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Pacific Capital Bancorp 10-Q 2011 Table of Contents
UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
Form 10-Q (Mark One)
For the quarterly period ended June 30, 2011 OR
For the transition period from to COMMISSION FILE NUMBER NO: 001-35026
(Exact Name of Registrant as Specified in its Charter)
(805) 564-6405 (Registrant’s telephone number, including area code)
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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ¨ Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company x (Do not check if a smaller reporting company) Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x Number of shares of common stock of the registrant outstanding as of July 30, 2011: 32,904,995
Table of ContentsTABLE OF CONTENTS
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Table of ContentsPART I Forward-Looking Statements This Quarterly Report on Form 10-Q (“Form 10-Q”) contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Pacific Capital Bancorp (the “Company”) intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in these provisions. All statements, other than statements of historical fact, are “forward-looking statements” for purposes of federal and state securities laws, including, but not limited to, statements about anticipated future operating and financial performance, financial position and liquidity, business prospects, strategic alternatives, business strategies, regulatory and competitive outlook, investment and expenditure plans, capital and financing needs and availability, acquisition and divestiture opportunities, plans and objectives of management for future operations, and other similar forecasts and statements of expectation and statements of assumptions underlying any of the foregoing. Words such as “will likely result,” “aims,” “anticipates,” “believes,” “could,” “estimates,” “expects,” “hopes,” “intends,” “may,” “plans,” “projects,” “seeks,” “should,” “will,” and variations of these words and similar expressions are intended to identify these forward-looking statements. Forward-looking statements are based on the Company’s current expectations and assumptions regarding its business, the regulatory environment, the economy and other future conditions. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict. The Company’s actual results may differ materially from those contemplated by the forward-looking statements. The Company cautions the reader of these statements therefore against relying on any of these forward-looking statements. They are neither statements of historical fact nor guarantees or assurances of future performance. Important factors that could cause actual results to differ materially from those in the forward-looking statements include, but are not limited to, the following:
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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, whether as a result of new information, future developments or otherwise, except as may be required by law. Definition of Terms Specific accounting and banking industry terms and acronyms used throughout this document are defined in the glossary on pages 97 through 98.
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Table of ContentsPacific Capital Bancorp and Subsidiaries CONSOLIDATED BALANCE SHEETS (dollars and shares in thousands, except per share amounts)
The accompanying notes are an integral part of these financial statements.
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Table of ContentsPacific Capital Bancorp and Subsidiaries CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited) (dollars and shares in thousands, except per share amounts)
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Table of ContentsPacific Capital Bancorp and Subsidiaries CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited) (dollars and shares in thousands, except per share amounts) (continued)
The accompanying notes are an integral part of these financial statements.
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Table of ContentsPacific Capital Bancorp and Subsidiaries CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY AND COMPREHENSIVE (LOSS)/INCOME (unaudited) (dollars and shares in thousands)
The accompanying notes are an integral part of these financial statements. (continued on next page)
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Table of ContentsPacific Capital Bancorp and Subsidiaries CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY AND COMPREHENSIVE (LOSS)/INCOME (unaudited) (dollars and shares in thousands)
The accompanying notes are an integral part of these financial statements.
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Table of ContentsPacific Capital Bancorp and Subsidiaries CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) (dollars in thousands)
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Table of ContentsPacific Capital Bancorp and Subsidiaries CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) (dollars in thousands) (continued)
The accompanying notes are an integral part of these financial statements.
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Table of ContentsPacific Capital Bancorp and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Operations Pacific Capital Bancorp is a bank holding company organized under the laws of the state of Delaware. The Company provides a full range of commercial and consumer banking services to households, professionals, and businesses through its wholly-owned subsidiary Santa Barbara Bank & Trust, National Association. These banking services include depository, lending and wealth management services. The Bank’s lending products include commercial and industrial (“commercial”), consumer, commercial and residential real estate loans and Small Business Administration (“SBA”) loans. Depository services include checking, interest bearing checking (“NOW”), money market demand accounts (“MMDA”), savings, and Certificate of Deposit (“CD”) accounts, as well as safe deposit boxes, travelers’ checks, money orders, foreign exchange services, and cashier’s checks. The Bank also offers a wide range of wealth management services through a full service trust operation and two registered investment advisors that are wholly-owned subsidiaries, Morton Capital Management (“MCM”) and R.E. Wacker Associates (“REWA”). In December 2010, the Company announced plans to begin to consolidate the brand names of First National Bank of Central California, South Valley National Bank, San Benito Bank, and First Bank of San Luis Obispo, to the Santa Barbara Bank & Trust brand name. The rebranding consolidation has been completed. SBB&T currently conducts its banking in the counties of Santa Barbara, Ventura, Los Angeles, Monterey, San Luis Obispo, Santa Clara, Santa Cruz, and San Benito. During the second quarter of 2011, the Company announced a change in the legal name of its wholly-owned nationally chartered banking subsidiary from Pacific Capital Bank, National Association to Santa Barbara Bank & Trust, National Association. Basis of Presentation The accompanying Consolidated Financial Statements of Pacific Capital Bancorp are unaudited and, in the opinion of Management, include all adjustments necessary for a fair statement of the Company’s financial position and results of operations for the periods presented. All inter-company balances and transactions are eliminated in consolidation. The Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and footnotes thereto included in the Company’s Form 10-K for the fiscal year ended December 31, 2010. The accompanying unaudited Consolidated Financial Statements and related footnotes have been prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X and conform to practices within the financial services industry. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. The results of operations for the three and six months ended June 30, 2011 are not necessarily indicative of the results to be expected for the fiscal year ending December 31, 2011. The Consolidated Financial Statements refer to “Management” within the disclosures. The Company’s definition of Management is the executive management team of the Company and its subsidiaries.
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Table of ContentsPacific Capital Bancorp and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED
The preparation of financial statements in conformity with GAAP requires Management to make estimates and assumptions that affect the amount of assets and liabilities as well as disclosures of contingent assets and liabilities at the date of the financial statements. Although Management believes these estimates to be reasonably accurate, actual amounts may differ. In the opinion of Management, all adjustments considered necessary have been reflected in the financial statements during their preparation. Certain amounts in the 2010 financial statements have been reclassified to be comparable with classifications used in the 2011 financial statements. On December 28, 2010, the Company effected a 1-for-100 reverse stock split, reducing its authorized common shares from 5 billion to 50 million. Outstanding shares were reduced from 3.29 billion to 32.9 million. All outstanding stock options and warrants to purchase stock, and their respective exercise prices, were adjusted for this reverse stock split. All per share amounts for both the Predecessor Company and the Successor Company in the Company’s Consolidated Financial Statements have been restated to reflect this reverse stock split. Recapitalization through the Investment Transaction and Purchase Accounting On August 31, 2010, pursuant to the terms of an Investment Agreement (the “Investment Agreement”), dated as of April 29, 2010, by and among the Company, the Bank and SB Acquisition Company LLC, a wholly-owned subsidiary of Ford Financial Fund, L.P. (the “Investor”), the Company issued to the Investor (i) 2,250,000 shares of common stock at a purchase price of $20.00 per share and (ii) 455,000 newly created shares of our Series C Convertible Participating Voting Preferred Stock (the “Series C Preferred Stock”) at a purchase price of $1,000 per share (the purchase and sale of these securities, the “Investment Transaction”). The aggregate consideration paid to the Company by the Investor for these securities was $500 million in cash. As a result of the Investment Transaction, pursuant to which the Investor acquired and controlled 98.1% of the voting securities of the Company, the Company followed the acquisition or purchase method of accounting as required by the Business Combinations Topic of the Accounting Standard Codification (“ASC”) Topic 805, Business Combinations (“ASC 805”). Under the rules of the SEC Staff Accounting Bulletin T. 5J, New Basis of Accounting Required in Certain Circumstances (“SEC SAB T. 5J”) or ASC 805-50-S99, the application of “push down” accounting is required. As a result of the adjustments required by purchase accounting, the Company’s balance sheets and results of operations from periods through August 31, 2010 are labeled as “Predecessor Company” and may not be comparable to balance sheets and results of operations from periods after the close of business on August 31, 2010 (the “Transaction Date”), which are labeled as “Successor Company. ” Purchase accounting requires that the assets purchased, the liabilities assumed, and non-controlling interests all be reported in the acquirer’s financial statements at their fair value, with any excess of purchase consideration over the net assets being reported as goodwill. Although the $500 million in cash from the Investor was received on August 31, 2010, the purchase accounting adjustments are reflected in the Consolidated Financial Statements after the close of business on the Transaction Date. The purchase accounting transactions are reflected within the Successor Company’s Consolidated Financial Statements. Acquisition accounting requires that the valuation of assets, liabilities, and non-controlling interests be recorded in the acquiree’s records as well. Accordingly, the Company’s Consolidated Financial Statements and transactional records prior to the Investment Transaction reflect the historical accounting basis of assets and liabilities and are labeled “Predecessor Company,” while such records subsequent to the Investment Transaction are labeled “Successor Company” and reflect the push down basis of accounting for the new fair values in the Company’s Consolidated Financial Statements. This change in accounting basis is represented in the Consolidated Financial Statements by a vertical black line which appears between the columns entitled “Successor Company” and “Predecessor Company” on the statements and in the relevant notes of the Consolidated Financial Statements. The black line signifies that the amounts shown for the periods prior to and subsequent to the Investment Transaction may not be comparable.
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Table of ContentsPacific Capital Bancorp and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED
In addition to the new accounting basis established for assets, liabilities and noncontrolling interests, purchase accounting requires the reclassification of any retained earnings from periods prior to the acquisition to be recognized as common share equity and the elimination of any accumulated other comprehensive income (“OCI”) or loss and paid in capital within the Company’s Shareholders’ Equity section of the Company’s Consolidated Financial Statements. Accordingly, retained earnings and OCI since the Transaction Date represent only the results of operations subsequent to the Transaction Date. Consolidation of Subsidiaries and Variable Interest Entities The Company has five wholly-owned subsidiaries: SBB&T, a banking subsidiary, and four unconsolidated subsidiaries used as business trusts in connection with issuance of trust preferred securities as described in Note 17, “Long Term Debt and Other Borrowings” of the 2010 Form 10-K. SBB&T has three wholly-owned consolidated subsidiaries:
SBB&T also retains ownership in several low income housing tax credit partnerships (“LIHTCP”) that generate tax credits. These partnerships are not consolidated into these Consolidated Financial Statements. These investments historically have played a significant role in meeting SBB&T’s Community Reinvestment Act (“CRA”) requirements as well as providing tax credits to reduce the Company’s taxable income. The Company does not have any other entities that should be considered for consolidation. Recent Accounting Pronouncements During the six months ended June 30, 2011, the following accounting pronouncements applicable to the Company were issued or became effective: In January 2011, the FASB issued Accounting Standards Update (“ASU”) 2011-01, Receivables (Topic 310): Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20 (“ASU 2011-01”). The ASU 2011-01 is temporarily delayed and the effective date has not been finalized. The ASU 2011-01 disclosures for troubled debt restructurings are delayed until the FASB completes its deliberations on what constitutes a troubled debt restructuring. In April 2011, the FASB issued ASU 2011-02, Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring. The ASU clarifies which loan modifications constitute troubled debt restructuring and is intended to assist creditors in determining whether a modification of the terms of a receivable meet the criteria to be considered a troubled debt restructuring, both for purposes of recording an impairment loss and for disclosure of troubled debt restructurings. In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist: (a) the restructuring constitutes a concession; and (b) the debtor is experiencing financial difficulties. The guidance will be effective for the Company on July 1, 2011 and applies retrospectively to restructurings occurring on or after January 1, 2011. At the same time it adopts ASU 2011-02, the Company will be required to disclose the activity-based information about TDRs that was previously deferred by ASU No. 2011-01. The adoption of the new guidance is not expected to have a material impact on the Company’s Consolidated Financial Statements.
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NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED
In May 2011, the FASB issued ASU 2011-04, Amendments to Achieve Common Fair Value Measurements and Disclosure Requirements in U.S. GAAP and IFRS, which updates Topic 820: Fair Value Measurements. This update is effective for interim and annual reporting periods beginning after December 15, 2011, and should be applied prospectively. Early adoption is not permitted. The adoption of the new guidance is not expected to have a material impact on the Company’s financial statements. In June 2011, the FASB issued ASU 2011-05, Presentation of Comprehensive Income which updates Topic 220: Comprehensive Income. The FASB’s objective in updating this area of the codification is to increase comparability, consistency and transparency of financial reporting and to increase the prominence of items reported in other comprehensive income. This update requires all non-owner changes in stockholder’s equity to be presented in either a single continuous statement of comprehensive income, or in two separate but consecutive statements. The provisions of this update are effective for interim and annual periods beginning after December 15, 2011. Cash Reserve Requirement All depository institutions are required by law to maintain reserves against their transaction deposits. The reserves must be held in cash or with the Reserve Bank. The amount of the reserve may vary each day as banks are permitted to meet this requirement by maintaining the specified amount as an average balance over a two week period. In addition, the Bank must maintain sufficient balances to cover the checks written by bank customers that are clearing through the Reserve Bank because they have been deposited at other banks. Trading Assets The identification of a trading asset is determined at the time of purchase. Trading securities are recorded at fair value on a recurring basis. Trading assets are reported on the Consolidated Balance Sheets at their estimated fair value. The changes in the fair value of the trading securities are reported in noninterest income as they occur. All trading assets were transferred to the available for sale (“AFS”) portfolio at the Transaction Date. Investment Securities All investment securities are debt securities and are classified as AFS. The appropriate classification is determined at the time of purchase. Securities classified as AFS are reported as an asset on the Consolidated Balance Sheets at their estimated fair value. As the fair value of AFS securities changes, the changes are reported (net of the appropriate income tax) as an element of OCI. When AFS securities, specifically identified, are sold, the unrealized gain or loss is reclassified from OCI to noninterest income. When the estimated fair value of a security is lower than the book value, a security is considered to be impaired. On a quarterly basis, Management evaluates any securities in a loss position to determine whether the impairment is other-than-temporary. If there is intent to sell the security or if the Company will be required to sell the security or if the Company will not recover the entire cost basis of the security, the security is other-than-temporarily impaired and impairment is recognized. The amount of impairment resulting from credit loss is recognized in earnings and impairment related to all other factors is recognized in OCI.
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NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED
Interest income is recognized based on the coupon rate and is increased by the accretion of discounts earned or decreased by the amortization of premiums paid over the contractual life of the security using the effective interest method. The Bank is a member of both the Reserve Bank and the Federal Home Loan Bank (“FHLB”), and as a condition of membership in both organizations, it is required to purchase stock. In the case of the Reserve Bank, the amount of stock that is required to be held is based on the Bank’s capital. The required ownership of FHLB stock is based on the borrowing capacity used by the Bank. These investments are considered equity securities with no actively traded market. Therefore, the shares are considered restricted investment securities and reported in FHLB and other investments in the Consolidated Balance Sheets. Such investments are carried at cost, which is equal to the value at which they may be redeemed. The dividend income received from the stock is reported in interest income. Loans Held for Sale Periodically, the Company originates or identifies loans it expects to sell prior to maturity. When loans are originated or identified to be sold, they are recorded as held for sale and reported at the lower of cost or fair value in the Consolidated Balance Sheets. The loan’s cost basis includes unearned deferred fees and costs, and premiums and discounts. These loans are generally held between 30 to 90 days from their origination date. Due to the short period of time loans are held for sale, deferred fees or expenses are not amortized. If a loan has been reported as held for sale and is then determined that it is unlikely to be sold, the loan is reclassified to loans held for investment at the lower of cost or fair value. The majority of loans held for sale by the Company are residential real estate loans. Loans classified as held for sale are disclosed in Note 4, “Loans” of these Consolidated Financial Statements. Loans Held for Investment Loans held for investment, except for Purchased Credit Impaired (“PCI”) Loan Pools described below, are reported at their outstanding principal balances net of any unearned income, cumulative charge-offs, unamortized deferred fees and costs on originated loans and unamortized premiums or discounts on purchased loans. Loans originated and purchased since the Transaction Date are included in “Loans Held for Investment” within these Consolidated Financial Statements and are referred to within these Consolidated Financial Statements as “Loans originated and purchased since the Transaction Date.” At June 30, 2011 and at December 31, 2010, a majority of the loans reported as Loans Held for Investment are PCI Loan Pools. The accounting for PCI Loan Pools is significantly different from the accounting for loans originated and purchased since the Transaction Date. The accounting policies for the loans originated since the Transaction Date are covered within this section, while the accounting for PCI Loan Pools is described in the section below called “Accounting for PCI Loan Pools.” Interest income on all loans originated or purchased since the Transaction Date is accrued daily, except for PCI Loan Pools and loans in a nonaccrual status. Loan fees collected for the origination of loans less direct loan origination costs (net deferred loan fees) are amortized over the contractual life of the loan through interest income. If a loan has scheduled payments, the amortization of the net deferred loan fee is calculated using the effective interest method over the contractual life of the loan. If the loan does not have scheduled payments, such as a line of credit, the net deferred loan fee is recognized as interest income on a straight line basis over the contractual life of the loan commitment. Loan fees received for loan commitments are recognized as interest income over the term of the commitment. When loans are repaid, any remaining unamortized balances of unearned fees, deferred fees and costs and premiums and discounts paid on purchased loans are accounted for through interest income.
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NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED
Unfunded Loan Commitments and Letters of Credit Letters and lines of credit are commitments to extend credit and standby letters of credit to the Company’s customers. These commitments meet the financing needs of the Company’s customers in the normal course of business and are commitments with “off-balance sheet” risk since the Company has committed to issuing funds to or on behalf of customers, but there is no current loan outstanding. Included in unfunded loan commitments are secured and unsecured lines of credit. Lines of credit are obligations to lend money to a borrower. Credit risk arises when the borrowers’ current financial condition may indicate less ability to pay than when the commitment was originally made. Standby letters of credit and financial guarantees are conditional commitments issued by the Company to guarantee the performance of a customer to a third party in borrowing arrangements. In the case of standby letters of credit, the risk arises from the possibility of the failure of the customer to perform according to the terms of a contract. In such a situation, the third party might draw on the standby letter of credit to pay for completion of the contract and the Company would have to look to its customer to repay these funds to the Company with interest. The Company uses the same credit policies in making commitments and conditional obligations as it would for a loan to that customer. The Company has exposure to losses from unfunded loan commitments and letters of credit. Since the funds have not been disbursed on these commitments, they are not reported as loans outstanding. Losses related to these commitments are not included in the allowance for loan and lease losses reported in Note 6, “Allowance for Loan and Lease Losses” of these Consolidated Financial Statements. Instead, they are accounted for as a separate loss contingency or reserve within other liabilities on the Company’s Consolidated Balance Sheets. The reserve for unfunded commitments is an estimate of losses inherent in loan commitments which have not funded. The determination of the reserve for unfunded commitments applies the same historical loss rates and qualitative factors to the unfunded commitments using the same credit risk characteristics in calculating the allowance for loan and lease losses and then applies estimates regarding usage of the unfunded commitments. Prior to the funding of a loan, the Company may provide an interest rate lock commitment for mortgage loans that will be originated with the intent to sell. The Company may also enter into mandatory delivery contracts, which are loan sale agreements in which the Company has committed to deliver a certain principal amount of mortgage loans to a third party investor at a specified price on or before a specified date. These interest rate lock commitments and mandatory delivery contracts qualify as derivatives under GAAP. The fair value of the interest rate lock commitments is based on the change in interest rates between the date the interest rate lock commitment is executed and the date the loan is funded. The fair value of the mandatory delivery contracts is calculated by comparing the price on the contract accepted date to the price on the actual sale date. The fair value of these derivatives is reported as other assets or other liabilities and changes in the fair values are reflected through noninterest income in the Company’s Consolidated Financial Statements.
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Table of ContentsPacific Capital Bancorp and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED
Accounting for PCI Loan Pools Loans acquired in a transfer, including business combinations, where there is evidence of credit deterioration since origination and it is probable at the date of acquisition that the acquirer will not collect all contractually required principal and interest payments, are accounted for using the guidance for PCI Loan Pools, which is contained in the ASC 310-30, Receivables, Loans and Debt Securities Acquired with Deteriorated Credit Quality (“ASC 310-30”). In addition, the American Institute of Certified Public Accountants (“AICPA”) reached an understanding with the SEC that permits an acquirer to elect to account for acquired loans that are not impaired by means of expected cash flows rather than contractual cash flows. This understanding is documented in a letter from the AICPA to the SEC dated December 18, 2009. The Company has elected an accounting policy to apply expected cash flows accounting guidance to all loans subject to the business combination and push-down accounting requirements for loan portfolios acquired in a business combination and will herein be referred to as “PCI Term Pools.” Some loans that otherwise meet the definition of credit impaired, such as revolving lines of credit, are specifically excluded from the scope of the accounting guidance in ASC 310-30 and are accounted for using ASC 310-20, Receivables, Nonrefundable Fees and Other Costs (“ASC 310-20”). However, Management considers these revolving lines of credit to also be credit impaired and has pooled these revolving lines of credit purchased through the Investment Transaction and herein will refer to these loans as “PCI Revolving Pools.” PCI Term Pools are initially recorded at fair value, and any related allowance for loan and lease losses from before the acquisition cannot be carried over. Fair value is determined by estimating the principal and interest cash flows expected to be collected after discounting at the prevailing market rate of interest. The difference between contractual cash flows and expected cash flows, on an undiscounted basis, represents the nonaccretable difference. The difference between undiscounted expected cash flows and discounted expected cash flows represents the accretable yield. The Company’s estimated expected cash flows on PCI Loan Pools take into consideration estimated prepayments based on the characteristics of the loans contained in each loan pool and expected charge-offs and recoveries of the PCI Loan Pools. The accretable yield is recognized in interest income over the remaining life of the pool of loans using the effective yield method or cost recovery method if cash flows are not estimable. Management has elected to have PCI Loan Pools aggregated into several pools based on common risk characteristics as allowed under ASC 310-30. Each pool is accounted for as a single asset with a single composite interest rate and an aggregate expectation of cash flows. Both the accretion of interest income and the comparison of actual cash flows to expected cash flows are completed at the pool level rather than by individual loans. The Company has aggregated all of the loans acquired at the Transaction Date into the pools. Loans may not be removed from a pool, added to a pool, or moved from one pool to another. All activity such as payments, charge-offs, recoveries, and prepayments received are applied to the loan pool in which the loan was placed at the Transaction Date. Payments which are in excess of expectations in one pool may not be applied to other pools to avoid the recognition of impairment for deficient payments within another pool. Only the disposal of a loan, which may include sales of loans to third parties, payoff or prepayment by the borrower, foreclosure of the collateral, or charge-off will result in the removal of a loan from a loan pool. When a loan is removed from a pool, it is removed at its carrying amount. The Company periodically compares actual cash flows to expected cash flows for PCI Term Pools to determine whether such cash flows are substantially the same as was expected at the time the loans expected cash flows were last estimated. Differences in actual cash flows from that previously expected may result in a revision to the Company’s estimate for expected cash flows. If upon reevaluation of expected cash flows the Company determines they will be less than previously estimated, an allowance for loan losses is established through a charge to the provision for loan losses and an impairment is recorded. If reevaluation of expected cash flows indicates there is a significant and probable increase over that previously expected, the Company would decrease any previously established allowance, and then record an increase to interest income through the adjustment of the discount rate used to calculate the accretable yield.
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NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED
Because PCI Term Pools are written down at acquisition to an amount estimated to be collectible and aggregated into pools, the classification and disclosures are at pool levels regardless of the underlying individual loan performance. PCI Term Pools are not reported as delinquent, nonaccrual, impaired or troubled debt restructured (“TDRs”) even though some of the underlying loans may be contractually past due, on nonaccrual, impaired or TDRs as the pool is evaluated as a single unit of account. PCI Revolving Pools As mentioned above, acquired loans which are revolving are excluded from ASC 310-30. The accounting for purchase discounts on pooled revolving lines of credit is required in accordance with ASC 310-20. Individual revolving lines of credit that had been originated prior to the Investment Transaction were placed in pools with similar risk characteristics. PCI Revolving Pools were recorded at fair value at the Transaction Date, similar to PCI Term Pools, based on expected cash flows, which included estimated losses inherent in the pool at the Transaction Date. A new carrying amount is established for PCI Revolving Pools based on its fair value, which represents its net realizable value. The difference between the former carrying value and the net realizable value is the purchase discount. Because of the uncertainty in the underlying cash flows associated with the PCI Revolving Pools at the Transaction Date, Management has determined that the purchase discount should not be accreted until it is significantly probable that the net realizable value exceeds the net carrying amount. Therefore, the Company has only recorded interest income on these pools at the contractual rate to the extent considered collectible. Management periodically reassesses the net realizable value of each PCI Revolving Pool and records interest income relating to the purchase discount in accordance with ASC 310-20. Such amounts are recognized in income on a straight line basis over the period the revolving line of credit is active, assuming that borrowings are outstanding for the maximum term provided in the loan contract. In the event that credit losses are higher than expectations, the Company records an allowance to the extent that the carrying value exceeds the amounts expected to be collected. Unlike PCI Term Pools, accounting guidance requires that disclosures be made on the underlying loans in PCI Revolving Pools even though such loans were written down to fair value on the Transaction Date. As a result, the underlying loans in PCI Revolving Pools are reported as contractually delinquent, nonaccrual, impaired, or TDRs to the extent applicable. Allowance for Loan and Lease Losses Credit risk is inherent in the business of extending loans and leases to borrowers. Normally, this credit risk is addressed through a valuation allowance termed Allowance for Loan and Lease Losses (“ALLL”). The ALLL represents a creditor’s estimate of loan losses inherent within the loan portfolio at each balance sheet date. Netted against the outstanding loan balance, this allowance reduces the carrying amount to the creditor’s estimate of what will be collected from borrowers. The ALLL is established through charges to current period earnings by recording a provision for loan losses. When losses become specifically identifiable and quantifiable, the carrying amount is reduced through recording a charge-off against the ALLL. Should payments be received on charged-off loans, the payment is credited to the allowance as a recovery.
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Charge-offs of loans are generally processed by policy as well as by regulatory guidance. Secured consumer loans, including residential real estate loans, that are 120 days past due are written down to the fair value of the collateral. Unsecured consumer loans are charged-off once the loan is 120 days past due. Decisions on when to charge-off commercial loans and loans secured by commercial real estate are made on an individual basis rather than length of delinquency, though it is a factor in the decision. The financial resources of the borrower and/or guarantor and the nature and value of any collateral are other factors considered. It is also more common among these business loans to charge-off or write down portions of the balance than with consumer loans other than real estate. The purchase accounting guidance for business combinations significantly impacted the Company’s allowance for loan and lease losses as of the Transaction Date. The revaluation of assets required by this accounting guidance resulted in all loans being reported at their fair value as of the Transaction Date. The fair value is presumed to take into account the contractual payments on loans that are not expected to be received, and consequently no allowance for loan and lease losses was carried over for the Company’s loans as of the Transaction Date. Subsequent to the Transaction Date, the ALLL is comprised of the Company’s estimate of losses inherent in successor loans originated and purchased since the Transaction Date; the differential between current expected cash flows and prior expected cash flows for PCI Term Pools when current expected cash flows are less than prior expected cash flows; and the amount of credit losses inherent in PCI Revolving Pools in excess of the net realizable value. Credit risk ratings of large problem loans in the commercial loan portfolio (loans secured by multifamily real estate, loans secured by commercial real estate, loans secured by the construction of multifamily or commercial real estate, commercial and industrial/commercial loans, and other) are reviewed at a minimum, quarterly. A credit risk rating for a commercial loan may be assessed and require a credit risk rating change when the following events occur:
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Credit risk ratings in the consumer loan portfolio (term and revolving loans secured by residential real estate for 1 to 4 families, secured consumer loans, and unsecured lines of credit for consumer loans) are assessed and require a credit risk rating change when the following events occur:
The change in a borrower’s credit risk rating is not limited to the listing above. Quarterly, the Company’s credit administration department obtains a credit score refreshment report which assesses consumer loan borrower’s credit scores to identify borrowers which could have a deterioration of credit score which would trigger a credit risk rating change for a borrower. Once a credit risk rating is assessed for a loan, its classification is determined based on the expectation of repayment. Nonclassified loans generally include those loans that are expected to be repaid in accordance with contractual loan terms. Classified loans are those loans that are classified as substandard or doubtful consistent with regulatory guidelines. Loans Classified as Substandard A substandard loan is a loan which is inadequately protected by a current sound worth and paying capacity of the borrower or the collateral pledged, if any. The extension of credit has a well defined weakness and/or the Company identifies a distinct possibility that a loss will be incurred if the deficiency identified is not corrected. When a loan is classified as substandard it does not necessarily imply there is a loss exposure in a specific loan, but a loss potential does exist. Loans Classified as Doubtful Loans classified as doubtful have all of the weaknesses inherent in a loan classified as substandard with an added characteristic that the weaknesses make the collection or liquidation in full, on the basis of currently existing facts, conditions, and values highly questionable and improbable. After reviewing the credit risk ratings in the loan portfolio, the second step is to develop an estimate of the loss inherent in individual loans or groups of similar loans. The estimation of probable losses takes into consideration the loan credit risk ratings and other factors such as:
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The amount of the allowance recorded at the end of the prior reporting period is then compared with the new estimate of inherent loss. If additional allowance is required to cover the revised estimate, the additional amount is provided through a charge to provision for loan losses. If the recorded allowance is higher than the revised estimate, the allowance is reduced by a negative provision for loan losses. For PCI Loan Pools, which represent 91.6% of the carrying value of the Company’s loans held for investment at June 30, 2011, there is no ALLL unless further deterioration of credit quality has occurred since the Transaction Date. These loans were recorded at fair value as of the Transaction Date based on the acquirer’s estimate of collections to be received. In addition, each quarter, Management must make a determination whether the estimate of expected cash flows from these loans needs to be revised. This determination is based on actual cash flows received and any information available about the borrowers and their financial condition that would lead Management to conclude that expected cash flows will be substantially different from what was estimated at the end of the last accounting period. Of the factors noted above for PCI Loan Pools, those that relate specifically to the borrower, to the economy, and to credit deterioration seen for similar borrowers or similar businesses or industries will be most relevant. As is indicated in the section above for PCI Loan Pools, the Company has aggregated all of these loans into pools with similar risk characteristics that have become the individual units of accounting. The estimates of expected cash flows are therefore calculated at the pool level. An unfavorable change in the estimate of expected cash flows requires that the Company recognize the impairment by establishing an ALLL on a pool by pool basis. A favorable change in the estimate of expected cash flows – where it is significantly probable that the net realizable value exceeds the net carrying amount – would result in reversing any allowance previously established because of an unfavorable change, but no negative provision is recorded if the favorable change exceeds any previously recorded allowance. Instead, the excess expected cash flows are accreted into income over the remaining estimated terms of the loans in the pool.
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Further information on the allowance for loan loss is provided in Note 6, “Allowance for Loan and Lease Losses” of these Consolidated Financial Statements. ALLL Model Methodology The Company considers both quantitative and qualitative factors when determining the level of estimated ALLL. Quantitative factors are based primarily on historical credit losses for each portfolio of similar loans over a time horizon or “look-back” period. The Company uses historical credit losses over the past six quarters as a basis for its quantitative factors. Qualitative factors are used to adjust historical loss rates based on the Company’s estimate of the losses inherent in the outstanding loan portfolio that are not fully captured by the quantitative factors alone. Qualitative factors taken into consideration in calculations of the ALLL include: concentrations of types of loans, loan growth, control environment, delinquency and classified loan trends, Management and staffing experience and turnover, economic conditions, results of independent loan review, underlying collateral values, competition, regulatory, legal issues, structured finance and syndicated national credits, and other factors. These qualitative factors are applied as adjustments to the historical loss rates when Management believes they are necessary to better reflect current conditions. Nonaccrual Loans, Impaired Loans, and Restructures of Troubled Debt As discussed above in the PCI Loan Pools section, the accounting for pooled credit impaired loans has implications for classification and reporting disclosures of loans classified as nonaccrual, impaired, or TDRs. Because the Company’s loans were written down to fair value and pooled as of the Transaction Date, the carrying amount of the loans in the Company’s Consolidated Financial Statements is based upon amounts estimated to be collected. Term Pools are not classified as nonaccrual, impaired or TDRs even though some of the underlying loans may be contractually past due or nonperforming unlike the underlying loans in the PCI Revolving Pools which are required to be accounted for as delinquent, nonaccrual, impaired, or TDR. Quarterly, the individual pools are assessed for the overall collectability of the expected cash flows on a pool by pool basis. For all loans originated since the Transaction Date, when an individual borrower discontinues making payments as contractually required by the note, the Company must determine whether it is appropriate to continue to accrue interest. Generally, the Company places loans in a nonaccrual status and ceases recognizing interest income when the loan has become delinquent by more than 90 days and/or when Management determines that the repayment of principal and collection of interest is unlikely. The Company may decide that it is appropriate to continue to accrue interest on certain loans more than 90 days delinquent if they are well secured by collateral and collection is in process. When a loan is placed on nonaccrual status, any accrued but uncollected interest for the loan is reversed out of interest income in the period in which the status is changed. Subsequent payments received from the customer are applied to principal and no further interest income is recognized until the principal has been paid in full or until circumstances have changed such that payments are again consistently received as contractually required. In the case of commercial customers, the pattern of payment must also be accompanied by a positive change in the financial condition of the borrower.
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A loan is identified as impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. However, there are some loans that are termed impaired because of doubt regarding collectability of interest and principal according to the contractual terms, but are both fully secured by collateral and are current in their interest and principal payments. These impaired loans may be placed back on accrual. Once a loan is identified as impaired, the amount of any impairment is determined based on the extent to which the Company’s recorded investment in the loan exceeds the loan’s estimated fair value. The Company determines an impaired loan’s fair value based on either the present value of the expected future cash flows, discounted at the loan’s effective interest rate, or the fair value of the collateral securing the loan. When using the fair value of the collateral securing an impaired as the basis for measuring impairment, the Company takes into consideration estimated costs to sell the collateral when determining it’s fair value. A valuation allowance is established for an impaired loan through a charge to earnings when the fair value of the loan is less than the Company’s recorded investment in the loan. For additional information in obtaining the fair value of a loan, refer to Note 2, “Fair Value of Financial Instruments,” on page 30 of these Consolidated Financial Statements. A loan may be restructured when the Company determines that a borrower’s financial condition has deteriorated, but still has the ability to repay at least some portion of the loan. A loan is considered to be a TDR when the original terms have been modified in favor of the borrower such that either principal or interest has been forgiven, contractual payments are deferred, or the interest rate is reduced. A loan may also be considered a TDR when the loan of a financially troubled borrower is renewed with the same terms as were offered when the borrower was not troubled because it is normally expected that interest rates will be higher to cover the increased credit risk from a troubled borrower. Additional information regarding loans classified nonaccrual, impaired, and TDRs is disclosed in Note 6, “Allowance for Loan and Lease Losses” of these Consolidated Financial Statements Premises and Equipment Premises and equipment are reported at cost less accumulated depreciation. Depreciation is expensed over the estimated useful lives of the assets. The Company depreciates assets utilizing a combination of accelerated methods of depreciation and straight line depreciation. The estimated useful lives of premises and equipment are as follows:
Leasehold improvements are amortized over the terms of the leases or the estimated useful lives of the improvements, whichever is shorter. Management annually reviews Premises and Equipment in order to determine if facts and circumstances suggest that the value of an asset is not recoverable. Leases The Company leases a majority of its branches and support offices. Most of these leases are operating leases for which a monthly rental expense is recognized. However, when the terms of the lease are such that the Company is leasing the building for most of its useful economic life or the present value of the sum of lease payments represents most of the fair value of the building, the transaction
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is accounted for as a capital lease. In a capital lease, the building is recognized as an asset of the Company and the net present value of the contracted lease payments is recognized as a long term liability. The amortization charge relating to assets recorded under capital leases is included with depreciation expense. Some of the Company’s leases have cost-of-living adjustments based on the consumer price index. Some of the leases have fixed increases provided for in the terms or increases based on the index but have a minimum increase irrespective of the change in index. In these cases, the total fixed or minimum lease expense is recognized on a straight line basis over the term of the lease. As part of the purchase accounting due to the Investment Transaction, the Company evaluated all of its leases. A liability was recorded as of the Transaction Date because the contractual lease payments were above the current market rates for several leased properties in aggregate. The contractual obligations for leases are disclosed in Note 9, “Premises and Equipment” of the 2010 Form 10-K’s Consolidated Financial Statements. Goodwill and Intangible Assets Intangible assets are generally acquired through an acquisition. If the benefit of the intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed, rented, or exchanged, regardless of the acquirer’s intent to do so, the acquired intangible asset will be a separately recognized asset. Such intangible assets are subject to amortization over their useful lives. Among these identifiable intangible assets are core deposit intangibles and customer relationship intangibles (“CRI”). The Company amortizes core deposit intangibles and core relationship intangibles over their estimated useful lives. Any excess of the purchase price over the estimated fair value of the assets received and liabilities assumed is an unidentifiable intangible asset and is recorded as goodwill. Goodwill must be reviewed for impairment whenever there is evidence to suggest that the reason an acquirer paid more than the estimated value of the net assets no longer is present but not less frequently than once per year. This evidence may be in the form of a triggering event or a series of events or developments. Testing goodwill for impairment consists of a two part test to determine the fair value of goodwill. In Step 1, the fair value of the reporting unit is determined and compared to its carrying value including goodwill. If the fair value of the reporting unit is more than its carrying value, goodwill is not impaired. If the fair value of the reporting unit is less than its carrying value, the company must proceed with Step 2. In Step 2, the implied fair value of goodwill is estimated. The implied fair value of goodwill is the excess of fair value of the reporting unit over the fair values of the assets and liabilities of the reporting unit as they would be determined in an acquisition. If the carrying amount of the goodwill is more than its implied fair value, it is impaired and an impairment charge must be recognized. All of the goodwill recognized in the Company’s Consolidated Financial Statements as of June 30, 2011 is the result of the purchase accounting for the Investment Transaction. Additional information regarding goodwill and the computation of goodwill is disclosed in Note 2, “Business Combination—Investment Transaction” and Note 10, “Goodwill and Intangible Assets” of the 2010 Form 10-K’s Consolidated Financial Statements. Bank Owned Life Insurance Bank owned life insurance (“BOLI”) involves the purchase of life insurance by the Company on a chosen group of employees. The Company is the owner and is a joint or sole beneficiary of the policies. This life insurance investment is carried as an asset at the cash surrender value of the underlying policies. In cases where the Company is a joint beneficiary of the policies, the Company has recorded a liability for the portion of the cash surrender value owned by the other party. Income from the increase in cash surrender value of the policies is reflected in noninterest income. The cash surrender value approximates fair value.
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Other Real Estate Owned Real estate acquired through foreclosure on a loan or by the surrender of real estate in lieu of foreclosure is called Other Real Estate Owned or (“OREO”). OREO is recorded in the Company’s financial records at the lower of its carrying value or fair value of the OREO, less estimated costs to sell. If the outstanding balance of the loan is greater than the fair value of the OREO at the time of foreclosure, the excess of the loan balance over the fair value is charged-off against the ALLL before recording the asset as an OREO. OREOs are recorded as other assets within the Consolidated Financial Statements. Once the collateral is foreclosed on and the property becomes an OREO, Management periodically obtains appraisals to determine if further valuation adjustments are required. Valuation adjustments are also required when the listing price to sell an OREO has had to be reduced below the current carrying value. If there is a decrease in the fair value of the property from the last valuation, the decrease in value is charged against noninterest income. During the time the property is held, all related operating and maintenance costs are expensed as incurred. Increases in the values of properties are not recognized until sale. All income produced from OREOs, such as from renting the property, is included in noninterest income. Mortgage and Other Loan Servicing Rights Included in other assets are mortgage and other loan servicing rights associated with the sale of loans for which the servicing of the loan is retained. The Company receives a fee for servicing these loans. The right to receive this fee for performing servicing is of value to the Company and could be sold should the Company choose to do so. Companies engaged in selling loans and retaining servicing rights for a fee are required to recognize servicing rights as an asset or liability. The rights are recorded at the net present value of the fees that will be collected, less estimated servicing costs, which approximates the fair value. Loan servicing rights are amortized into noninterest income in proportion to, and over the period of, estimated future net servicing income. Estimates of the lives of the loans are based on several industry standard sources and take into consideration prepayment rates expected in the current market interest rate environment. Each quarter Management evaluates servicing rights for impairment. Impairment occurs when the fair value of loan servicing rights is less than amortized cost. The rates at which consumers prepay their loans are impacted by changes in interest rates—prepayments generally increase as interest rates fall, and generally decrease as interest rates rise so the value of the servicing right changes with changes in interest rates. When prepayments increase, the Company will collect less servicing fees, and the value of the servicing rights declines. A valuation of the servicing assets is performed at each reporting period and reductions to the servicing assets’ carrying value are made when the carrying balance is higher than the fair value of the servicing asset utilizing the lower of cost or fair value valuation methodology.
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Securities Sold Under Agreement to Repurchase The Company enters into repurchase agreements whereby it sells securities or loans to another institution and agrees to repurchase them at a later date for an amount in excess of the sale price. While in form these are agreements to sell and repurchase, in substance they are secured borrowings in which the excess of the repurchase price over the sale price represents interest expense. This expense is accrued over the term of the borrowing. For security or collateral, the Company must pledge assets with a higher fair value than the amount borrowed. Information about the amounts held and the interest rates may be found in Note 16, “Securities Sold Under Agreements to Repurchase and Federal Funds Purchased” of the 2010 Form 10-K’s Consolidated Financial Statements. There was a purchase accounting premium recorded as a result of the Investment Transaction for these repurchase agreements based on current market rates for similar instruments. Other Borrowings Management utilizes a variety of sources to raise borrowed funds at competitive rates, including FHLB borrowings and subordinated debt. FHLB borrowings typically carry rates approximating the London Inter-Bank Offered Rate (“LIBOR”) for the equivalent term because they are secured with investments or high quality loans. Interest is accrued on a monthly basis based on the outstanding borrowings interest rate and is included in interest expense. In past quarters, a majority of the long term and short term debt of the Company were advances with the FHLB. Long term funding through the FHLB is collateralized by pledging qualifying loans and/or securities. Virtually all of the FHLB advances were repaid by the Company in early September 2010 from the proceeds received in the Investment Transaction and deposits maintained at the Reserve Bank. Purchase accounting adjustments were made based on current market rates for similar instruments. Refer to Note 10, “Other Borrowings” of these Consolidated Financial Statements for the current period activity within long term debt and other borrowings. Reserve for Off-Balance Sheet Commitments The Company has exposure to losses from unfunded loan commitments and letters of credit. Since the funds have not been disbursed on these commitments, they are not reported as loans outstanding. Estimated losses related to these commitments are not included in the ALLL reported in Note 6, “Allowance for Loan and Lease Losses” of these Consolidated Financial Statements. Instead, they are accounted for as a separate loss contingency or reserve as a liability within other liabilities on the Company’s Consolidated Balance Sheets also referred to as a “Reserve for Off-Balance Sheet Commitments”. Losses are experienced when the Company is contractually obligated to make a payment under these instruments and must seek repayment from a party that may not be as financially sound in the current period as it was when the commitment was originally made. As with its outstanding loans, the Company applies the same historical loss rates and qualitative factors to its off-balance sheet obligations in determining an estimate of losses inherent in these contractual obligations. The estimate for loan losses on off-balance sheet instruments is included within other liabilities and the charge to income that establishes this liability is reported within other noninterest expense. The estimate for loan losses on off-balance sheet instruments is included as a contingent liability under the provisions of ASC 450, Loss Contingencies. It is included within other liabilities and the charges to income that establish this liability are reported within other noninterest expense.
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At the Transaction Date, a liability was recorded for the fair value of the unfunded commitments as part of the purchase accounting adjustments and therefore no further reserve for off-balance sheet commitments are carried-over. This is a onetime measurement, and the Company will reduce this liability as these commitments are funded or expire without being funded. Additional disclosure regarding the Company’s reserve for off-balance sheet commitments is located in Note 4, “Loans” of these Consolidated Financial Statements. Derivative Financial Instruments GAAP requires that all derivatives be recorded at their fair value on the balance sheet. Certain derivative transactions that meet specified criteria qualify for hedge accounting under GAAP. The Company does not hold any derivatives that meet the criteria for hedge accounting. If a derivative does not meet the specific criteria, gains or losses associated with changes in its fair value are immediately recognized in noninterest income. Trust Assets and Investment and Advisory Fees The Company has a trust department and two registered investment advisory subsidiaries, MCM and REWA, each of which have fiduciary responsibility for the assets that they manage on behalf of customers. These assets are not owned by the Company and are not reflected in the Consolidated Balance Sheets. Fees for most trust services are based on the market value of customer assets, and the fees are accrued monthly. All of the activity for the trust department and investment and advisory services are reported in the wealth management segment. Stock-Based Compensation The Company grants nonqualified stock options and restricted stock to directors and employees as a form of compensation. All stock-based compensation is accounted for in accordance with GAAP which requires compensation expense for the issuance of stock-based compensation be recognized over the vesting period of the share-based award. The amount of compensation expense to be recognized for options is based on the fair value of the options, utilizing a binomial option pricing model, at the date of the grant. The fair value for the options is estimated based on the length of their term, the volatility of the stock price in past periods, and other factors. Details regarding the accounting for stock-based compensation expense are disclosed in Note 21 “Shareholders’ Equity” of the 2010 Form 10-K’s Consolidated Financial Statements. A valuation model is not used for pricing restricted stock because the value is based on the closing price of the Company’s stock on the grant date. The amount of expense is the number of shares granted multiplied by the stock price. The employee receives any dividends paid on the stock from the time of the grant, but receives the restricted stock only when the vesting period has elapsed. Discontinued Operations—RAL and RT Programs The RAL and RT Programs were sold in January 2010, requiring that the assets and liabilities of these programs be reported in the Consolidated Balance Sheets as “Assets from discontinued operations” and as “Liabilities from discontinued operations,” and that the results of operations from these programs be reported in a single line net of tax in the Consolidated Statements of Operations as “Expense from discontinued operations, net”. An abbreviated statement of operations for the programs is provided in Note 26, “Discontinued Operations—RAL and RT Programs” of the 2010 Form 10-K’s Consolidated Financial Statements. Because the sale of the programs occurred before the start of the 2010 tax season, there were only staff and operating expenses in 2010.
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Income Taxes The Company uses the asset and liability method, which recognizes a liability or asset representing the tax effects of future deductible or taxable amounts attributable to events that have been recognized in these Consolidated Financial Statements. Due to tax regulations, several items of income and expense are recognized in different periods for tax return purposes than for financial reporting purposes. These items represent “temporary differences.” The Company is required to provide in its financial statements for the eventual liability or deduction in its tax return for these temporary differences until the item of income or expense has been recognized for both financial reporting and for taxes. The provision is recorded in the form of deferred tax expense or benefit as the temporary differences arise, with the accumulated amount recognized as a deferred tax liability or asset. Deferred tax assets represent future deductions in the Company’s income tax return, while deferred tax liabilities represent future payments to tax authorities. When realization of the benefit of a deferred tax asset is uncertain, the Company is required to recognize a valuation allowance so as not to overstate the realizability. The valuation allowance recorded by the Company in 2009 and maintained throughout 2010 due to a lack of assurance of future taxable income against which to apply the benefit is discussed in Note 9, “Deferred Tax Assets and Tax Provision” of these Consolidated Financial Statements and in Note 13, “Deferred Tax Assets and Tax Provision” of the 2010 Form 10-K’s Consolidated Financial Statements. Earnings Per Share The computation of basic earnings per share for all periods presented in the Consolidated Statements of Operations is based on the weighted average number of shares outstanding during each year retroactively adjusted for the reverse stock split effective December 28, 2010. Diluted earnings per share include the effect of common stock equivalents for the Company, which consist of shares issuable on the exercise of outstanding options and restricted stock awards and common stock warrants. The number of options assumed to be exercised is computed using the “treasury stock method.” This method assumes that all options with an exercise price lower than the average stock price for the period have been exercised at the average market price for the period and that the proceeds from the assumed exercise have been used for market repurchases of shares at the average market price. Normally, the Company would receive a tax benefit for the difference between the market price and the exercise price of nonqualified options when options are exercised. The treasury stock method also assumes that the tax benefit from the assumed exercise of options is used to retire shares thereby lowering the number of shares assumed to be exercised. Options that have an exercise price higher than the average market price are excluded from the computation because they are anti-dilutive. When the Company’s net income available to common shareholders is in a loss position, the diluted earnings per share calculation utilizes only the average shares outstanding, because assuming the exercise of stock options or warrants would lower the loss per share. Once stock options are exercised or restricted stock vests, the shares are included in the actual weighted average shares outstanding rather than as common stock equivalents. Statement of Cash Flows For purposes of reporting cash flows, “cash and cash equivalents” includes cash and due from banks, Federal funds sold, and securities purchased under agreements to resell. Federal funds sold and securities purchased under agreements to resell are one-day transactions, with the Company’s funds being returned to it the next business day.
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Segments GAAP requires that the Company disclose certain information related to the performance of various segments of its business. Segments are defined based on how the chief operating decision maker of the Company views the Company’s operations. Management has determined that the Company has two reportable operating segments: (1) Commercial & Community Banking and (2) Wealth Management. The All Other segment is not considered an operating segment, but includes all corporate administrative support departments such as human resources, legal, finance and accounting, treasury, information technology, internal audit, risk management, facilities management, marketing, and the holding company. In the first quarter of 2010, the RAL and RT Programs were sold and were reported as discontinued operations. Up until the sale of the RAL and RT Programs, they were a separate operating segment but, due to the sale, this segment was removed from this disclosure. The factors used in determining these reportable segments are explained in Note 27, “Segments” of the 2010 Form 10-K. NOTE 2. FAIR VALUE OF FINANCIAL INSTRUMENTS The accounting guidance for fair value establishes a framework for measuring fair value and establishes a three-level valuation hierarchy for disclosure of fair value measurement. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:
Fair value is defined as the amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale. The assets and liabilities which are fair valued on a recurring basis are described below and contained in the following tables. In addition, the Company may be required to record other assets and liabilities at fair value on a nonrecurring basis. These nonrecurring fair value adjustments involve the lower of carrying value or fair value accounting and write downs resulting from impairment of assets. The following methods and assumptions were used to estimate the fair value of each class of financial instruments that are recorded in the Company’s Consolidated Financial Statements at fair value on a recurring and nonrecurring basis.
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Investment Securities Investment securities are recorded at fair value on a recurring basis. Where quoted prices are available in an active market for identical assets, securities are classified within Level 1 of the valuation hierarchy. The Company’s securities are quoted using observable market information for similar assets which requires the Company to report and use Level 2 pricing for them. When observable market information is not available for securities or there is limited activity or less transparency around inputs, such securities would be classified within Level 3 of the valuation hierarchy. The Company does not have any securities within the Level 1 or Level 3 hierarchy. Derivatives The Company’s swap derivatives are not listed on an exchange and are instead executed over the counter (“OTC”). Because there are no quoted market prices for such instruments, the Company values these OTC derivatives primarily based on the broker pricing indications, which involve proprietary models based upon financial principles and assumptions regarding past, present, and future market conditions. As a result, the swap values are classified within Level 3 of the fair value hierarchy.
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As discussed in Note 1, “Summary of Significant Accounting Policies,” of these Consolidated Financial Statements, prior to the funding of a mortgage loan, the Company may provide an interest rate lock commitment and mandatory delivery contracts for mortgage loans originated for sale that qualify as derivatives under GAAP. The value of the interest rate lock commitments is based on the change in interest rates between the date the interest rate lock commitment is executed and the date the loan is funded. The interest rates used to fair value these derivatives are of similar assets in observable markets. The value of the mandatory delivery contract is calculated by comparing the price on the contract accepted date to the price on the actual sale date on similar assets that are currently being sold. As a result, these derivatives are classified within Level 2 of the fair value hierarchy. Foreclosed Collateral Foreclosed collateral is carried at the lower of its carrying value or fair value less estimated cost to sell. Fair value is determined by the lower of suggested market prices obtained from independent certified appraisers, the current listing price, or the net present value of expected cash flows of the asset received. When the fair value of the collateral is based on a current appraised value or the appraised value, the Company reports the fair value of the foreclosed collateral as nonrecurring Level 2. When a net present value technique using the cash flows of the asset received is used, the asset is classified within the Level 3 of the fair value hierarchy. Low Income Housing Tax Credit Partnerships At June 30, 2011, and December 31, 2010, the Company had investments in LIHTCP’s with a carrying value of $35.4 million and $37.8 million, respectively. Because the Company is profitable, it is not required to fair value the LIHTCP’s on a quarterly basis. Therefore, Management evaluates the recoverability of these investments by obtaining fair value indications through LIHTCP asset managers at a minimum on an annual basis. The fair value of the LIHTCP’s was assessed for impairment at June 30, 2011 and no impairment was recognized as the fair value was higher than the current carrying value. The Company classifies the valuation of these investments in LIHTCP as a nonrecurring Level 2 in the fair value hierarchy. Loans Held for Sale Loans held for sale are carried at the lower of carrying value or fair value. The fair value of loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics or based on the agreed upon sale price. As such, the Company classifies the fair value of loans held for sale as a nonrecurring valuation within Level 2 of the fair value hierarchy. At June 30, 2011, and December 31, 2010, the Company had loans held for sale with an aggregate carrying value of $1.6 million and $16.5 million, respectively. Mortgage and Other Loan Servicing Rights Servicing rights are carried at the lower of aggregate cost or estimated fair value. Servicing rights are subject to quarterly impairment testing. When the fair value of the servicing rights is lower than their carrying value, an impairment is recorded by establishing or increasing the amount of a valuation allowance so that the net carrying amount is equal to the fair value. The Company uses independent third parties to value the servicing rights. At the Transaction Date, the Company wrote the servicing rights asset down to its fair value, eliminating the valuation allowance and establishing a new “cost” basis. The valuation model takes into consideration discounted cash flows using current interest rates and prepayment speeds for each type of the underlying asset being serviced. At December 31, 2010, the Company recognized a valuation adjustment of $10,000. There was no valuation adjustment required at June 30, 2011. The Company classifies these servicing rights as nonrecurring Level 3 in the valuation hierarchy.
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NOTE 2. FAIR VALUE OF FINANCIAL INSTRUMENTS - CONTINUED
Financial Assets and Liabilities Measured at Fair Value on a Recurring Basis Assets and liabilities measured at fair value on a recurring basis at June 30, 2011, and December 31, 2010, are summarized in the following tables:
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NOTE 2. FAIR VALUE OF FINANCIAL INSTRUMENTS - CONTINUED
The following table provides a reconciliation of the beginning and ending balances for the net derivative liabilities that are measured at fair value using significant unobservable inputs (Level 3):
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NOTE 2. FAIR VALUE OF FINANCIAL INSTRUMENTS - CONTINUED
Financial Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis The Company was required to measure all assets and liabilities at fair value on the Transaction Date. In addition, the Company may be required to measure certain assets and liabilities at fair value on a nonrecurring basis in accordance with GAAP, usually upon some triggering event. These include assets and liabilities that are measured at the lower of cost or fair value that were recognized at fair value below cost at the end of the period. Assets and liabilities measured at fair value on a nonrecurring basis at June 30, 2011, and December 31, 2010, are summarized in the table below:
There were no liabilities measured at fair value on a nonrecurring basis at June 30, 2011, and December 31, 2010. There were no transfers in or out of the Company’s Level 3 financial assets during the periods presented within this note of these Consolidated Financial Statements by reason of a change in the methodology for establishing the fair value.
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Table of ContentsPacific Capital Bancorp and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
NOTE 2. FAIR VALUE OF FINANCIAL INSTRUMENTS - CONTINUED
Disclosure of the Fair Value of Financial Instruments The disclosure below provides the carrying value and fair value of the financial instruments which are not carried on the Company’s Consolidated Financial Statements at fair value or are carried at the lower of cost or fair value and not disclosed in the recurring or nonrecurring fair value measurements in the tables above.
A summary of the valuation methodology used to disclose the fair value of the financial instruments in the table above is as follows: Cash and Due from Banks and Interest Bearing Demand Deposits in Other Financial Institutions The carrying values of cash and interest bearing demand deposits in other financial institutions are the fair value. Loans Held for Investment, net The carrying value of the loans held for investment at June 30, 2011, and December 31, 2010, was significantly impacted by the write down to fair value at the Transaction Date due to the application of purchase accounting related to the Investment Transaction. At the Transaction Date the loans purchased were at fair value based on the contractual cash flows expected to be collected. The fair value presented above is calculated based on the present value of expected principal and interest cash flows. The carrying value of the loans originated subsequent to the Investment Transaction is net of the ALLL which represents Management’s evaluation of expected credit losses inherent in those loan portfolios. These methods are based on the entrance price concept versus the exit price concept described in ASC 820, Fair Value Measurements. The methods used to estimate the fair value of loans are sensitive to the assumptions and estimates used. While Management has attempted to use assumptions and estimates that best reflect the Company’s loan portfolio and current market conditions, a greater degree of subjectivity is inherent in these values than in those determined in active markets. Accordingly, readers are cautioned in using this information for purposes of evaluating the financial condition and/or value of the Company in and of itself or in comparison with any other company.
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NOTE 2. FAIR VALUE OF FINANCIAL INSTRUMENTS - CONTINUED
Deposits The fair value of demand deposits, money market accounts, and savings accounts is the amount payable on demand at June 30, 2011, and December 31, 2010. The fair value of fixed-maturity certificates of deposit is estimated by discounting the interest and principal payments using the rates currently offered for deposits of similar remaining maturities. Other Borrowings For FHLB advances, the fair value is estimated using rates currently quoted by the FHLB for advances of similar remaining maturities. For subordinated debt and trust preferred securities, the fair value is estimated by discounting the interest and principal payments using current market rates for comparable securities. For treasury tax and loan (“TT&L”) obligations, the carrying amount is the fair value. Securities sold under agreements to repurchase The fair value of repurchase agreements is determined by reference to rates in the wholesale repurchase market. The rates paid to the Company’s customers are slightly lower than rates in the wholesale market and, consequently, the fair value will generally be less than the carrying amount. The fair value of the long term repurchase agreements is determined in the same manner as the other borrowings, above. Disclosed Fair Value of Financial Instruments is not Equivalent to Franchise Value The financial instruments disclosed in this note include such items as securities, loans, deposits, debt, and other instruments. Disclosure of fair values is not required for certain assets and liabilities that are not financial instruments such as obligations for pension and other postretirement benefits, premises and equipment, prepaid expenses, and income tax assets and liabilities. Accordingly, the aggregate fair value of amounts presented in this note does not purport to represent, and should not be considered representative of, the underlying “market” or franchise value of the Company. Further, due to a variety of alternative valuation techniques and approaches permitted by the fair value measurement accounting standards as well as the significant assumptions that are required to be made in the process of valuation, the determinations or estimations of fair value for many of the financial instruments disclosed in this note could and do differ between various market participants. A direct comparison of the Company’s fair value information with that of other financial institutions may not be appropriate.
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NOTE 3. INVESTMENT SECURITIES A summary of investment securities held by the Company at June 30, 2011, and December 31, 2010, is as follows:
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NOTE 3. INVESTMENT SECURITIES - CONTINUED
Available for Sale Securities At June 30, 2011, and December 31, 2010, the Company held $1.40 billion and $1.28 billion, respectively, of securities in its AFS portfolio. Unrealized gains or losses relating to AFS securities are accounted for by adjusting the carrying amount of the securities. An offsetting entry after the adjustment for taxes at the Company’s corporate effective tax rate of 42.05% is recognized in OCI. Fair values are obtained from independent sources based on current market prices for the specific security held by the Company or for a security with similar characteristics. If a security is in an unrealized loss position, Management is required to determine whether or not the security is temporarily or permanently impaired. The following table discloses all AFS securities that are in an unrealized loss position and temporarily impaired as of June 30, 2011, and December 31, 2010.
As of June 30, 2011, and December 31, 2010, 389 and 526 AFS securities were in an unrealized loss position. The $15.5 million and $33.7 million of unrealized losses for the AFS portfolio as of June 30, 2011, and December 31, 2010, respectively, are a result of changes in market interest rates. The fair value is based on current market prices obtained from independent sources for each security held. The issuers of these securities have not to the Company’s knowledge, established any cause for default on these securities and the most recent ratings on all securities have an investment grade rating, except for one security. At June 30, 2011, Management does not intend to sell any of the securities in a loss position nor are there any conditions present at June 30, 2011, that would require Management to sell them. As such, Management does not believe that there are any securities that are other-than-temporarily impaired as of June 30, 2011.
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NOTE 3. INVESTMENT SECURITIES - CONTINUED
Contractual Maturities for Securities Portfolio The amortized cost and estimated fair value of debt securities at June 30, 2011, and December 31, 2010, by contractual maturity, are shown in the table below.
Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay investment securities with or without call or prepayment penalties. The calculation of the amortization and accretion of premiums and discounts on investment securities takes into consideration estimated prepayments and the right to call certain investment securities. With interest rates on a number of the Company’s securities having coupon rates higher than the current market rates, Management expects that issuers that have the right to call the securities will exercise these rights and pay the investment securities off earlier than the contractual term.
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NOTE 3. INVESTMENT SECURITIES - CONTINUED
Interest Income The following table summarizes interest income from investment securities for the three and six months ended June 30, 2011 and 2010:
Pledged Securities Securities with a carrying value of approximately $661.0 million and $671.2 million at June 30, 2011, and December 31, 2010, respectively, were pledged to secure public funds, trust deposits, repurchase agreements and other borrowings as required or permitted by law. Investment in FHLB and Reserve Bank Stock The Company’s investment in stock of the FHLB was $59.6 million and $64.8 million at June 30, 2011, and December 31, 2010, respectively. The Company’s investment in stock of the Reserve Bank was $18.8 and $18.2 million at June 30, 2011, and December 31, 2010, respectively. The investment of FHLB and Reserve Bank stock is included in FHLB stock and other investments of the Company’s Consolidated Balance Sheets.
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NOTE 4. LOANS Loans held for sale As of June 30, 2011, and December 31, 2010, the Company had $1.6 million and $16.5 million, respectively, of loans held for sale. All of the loans held for sale are residential real estate mortgages. Loans held for investment The composition of the Company’s loans held for investment portfolio at carrying value is as follows:
The table above includes PCI Term Pools and PCI Revolving Pools, which were written down to fair value at the Transaction Date. The loan balances above are net of deferred loan origination fees, commitment, extension fees and origination costs of $728,000 and $4.0 million at June 30, 2011, and December 31, 2010, respectively. Of the loans held for investment, a summary of the carrying balance of loans originated and purchased since the Transaction Date is as follows:
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NOTE 4. LOANS - CONTINUED
Loan Purchases
In June 2011, the Company purchased $26.0 million of residential – 1 to 4 family loans. The loans were purchased at a premium which will be amortized into interest income over the remaining lives of the loans using the level yield method. The loans purchased are performing, and not considered credit impaired. In March 2011, the Company purchased $188.4 million of multifamily and commercial real estate loans. The loans were purchased at a discount which will accrete into income over the life of the loans using a level yield method. The purchased loans are not credit impaired based on the due diligence prior to the purchase. When reviewing and selecting the loans purchased, the Company required that the loans purchased had not been delinquent for the last 36 months, i.e. all contractual payments had been made on time. In addition, a majority of the loans purchased were seasoned loans which had been originated prior to 2005 and the collateral securing the loans purchased were considered to be lower risk based on the experience of the Company. Finally, all these loans were assigned a risk rating of “Pass” loans.
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NOTE 4. LOANS - CONTINUED
Loan Sales A summary of the loan sale activities by loan portfolio, excluding SBA loans, is below.
SBA Loan Sales Successor Company There were no SBA loan sales during the three and six months ended June 30, 2011. Predecessor Company During the three and six months ended June 30, 2010, the Company sold $1.6 million and $4.3 million of SBA loans, respectively. Gains recognized from the sale of SBA loans for the three and six months ended June 30, 2010, were $26,000 and $214,000, respectively.
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NOTE 4. LOANS - CONTINUED
Due to the new accounting standard adopted for the transfer of financial assets on January 1, 2010, the sale of these loans were not recognized until 90 days after the date of sale. The loans sold were reported in loans held for sale with an offsetting liability reported as a secured borrowing. The majority of the gains on the sale of the SBA loans were not recognized until 90 days after the date of the sale. SBA loans have a government-guaranteed portion, and it is this portion that the Company sells into the secondary market, on a servicing retained basis. If the transfer of the guaranteed portion of an SBA loan results in a premium, the “seller” is obligated by the SBA to refund the premium to the “purchaser” if the loan is repaid within 90 days of the transfer. Due to these conditions, the Company was precluded from recognizing this gain until 90 days after the sale. Pledged Loans At June 30, 2011, loans with principal balances totaling $38.8 million were pledged to FHLB as collateral for the Bank’s letters of credit. These amounts pledged do not represent the amount of outstanding borrowings that are required to be supported by collateral. The Bank maintains an excess of collateral at these institutions so that it may borrow without having to first transfer collateral to them. Unfunded Loan Commitments and Letters of Credit As of June 30, 2011, and December 31, 2010, the contractual commitments for unfunded commitments and letters of credit are as follows:
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