its interest rate and currency risk positions. The Company generally earns a spread to compensate it for its services. Credit risk is also associated with these swaps in that a counterparty, either the Companys customer or the other financial institution, may default on its obligation.
GAAP requires companies to disclose the fair value of those financial instruments for which it is practicable to estimate that value and the methods and significant assumptions used to estimate those fair values. This must be done irrespective of whether or not the instruments are recognized on the balance sheets of the Company. There are uncertainties inherent in the process of estimating the fair value of certain financial instruments.
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:
Cash and Cash Equivalents
The face value of cash, Federal funds sold, and securities purchased under agreements to resell are their fair value.
For securities, fair value equals quoted market price, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. As explained in Note 1, Summary of Significant Accounting Policies, all of the Companys securities are classified as available-for-sale and are therefore carried at fair value. Consequently, the carrying amount is equal to the fair value in the table below.
The fair value of loans is estimated by discounting the future contractual cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. These contractual cash flows are adjusted to reflect estimates of uncollectible amounts.
The fair value of demand deposits, money market accounts, and savings accounts is the amount payable on demand as of the period end. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. The Company must exclude from its estimate of the fair value of deposit liabilities any consideration of its on-going customer relationships that provide stable sources of investable funds.
Repurchase Agreements, Federal Funds Purchased, and Other Borrowings
For short-term instruments, the carrying amount is a reasonable estimate of their fair value. For FHLB advances, the fair value is estimated by discounting the required debt payments using rates currently quoted by the FHLB for advances of similar remaining maturities. The fair value of the senior and subordinated notes and the capital lease obligation is estimated by discounting the required debt payments using approximately the same spread to the rates current in the market for U.S. Treasury securities of comparable maturity as was present when the notes were issued and the obligation incurred.
Fair values for derivative financial instruments are based on quotes received from other financial institutions for the cost of or the benefit from settling the contract.
Financial Guarantees and Commitments
The fair value of guarantees and letters of credit is based on fees currently charged for similar agreements. The Company does not believe that its loan commitments have a fair value within the context of this note because generally fees have not been charged, the use of the commitment is at the option of the potential borrower, and the commitments are being written at rates comparable to current market rates.
Fair values for off-balance-sheet, credit related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties credit standing.
The fair value of the financial guarantees, commitments and other off-balance-sheet instruments are immaterial.
The carrying amount and estimated fair values of the Companys financial instruments as of June 30, 2005 and December 31, 2004, are as follows:
The following table presents information for each segment regarding assets, profit or loss, and specific items of revenue and expense that are included in that measure of segment profit or loss as reviewed by the chief operating decision maker. Information regarding how the Company determines its segments is provided in Note 26, Segment Reporting, to the Consolidated Financial Statements included in the Companys 2004 10-K.
In connection with the March 5, 2004 PCCI acquisition, the operations of the three branches acquired were included in the Community Banking segment along with the other branch activities of the Company. The operations of PCCIs commercial real estate and SBA lending areas originally reported to the former CEO of PCCI, who reported to the CEO of the Company and, consequently, they had been identified as a reportable segment. As of the beginning of 2005, these lending areas report to the Manager of Retail and Small Business Lending with the Community Banking segment. The following tables disclose segment performance for the three and six month periods ended June 30, 2005 and 2004 with these lending activities included in the Community Banking segment. Also included for comparative purposes are the segment performance tables for the three month periods ended March 31, 2005 and 2004 using the same segments, because the reporting of segment performance for these periods reported in the Quarterly Report on Form 10-Q for the first quarter of 2005 presented these lending areas as a separate segment.
Second Quarter Segment Information:
First Quarter Segment Information Restated:
Second Quarter Year to Date Segment Information:
The following table reconciles total revenues and profit for the segments to total revenues and pre-tax income, respectively, in the consolidated statements of income for the three and six-month periods ended June 30, 2005 and 2004.
As a fiscal intermediary, a large proportion of the Companys business consists of borrowing from some customersdepositors and other financial institutions or bankersand lending the funds to other customersborrowers and securities issuers. The interest expense paid on the borrowings is charged to the segment that does the borrowingCommunity Banking for deposits and Treasury (in All Other) for non-deposit borrowing. The interest earned on loans and securities is credited to the segments that do the lending or investingCommunity Banking, Commercial Banking, and Pacific Capital for loans and Treasury for investments.
Transfer pricing is the process of crediting or charging segments for the benefits they provide to or receive from other segments. The Company does not attempt to transfer price services provided from one segment to another in determining each segments profit or loss, e.g. there is no allocation of administration overhead to the operating units, but the Company does transfer price funds provided or used.
Intersegment revenues consist of transfer pricing for the funds provided by the Community Banking, Refund Programs, and Fiduciary segments, and through the borrowings incurred by the Companys Treasury department included in All Other. Internal charges for funds consist of the transfer pricing for the funds used for lending activities by Community Banking and Commercial Banking and for the purchases of investments by the Treasury department. The totals for intersegment revenues and charges for funds will equal each other because the Companys Treasury unit acts as the net seller or buyer of funds and hence receives the difference between intersegment revenues earned by the other units and charges for funds assessed against the other units. Charges for funds to the lending and Treasury units are reduced because a portion of each segments assets are assumed to be funded by capital rather than borrowed funds. A charge for capital is not included in the pre-tax profitability for each segment.
Intersegment revenues and internal charges for funds will generally be higher when interest rates are higher and lower when rates are low. Short-term interest rates were generally higher in the three-month period ended June 30, 2005 than in the corresponding period of 2004. The commercial loans in the Commercial Banking segment usually have short maturities or reprice frequently and therefore this segment is charged for funds by reference to the short-term rates. Intermediate-term rates were generally lower than the first quarter of 2004. The consumer and small business loans in the Community Banking segment are usually fixed or have infrequent repricings and therefore this segment is charged for funds by reference to intermediate-term rates. As indicated above, the Companys Treasury unit functions as a money center balancing the funding uses and sources. The changes in its intersegment revenues and charges for funds from one year to the next are primarily the result of changes in the relative amounts used and provided by the other segments.
The Company records provision expense for all loans other than RALs in its Credit Administration Department, which is included in the All Other segment.
GAAP AND NON-GAAP MEASURES
In various sections of this discussion and analysis, attention is called to the significant impacts on the Companys balance sheet and year to date income statement caused by its tax refund anticipation loans (RAL) and refund transfer (RT) programs. Because they relate to the filing of individual tax returns, these activities of these programs occur primarily during the first and second quarters of each year. The results of operations and actions taken by the Company to manage these programs are discussed in the section below titled Refund Anticipation Loan and Refund Transfer Programs. Included in the discussion is a summary statement of the results of operations for the programs. These programs comprise one of the Companys operating segments for purposes of segment reporting in Note 14, Segment Disclosure, to the Consolidated Financial Statements. As such, Management believes that separately reporting operating results for the programs is consistent with accounting principles generally accepted in the United States of America (GAAP).
Management computes a number of amounts and ratios exclusive of the balances and operating results of these programs for two reasons. First, because there are only two other financial institutions with nationwide refund programs of similar size to those of the Company, excluding the balances and results of operations for these programs allows Management to compare the results of the Companys traditional banking operations with the results of other financial institutions. Second, because of the high degree of seasonality in these programs, a disproportionate amount of earnings occurs in the first quarter of each year. The Company currently expects approximately 50-55% of its 2005 net income to have been earned in the first quarter. Computing results of operations without these programs allows Management to better identify quarter-to-quarter trends in performance, which are masked by the consolidated figures.
For the last several years, the Companys Management has conducted conference calls with analysts and investors in connection with its quarterly earnings releases. During these calls, investors and analysts have expressed through their questions an interest in knowing certain balances and the usual performance ratios for the Company exclusive of the RAL and RT programs. The Companys Management believes analysts and investors request this information for the same reason that Management uses it, namely to provide clear financial comparability with the Companys peers that do not operate such programs, and to better evaluate performance over sequential quarters. Consequently, the Company has provided these amounts and ratios both with and without the balances and results of the RAL and RT programs in its press releases and in its periodic quarterly and annual reports on Forms 10-Q and 10-K, respectively.
While Management provides these amounts and ratios both with and without the balances and results of the RAL and RT programs, it stresses that both shareholders and potential investors should pay attention primarily to the GAAP results that include the operating results of the RAL and RT programs.
Note A to this discussion includes several tables that provide reconciliations for all numbers and ratios reported in this discussion exclusive of the RAL/RT balances or results to the same numbers and ratios for the Company as a whole reported in the Consolidated Financial Statements. The tables provide the consolidated numbers or ratios, the RAL/RT adjustment, and the numbers or ratios exclusive of the RAL/RT adjustment. Notes designated by a letter are found at the end of this analysis and discussion. Notes designated by a number are notes to the financial statements that precede this discussion and analysis.
In addition to the non-GAAP measures computed related to the Companys balances and results exclusive of its RAL and RT programs, this filing contains other financial information determined by methods other than in accordance with GAAP. Management uses these non-GAAP measures in its analysis of the business and its performance. In particular, net interest income, net interest margin and operating efficiency are calculated on a fully tax-equivalent basis (FTE).
The use of FTE measurement is a common practice in banking and Management believes that the measures calculated on an FTE basis provide a useful picture of net interest income, net interest margin and operating efficiency for comparative purposes. Net interest income and net interest margin on an FTE basis is determined by adjusting net interest income to reflect tax-exempt interest income on an equivalent before-tax basis. The efficiency ratio also uses net interest income on an FTE basis. The FTE calculation is explained in Note B and reconciliations of amounts with and without the FTE adjustment are found in Table 23 in Note A. Net interest income as reported on the Companys Consolidated Income Statement in Item 1 of this Quarterly Report on Form 10-Q is not reported on an FTE basis.
Pacific Capital Bancorp and its wholly owned subsidiaries (together referred to as the Company) earned $14.4 million for the quarter ended June 30, 2005, compared to $16.5 million in the second quarter last year, an decrease of $2.1 million, or 13%. Diluted earnings per share for the second quarter of 2005 were $0.31 compared to $0.36 earned in the second quarter of 2004.
The Company has earned $73.8 million in the first six months of 2005, compared to $59.1 million for the same period of 2004, an increase of 25%.
Compared to the second quarter of 2004, net interest income (the difference between interest income and interest expense) for the second quarter of 2005 increased by $6.3 million, or 11.4%. Total interest income increased by $14.9 million, or 20.9%, partially offset by an increase in interest expense of $8.6 million, or 53.9%. In general, balances of both earning assets and interest-bearing liabilities increased while rates earned and paid were higher compared to the second quarter of 2004. Interest on loans increased $15.4 million, or 27.0%, while interest on securities decreased $0.4 million, or 3.0%. The Federal Open Market Committees (FOMC) increased the Target Federal funds rate by 25 basis points five times in 2004 subsequent to the end of the second quarter and four more times during the first half of 2005. These rate increases were a factor along with the growth in earning assets in generating the increase in net interest income.
Average interest earning assets for the second quarter of 2005 increased by $515 million, or 9.1%, over the same period in 2004. This was comprised of an increase in average loans of $499 million, or 13.4%, offset by a decrease in securities and money market instruments of $45 million, or 3.0%.
The increase in interest expense was comprised of an increase in interest on borrowed funds of $2.6 million, or 41.8%, plus an increase in interest on deposits of $6.1 million, or 61.3%. Average interest-bearing liabilities increased by $353 million, or 8.6%, during the second quarter of 2005 compared to the same period in 2004. This was comprised of an increase in average deposits of $201 million, or 16.5%, as well as an increase in average borrowed funds of $152 million, or 18.9%.
Provision for credit losses expense for loans other than RALs increased from $0.7 million in the second quarter of 2004 to $4.8 million in the second quarter of 2005. Provision expense for RALs was $3.1 million for the second quarter of 2005. The provision expense for non-RAL loans for both quarters was impacted by several factors as explained in the discussion of credit quality below. The increase in the provision for credit losses from RALs for the second quarter of 2005 is explained in the section below titled Refund Loan and Refund Transfer Programs.
Noninterest revenue increased $2.6 million, or 16.7%, in the second quarter of 2005 over the same quarter of 2004. Operating expense increased by $4.3 million, or 9.7%, during the second quarter of 2005 compared to the same quarter of 2004. An explanation of these changes is presented later in this discussion in the sections below titled Noninterest Revenue and Operating Expense, respectively.
TABLE 1PERFORMANCE RATIOS (Note B)
In 2005, the Companys return on average assets (ROA) for the second quarter was 0.94%, compared to 1.18% for the same quarter of 2004, and the return on average equity (ROE) was 11.50%, compared to 15.08%. These annualized ratios can be significantly impacted by the highly seasonal tax refund programs. Exclusive of the impact of RAL/RT programs in both periods, the ROA was 1.03% for the second quarter of 2005, compared to 1.13% for the same period in 2004 and the ROE was 14.51% for the second quarter of 2005 compared with 15.42% for the same period of 2004. The strong performance of the RAL/RT programs and the other business lines of the Company in the first quarter are reflected in the ratios above for the first six months of 2005 both with and without the RAL/RT programs.
The operating efficiency ratio measures what proportion of a dollar of operating income it takes to earn that dollar. The operating efficiency ratio decreased to 59.01% for the second quarter of 2005 from 60.46% for the same quarter in 2004. Exclusive of the impacts of the RAL/RT programs, the operating efficiency ratio improved from 60.98% in the second quarter of 2004 to 58.32% in the same quarter of 2005.
The net interest margin, exclusive of the impact of RAL/RT programs, was higher in the second quarter of 2005 compared to the margin in the first quarter of 2004, 4.41% vs. 4.35%. The FOMC rate increases in general benefited the margin. The low interest rate environment had tended to cause a lower net interest margin because the rates paid on deposits could not be decreased at the same rate that interest rates the Company charges on loans were decreased. With interest rates now rising, the Companys loans are starting to reprice to higher rates rather than to lower rates as had been the case for the last several years. Competitive pressure to raise deposit rates has developed in the second quarter, lowering the margin from 4.67% for the first quarter of 2005. This competitive pressure is expected to remain for the next few quarters.
The Company is a bank holding company. All references to the Company apply to Pacific Capital Bancorp and its subsidiaries on a consolidated basis. Bancorp will be used to refer to the parent company only. The Bank refers to the Companys primary subsidiary, Pacific Capital Bank, N.A. The Bank uses five brand names in different geographic areas. The Bank is a member of the Federal Reserve System. The Bank offers a full range of retail and commercial banking services. These include commercial, real estate, and consumer loans, a wide variety of deposit products, and full trust services.
Bancorp has seven other subsidiaries. PCB Services Corporation has only insignificant activities and Pacific Capital Services Corporation is an inactive corporation. SBB&T Automobile Loan Securitization Corporation was used for an automobile loan securitization that ended in the second quarter of 2004 and is also now inactive. SBB&T RAL Funding Corporation is used in the RAL securitization that is described in Note 8, Transfers and Servicing of Financial Assets, to the Consolidated Financial Statements. It was inactive in the second quarter of 2005 and will remain so until January 2006.
On March 5, 2004, the Company acquired PCCI and its wholly owned subsidiaries, Pacific Crest Bank, Pacific Crest Capital Trust I (PCC Trust I), Pacific Crest Capital Trust II (PCC Trust II), and Pacific Crest Capital Trust III (PCC Trust III). PCCI was merged into Bancorp, while Pacific Crest Bank was merged into the Bank. PCC Trust I, PCC Trust II, and PCC Trust III had been created by PCCI for the exclusive purpose of issuing trust preferred securities. These last three entities will remain subsidiaries of Bancorp but are not consolidated in the financial statements of the Company (see the discussion in Variable Interest Entities in Note 1).
On August 1, 2005, the Company completed its acquisition of First Bancshares, Inc., and its wholly owned subsidiaries, First Bank of San Luis Obispo and First BancShares Trust I. The second subsidiary was created by FSLO for the exclusive purpose of issuing trust-preferred securities. First Bank of San Luis Obispo was merged into the Bank, FSLO into Bancorp, and First Bancshares Trust I was not consolidated for the same reason as the trust subsidiaries of PCCI are not consolidated.
This quarterly report on Form 10-Q, including this discussion and analysis, contains forward-looking statements with respect to the financial condition, results of operation and business of the Company that are based on Managements beliefs as well as assumptions made by and information currently available to the Companys management. These include, but are not limited to statements that relate to or are dependent on estimates or assumptions relating to the prospects of continued loan and deposit growth, improved credit quality, the trend and intensity of changes in interest rates, and the operating characteristics of the Companys income tax refund programs. The subjects of these forward-looking statements involve certain risks and uncertainties, many of which are beyond the Companys control. Such statements are intended to be covered by the safe-harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 and this statement is being included for the purpose of invoking these safe-harbor provisions. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include, among others, the following possibilities: (1) increased competitive pressure among financial services companies; (2) changes in the interest rate environment reducing interest margins or increasing
interest rate risk; (3) deterioration in general economic conditions, internationally, nationally or in the State of California; (4) reduced demand for or earnings derived from the Companys income tax refund loan and refund transfer programs; (5) judicial, legislative or regulatory changes adversely affecting the business in which the Company engages; (6) the occurrence of future events such as the terrorist acts of September 11, 2001 or consequences of U.S. military involvement in the Middle East; (7) difficulties integrating acquired operations; (8) implementation risk relating to a new computer system mentioned in the section titled Operating Expense; and (9) other risks detailed in the 2004 10-K. Forward-looking statements speak only as of the date they are made, and the Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made.
CRITICAL ACCOUNTING POLICIES
A number of critical accounting policies are used in the preparation of the Consolidated Financial Statements which this discussion accompanies.
The Use of Estimates
The preparation of Consolidated Financial Statements in accordance with GAAP requires Management to make certain estimates and assumptions that affect the amounts of reported assets and liabilities as well as contingent assets and liabilities as of the date of these financial statements. These estimates and assumptions also affect the reported amounts of revenues and expenses during the reporting period(s). Although Management believes these estimates and assumptions to be reasonably accurate, actual results may differ.
The principal areas in which estimates are used are as follows:
Allowance for credit losses: An estimate of the amount of the probable losses incurred in the Companys loan portfolio is used in determining the amount of the allowance for credit losses and therefore the periodic charge to income for the provision for credit losses expense. A description of the method of developing the estimate is described in the section below titled Credit Quality and the Allowance for Credit Losses and in Note 1, Summary of Significant Accounting Policies, to the Consolidated Financial Statements presented in the Companys 2004 10-K. If the actual losses incurred in fact materially exceed the estimate of probable losses developed by Management, then the allowance for credit losses will have been understated and the Company will have to record additional provision expense in future periods as the actual amount of losses are recognized. If the losses currently in the portfolio are subsequently determined to be materially less than the estimate, then the Company will reverse the excess allowance through provision expense in future periods.
Events or circumstances that can cause this estimate of losses to be substantially different than eventually occur are primarily due to a lack of sufficient information about borrowers current financial condition or as such financial condition may change over time. This occurs because the borrower does not provide the information on a timely basis or because it is incomplete or inaccurate.
In addition to the estimation of probable losses developed for loans other than RALs, the Company also develops an estimate of losses for RALs outstanding at June 30. A description of the method used in developing the estimate is described in the section below titled Refund Loan and Refund Transfer Programs.
Realizability of deferred tax assets: The Companys deferred tax assets are explained in the section below titled Income Tax and in Note 15, Income Taxes, to the Consolidated Financial Statements presented in the Companys 2004 10-K. The Company uses an estimate of future earnings to support its position that the benefit of its deferred tax assets will be realized. If future pre-tax income should prove non-existent or less than the amount of the temporary differences giving rise to the deferred tax assets within the tax years to which they may be applied, the assets will not be realized and the Companys net income will be reduced.
Actuarial estimates used in retiree health plan: The Company uses certain estimates regarding its employees to determine its liability for postretirement health benefits. These estimates include life expectancy, length of time before retirement, and future rates of growth of medical costs. Should these estimates prove materially wrong such that the liability is understated, the Company will either incur more expense to provide the benefits or it will need to amend the plan to limit benefits to the Company.
Prepayment assumptions used in determining the amortization of premium and discount for securities: Approximately two thirds of the Companys investment securities are mortgage-backed or asset-backed securities. Prepayment of principal by borrowers on the underlying loans results in faster return of principal for the securities. The rate at which prepayments are expected to occur in future periods impacts the amount of premium to be amortized in the current period. If prepayments in a future period are higher than estimated, then the Company will
need to amortize a larger amount of premium in that future period, such that the total premium amortized to date as of the end of that future period will equal the amount that would have been amortized had the higher prepayment rate been experienced during all past periods over which the security was held. If future prepayments are less than estimated, then less premium will be amortized in the future period to similarly result in an amount of premium amortization life-to-date as if the lower rate of prepayments had been experienced from the purchase of the security.
Estimates of the fair value of assets: Certain assets of the Company are recorded at fair value, or the lower of cost or fair value. In some cases, the fair value used is an estimate. Included among these assets are securities that are classified as available for sale, and other real estate owned and impaired loans. These estimates may change from period to period as they are impacted by changes in interest rates and other market conditions. Losses not anticipated or greater than anticipated could result if the Company were forced to sell one of these assets and discovered that its estimate of fair value had been too high. Gains not anticipated or greater than anticipated could result if the Company were to sell one of these assets and discovered that its estimate of fair value had been too low.
Goodwill is initially recorded as the difference between the compensation paid in the acquisition of a business or the portion of a business and the difference between the fair value of the assets and liabilities of the business or portion acquired. Other intangible assets that are acquired in business combination are initially recorded at their fair value at the time of acquisition. In both cases, estimates of fair value are used in determining the amount at which the asset is recorded.
Estimates of fair value are arrived at as follows:
Assumptions regarding mortgage and other servicing rights: For the Company, mortgage and other servicing rights arise from the sale of loans. There is a secondary market for servicing rights wherein a financial institution may purchase the right to service loans for and receive a fee from the holder of the loans. The market value for such servicing is based on the coupon rates, maturity, and prepayment rates experienced for the loans being serviced as well as on the fees received. The value of the servicing rights recorded by the Company at the time of the sale is based on Managements best estimate of the market value of servicing rights for similar pools of loans. If the Company overestimates the value of the servicing rights, it will recognize too large a gain at the time of sale and will hold an asset against which a charge to earnings will later have to be taken. If the Company underestimates the value of the servicing rights, it will have recognized too small a gain and will later recognize income from the servicing that should have been recognized in the period in which the loans were sold.
Available-for-sale securities: The fair value of most securities classified as available-for-sale are based on quoted market prices. These quoted market prices are derived from two independent sources and compared for consistency. If the two sources differ significantly, or if quoted market prices are not available, alternative methods are used, which include seeking bids from brokers on a representative security or extrapolating the value from the quoted prices of similar instruments. The Company also uses estimates of the future rate of prepayments on the loans underlying the various mortgage-backed securities to determine the expected life of that security. That estimated life then determines the rate of amortization or accretion to recognize against the premium or discount of those instruments.
Goodwill and other intangible assets: As discussed in Note 7, Goodwill and Other Intangible Assets, to the Consolidated Financial Statements, the Company must assess goodwill and other intangible assets each year for impairment. This assessment involves estimating cash flows for future periods, preparing analyses of market multiples for similar operations, and estimating the fair values of the reporting unit to which the goodwill is allocated. If the future cash flows were materially less than the estimates, the Company would be required to take a charge against earnings to write down the asset to the lower fair value.
Other real estate owned and impaired loans: The fair value of other real estate owned or collateral supporting impaired loans is generally determined from appraisals obtained from independent appraisers. The Company also must estimate the costs to dispose of the property. This is generally done based on experience with similar properties. When determining the valuation allowance for impaired loans, the Company may use the discounted cash flow method which may include estimates of borrower revenue, expenses, capital expenditures and disposals of capital assets, along with estimates of future economic conditions including forecasts of interest rates and other economic factors which Management believes would impact estimated future customer cash flows.
Estimates relating to self-insurance from workers compensation: The Company self-insures a portion of its workers compensation exposure. Because not all injuries are immediately reported to the Company, it must accrue an estimate of the claims loss for injuries that have occurred but not been reported. The estimate is based on actuarial data provided by the insurance company that covers the Company for large claims above the Companys self-insured amount. If the Company underestimates the cost of unreported claims, it will need to recognize an expense for these claims in subsequent periods. If the estimate is too large, the Company will report a reduction in expense in subsequent years for the excess.
Income tax estimates: With each period end, it is necessary for Management to make certain estimates and assumptions to compute the provision for income tax. Management uses the best information available to develop these estimates and assumptions, but generally some of these estimates and assumptions are revised when the Company files its tax return in the middle of the following year. In accordance with generally accepted accounting principles, revisions to estimates are recorded as income tax expense or benefit in the period in which they become known. Among the estimates are estimates of the years pre-tax income and permanent differences. These estimates are used to compute an effective tax rate used to record income tax expense for the interim periods. As of June 30, 2005, Management has calculated an effective tax rate for the year will be 37.65%. To the extent that the estimated changes during a subsequent quarter the effect of the change on prior quarters as well as on the current quarter will be included in tax expense for the current quarter. The effective tax rate is lower than the statutory rate of 42.05% due to the benefits relating to permanent differences such as tax-exempt income on municipal securities, tax exempt loans, and bank owned life insurance, and the deductibility for tax purposes of special expenses like the bargain element on exercises under the employee and director stock option plans and dividends paid to the Companys Employee Stock Ownership Plan.
Depreciation of fixed assets: The Company selects lives of assets over which to depreciate or amortize the cost based on the expected period it will benefit the Company. The Companys methods of depreciation and the lives of fixed assets are described in Note 1, Summary of Significant Accounting Policies, to the Consolidated Financial Statements presented in the Companys 2004 10-K. If a method is used or a life is chosen that results in a material amount of the cost not having been amortized when the asset provides no further benefit to the Company, then a loss will be incurred for the unamortized cost of the asset when it is disposed of or replaced.
Amortization of the cost of other assets: The Companys methods of amortizing assets other than fixed assets are described in notes to these Consolidated Financial Statements or in the 2004 10-K. As with fixed assets, if the method of amortization or the amortization term results in unamortized cost when the asset has no further value, a loss will be recognized.
Alternative Methods of Accounting
The accounting and reporting policies of the Company are in accordance with GAAP and conform to practices within the banking industry. As such there are few alternatives available to the Company in its accounting for items of income or expense or for assets and liabilities. The one significant area where a choice is available is accounting for stock-based compensation.
Stock options: When the Company adopted Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123) in 1996, it elected to continue to use the intrinsic value method of accounting for stock options. Under this method, the Company does not recognize compensation expense at the time options are granted. As required by SFAS 123, pro forma amounts of compensation expense and the pro forma impact on net income and earnings per share are disclosed in the Companys Annual Reports on Form 10-K and Quarterly Reports on Form 10-Q as if the Company had elected to instead use the fair value accounting method that recognizes compensation expense at the time options are granted. As indicated in Note 1, this alternative method of accounting will no longer be available beginning January 1, 2006.
NEW ACCOUNTING PRONOUNCEMENTS
The Companys financial results have been or will be impacted by several accounting pronouncements, issued over the last two years. These pronouncements and the nature of their impact are discussed in Note 1, Summary of Significant Accounting Policies to the Consolidated Financial Statements.
RISKS FROM CURRENT EVENTS
As of this writing, there seems to be no clear consensus as to how long U.S. military forces will be engaged in Iraq and Afghanistan. Commentators have expressed opinions that prolonged presence of US military forces in the region would be both expensive and could provoke further terrorist actions as has recently occurred in the United Kingdom. Either of these consequences could have an impact on the economy and therefore on the results of operations for the Company.
Over the last two years, it had been difficult for the California Legislature to pass the state budget on a timely basis. In addition, a substantial amount of borrowing has been necessary to balance these budgets. In July, the Legislature was able to pass a budget only six days into the start of the new fiscal year, but borrowing was still required. While such actions clearly impact the California economy, the Company does not believe that they will have any material impact on its operating results. The Company does not own any State of California debt obligations and has no concentration of customers that will specifically be impacted by the lower levels of governmental expenditures. The general consensus
appears to be that while either substantial cost-cutting, i.e., reduction in benefits and service levels or tax increases are still necessary, there is less of a crisis with respect to the states financial condition than was the case a year or two ago.
GROWTH TRENDS IN ASSETS AND DEPOSITS
The chart below shows the growth in average total assets and deposits since 1999. Annual averages are shown for 1999, 2000, 2001, and 2002, quarterly averages are shown for 2003, 2004, and 2005. Because significant but unusual cash flows sometimes occur at the end of a quarter and at year-end, the overall trend in the Companys growth is better shown by the use of average balances for the periods.
CHART 1GROWTH IN AVERAGE ASSETS AND DEPOSITS
(dollars in millions)
Deposit balances also have been included in the chart because an important factor in the profitability of the Company is the portion of assets that are funded by deposits. The interest rate paid on deposit accounts is generally less than the rate paid on nondeposit sources of funding.
There are three primary reasons for the overall growth trend shown above for the Company. The first is the acquisition of other financial institutions. The acquisition in 2000 of Los Robles Bank added $172 million to the Companys assets and $155 million to deposits. The acquisition of PCCI in March 2004 added $652 million in assets and $291 million in deposits.
The Companys other acquisitions in 1998 and 2000 were accounted for by the pooling of interests method. Asset and deposit totals for periods prior to the mergers have been restated to include the balances and so do not impact the totals shown in the above chart. However, growth at these institutions subsequent to the merger is reflected in the chart above.
Secondly, the Companys experience with acquisitions and mergers has been contrary to the general pattern in which banks lose customers of the acquired institution. Depositors of banks acquired by or merged with the Company have kept their deposits with the Company. The Company attributes this to its efforts to maintain the acquired institutions culture and management in place. The impact of this reason has been less in the last several years as the frequency of acquisitions in the financial industry has slowed in California.
Third, the Bank has opened new offices during the period covered by the table. The company also acquired some of the assets and deposits of two of the branches of another financial institution in the first quarter of 2002.
Average assets and deposits increase during the first quarters of each year and then generally decrease in the second quarter. The major reason for this is the Companys tax refund loan program. The growth in assets is from the loans held by the Company. The growth in deposits is due both to certificates of deposit used as one of the sources of funding for the refund loans and to the outstanding checks issued for loans and transfers (See Note C).
INTEREST RATE SENSITIVITY
Banks act as financial intermediaries. As such, they take in funds from depositors and then either lend the funds to borrowers or invest the funds in securities and other instruments. The Company earns interest income on loans and securities and pays interest expense on deposits and
other borrowings. Net interest income is the difference in dollars between the interest income earned and the interest expense paid. On an annual basis, net interest income represents approximately 70%-75% of the Companys net revenues.
Period-to-period Comparison of the Components of Net Interest Income and Net Interest Margin
Tables 2A and 2B show the average balances of the major categories of earning assets and liabilities for the three and six -month periods ended June 30, 2005 and 2004 together with the related interest income and expense. Table 3, an analysis of volume and rate variances, explains how much of the differences in interest income or expense for the three and six-month periods ended June 30, 2005 compared to the corresponding periods of 2004 is due to changes in the balances (volume) and how much is due to changes in rates. For example, Table 2A shows that for the second quarter of 2005, real estate loansmulti-family and nonresidential averaged $1.6 billion, interest income for them was $27.6 million, and the average rate received was 6.78%. In the same quarter of 2004, real estate loansmulti-family and nonresidential averaged $1.5 billion, interest income for them was $22.1 million, and the average rate received was 5.91%. Table 3 shows that the $5.5 million increase in interest income for these loans from the second quarter of 2004 compared to the second quarter of 2005 is the net result of a $2.1 million increase in interest income due to higher balances in 2005, and an increase of $3.4 million due to higher rates during 2005.
Tables 2A and 2B also disclose the net interest margin for the reported periods. Net interest margin is the ratio of net interest income to average earning assets. This ratio is useful in allowing the Company to monitor the spread between interest income and interest expense from month to month and year to year irrespective of the growth of the Companys assets. The net interest margin and net interest income are reported on a taxable equivalent basis (Note D). If the Company is able to maintain the net interest margin as the Company grows, the amount of net interest income will increase. If the net interest margin decreases, net interest income can still increase, but earning assets must increase at a higher rate. The increased volume of earning assets serves to replace the net interest income that is lost by the decreasing rate.
As shown in Table 2A, the net interest margin, 4.50%, for the second quarter of 2005 was higher than the comparable figure, 4.42%, for the second quarter of 2004. As noted at the start of this discussion, the RAL and RT programs have a significant impact on the Companys operating results. This is most pronounced during the first quarter. The second quarter is minimally impacted. For comparability with the reporting in prior quarters of net interest margin, both with and without RALs, the net interest margin for the second quarter of 2005, exclusive of RALs, was 4.41% compared to 4.35% for the second quarter of 2004, and 4.67% for the first quarter of 2005.
The Federal Reserve Banks (FRB) target Federal funds rate averaged 1.00% in the second quarter of 2004 and averaged 2.91% in the second quarter of 2005 as the FOMC has progressively raised short term rates over the last 12 months. Despite this increase, mid-term rates have risen much less than short-term rates and longer-term rates have fallen since June 30, 2004. This has caused the interest rate yield curve to flatten significantly (See Note E).
Some changes in the net interest margin are directly related to changes in market rates. These include the origination or renewal of loans and deposits in the new interest rate environment. Other changes occur, but are less direct. Examples of these include: (1) a change in prepayments in the securities portfolio, which results in changes in premium amortization; (2) a higher cost of funds due to an increase in the longer-term brokered CD accounts added in during 2004 to manage interest rate risk; and (3) a change in product mix due to higher growth rate in the loan portfolios than in the securities portfoliosloans earn higher rates compared to the rates earned on securities.
TABLE 2AAVERAGE BALANCES, INCOME AND EXPENSE, YIELDS AND RATES (1)