Pacific Premier Bancorp 10-K 2006
Documents found in this filing:
Washington, DC 20549
x ANNUAL REPORT PURSUANT TO SECTION 13 OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2005
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to .
Commission File No.: 0-22193
Pacific Premier Bancorp, Inc.
(Exact name of registrant as specified in its charter)
1600 Sunflower Ave. 2nd Floor, Costa Mesa, California 92626
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par
value $0.01 per share
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x
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 o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act (Check one).
Large accelerated filer o Accelerated filer o Non-accelerated filer x
Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes o No x
The aggregate market value of the voting stock held by non-affiliates of the registrant, i.e., persons other than directors and executive officers of the registrant was approximately $53,738,807 and was based upon the last sales price as quoted on The NASDAQ Stock Market as of June 30, 2005, the last business day of the most recently completed 2nd fiscal quarter.
As of March 30, 2006, the Registrant had 5,265,988 shares outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for the 2006 Annual Meeting of Stockholders are incorporated by reference into Part III of this Form 10-K.
All references to we, us, our, or the Company mean Pacific Premier Bancorp, Inc. and our consolidated subsidiaries, including Pacific Premier Bank, our primary operating subsidiary. All references to Bank refer to Pacific Premier Bank.
The statements contained herein that are not historical facts are forward looking statements based on managements current expectations and beliefs concerning future developments and their potential effects on the Company. There can be no assurance that future developments affecting the Company will be the same as those anticipated by management. Actual results may differ from those projected in the forward-looking statements. These forward-looking statements involve risks and uncertainties. These include, but are not limited to, the following risks: (1) changes in the performance of the financial markets, (2) changes in the demand for and market acceptance of the Companys products and services, (3) changes in general economic conditions including interest rates, presence of competitors with greater financial resources, and the impact of competitive projects and pricing, (4) the effect of the Companys policies, (5) the continued availability of adequate funding sources, and (6) various legal, regulatory and litigation risks.
We are a California-based holding company for Pacific Premier Bank, a federally-chartered savings bank. We conduct business throughout Southern California from our five locations in the counties of Los Angeles, Orange and San Bernardino. We operate three depository branches in the cities of Huntington Beach, San Bernardino and Seal Beach, a Small Business Administration (SBA) loan production office in Pasadena and our corporate headquarters in Costa Mesa California. In 2006, we will be opening three additional depository branches in the cities of Costa Mesa, Los Alamitos (formerly announced as Cypress) and Newport Beach to support our growth plans.
We provide banking services within our targeted markets in Southern California businesses, including the owners and employees of those businesses. Through our branches and our web site at www.PPBI.net on the internet, we offer a broad array of deposit products and services for both commercial and consumer customers including checking, money market and savings accounts, cash management services, electronic banking, and on-line bill payment. Our employees are compensated to increase low cost deposits through relationship banking. We offer a wide array of loan products, such as commercial business loans, lines of credit, commercial real estate loans, SBA loans, residential home loans, and home equity loans. At December 31, 2005, we had consolidated total assets of $702.7 million, net loans of $603.4 million, total deposits of $327.9 million, consolidated total stockholders equity of $50.6 million, and the Bank was considered a well-capitalized financial institution for regulatory capital purposes.
The Bank was founded in 1983 as a state chartered savings and loan and converted to a federally chartered stock savings bank in 1991. From 1983 to 1994, the Bank engaged in traditional community banking activities, consisting primarily of deposit taking and originating one-to-four family home loans. In 1994, the Bank shifted its operating strategy and implemented a nationwide sub-prime focused mortgage banking platform. The Bank expanded its operations to originate and to sell sub-prime residential home loans through asset securitizations and whole loan sales. Lending activities were funded primarily through non-core deposits, such as wholesale and brokered certificates of deposit (CDs), as well as, high rate consumer CDs. In 1998, the Company and Bank began to experience losses. By the third quarter of 2000, the Bank was deemed under-capitalized, was operating under regulatory enforcement agreements and incurring losses primarily due to loan defaults.
The current management team was retained and implemented a new business plan in the fourth quarter of 2000 in order to turn around the Company and Bank. We implemented a three phase strategic plan which involved (1) lowering the risk profile of the Bank and re-capitalizing the Company, (2) growing the balance sheet at an accelerated rate through the origination of adjustable rate multi-family loans, thus, returning the Company to profitability, and (3) transforming the institution to a commercial banking business model. The first two phases of our plan were completed in 2002 and 2004, respectively. Phase three of our plan involves the transition to a commercial banking platform and, thus, we are focusing on changing the deposit base to a higher percentage of low cost core deposits and a diversification of the Banks loan portfolio. We began implementing this phase of our strategic plan in late 2004 through a shift in our corporate focus towards relationship banking.
Our lending had been focused on multi-family or apartment loans since we implemented the second phase of our plan in 2002. We began originating these loans in the second quarter of 2002 with a focus on small to medium-sized loans, in the $200,000 to $2.0 million range, as we believe this market was underserved, especially in Southern California. During 2005, we began shifting our focus towards commercial real estate loans and commercial and industrial (C&I) business loans as part of our strategic transition towards a commercial banking platform. We will continue to originate multi-family loans as long as we can either obtain the borrowers deposits along with the loans or we can sell the loans for a profit as we have done in prior periods.
Our goal is to develop the Bank into one of Southern Californias top performing commercial banks as an alternative to the large regional and national banks for small businesses, their owners and employees for the long term benefit of our shareholders, customers and employees. The following are our operating strategies to achieve our goals:
· Recruitment of Commercial Bankers. We began our transition to a commercial banking platform by recruiting experienced commercial bankers who possess an established following of customer relationships. These relationships typically include businesses that have both deposit and loan needs, as well as, the personal depository needs of the business owners themselves. Our incentive plans compensate our commercial bankers for the generation and retention of customer relationships as measured by the level of low cost deposits maintained at the Bank. We will continue to recruit experienced bankers to staff our branches and serve our targeted markets.
· Relationship Banking. We recognize that customer relationships are built through a series of consistently executed experiences in both routine transactions and higher value interactions. Our commercial bankers are focused on developing long term relationships with business owners through consistent and frequent contact. Additionally, our bankers develop relationships with accountants and consultants that are focused on serving small businesses and, thus, seek referrals from these entities. Our bankers work closely with our real estate originators to cross-sell clients to ensure we are capturing the entire banking relationship of each customer with which we do business. Our bankers are actively involved in community organizations and events, thus building and capitalizing on the Banks reputation within our local communities.
· Growing Core Deposits/Reducing our Wholesale Funding. The second phase of our strategic plan relied on wholesale borrowings, such as advances from Federal Home Loan Bank (FHLB) System and brokered deposits to fund a large portion of our accelerated growth during that phase. As we transition towards a commercial banking platform, we intend to reduce our reliance on these funding sources over time. We will manage our growth, in part, by selling excess loan production, generally multi-family loans. We also expect to increase the growth of low cost core deposit
accounts by opening three new branches during 2006, in order to better serve our market area and to attract additional small business customers.
· Expansion through de novo branches, organic growth and acquisitions. We believe that the consolidation in the banking industry has created an opportunity at the community banking level in the areas that we serve. Many bank customers feel displaced by large out-of-market acquirers and are attracted to local institutions that have local decision making capability, more responsive customer service, and more familiarity with the needs in their markets. We intend to continue expanding our franchise in the high growth areas of Orange and Los Angeles Counties, including the opening of branches in Costa Mesa and Los Alamitos in the second quarter of 2006 and Newport Beach in the third quarter of 2006. Furthermore, as opportunities arise, we will consider expansion into markets contiguous to our own through potential acquisitions and/or de novo branching.
· Diversifying our Loan Portfolio. We believe it is important to diversify our loan portfolio and to increase the amount of commercial real estate, C&I loans and SBA loans within our portfolio. As a result, we believe it is essential to be able to offer our customers a wide array of products and services. We provide flexible and structured loan products to meet our customers needs, which, in turn, provide us the opportunity to become their full service banker.
· Change in our Banking Charter. As we increase the amount of the commercial real estate and C&I loans in our portfolio we will begin to approach the maximum amount of non-residential real estate loans allowed under our current charter (i.e., four times our regulatory capital). Additionally, our charter limits the amount of C&I loans we may invest in up to 20% of our assets, provided that the amounts in excess of 10% of total assets are used for small business loans. Consequently, the Bank intends to explore changing its charter from a federally-chartered savings association whose primary regulator is the Office of Thrift Supervision (OTS) to a California chartered commercial bank whose primary regulator is the California Department of Financial Institutions. In connection with such a charter change, the Federal Reserve Board would become the primary regulator of the Company.
· Maintain Excellent Asset Quality. Our credit and risk management culture has resulted in low levels of nonperforming loans and an overall high credit quality within our loan portfolio. We monitor existing economic trends and conditions that could positively or negatively impact our business. We will continue to adjust our risk management practices to changes in the conditions that impact our business.
· Premier Customer Service Provider. We believe it is imperative that the Bank provide a consistent level of quality service which generates customer retention and referrals. All of our employees, through training, understand that each interaction with our customers is an opportunity to exceed their expectations. Our employees incentive compensation is, in part, predicated on achieving a consistently high level of customer satisfaction.
Our executive offices are located at 1600 Sunflower Avenue, 2nd Floor, Costa Mesa, California 92626 and our telephone number is (714) 431-4000. Our internet website address is www.ppbi.net. Our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and all amendments thereto, from 1998 to present, are available free of charge on our internet website. Also on our website are our Code of Ethics, Insider Trading and Beneficial Ownership forms, and Corporate Governance Guidelines. The information contained in our website, or in any websites linked by our website, is not a part of this Annual Report on Form 10-K.
General. In 2005, we focused our lending strategy on originating commercial real estate loans, C&I loans, and multi-family loans primarily secured by properties in Southern California. We have and will continue to offer loans up to our legal lending limit, which was $8.7 million as of December 31, 2005. During 2005, we fully implemented a commercial banking platform offering business lines of credit, term loans, and various other C&I loan structures secured by business assets. In the fourth quarter of 2005, the Bank hired an experienced SBA team from a local competitor and received approval as an SBA lender in December 2005. These business loan products are assisting us in establishing depository relationships with new and existing customers consistent with the Banks strategic direction of transitioning to a commercial banking platform. During 2005, we originated $184.8 million in multi-family, $86.9 million in commercial real estate loans, and $11.4 million in commitments in commercial business loans. At December 31, 2005, we had $603.4 million in total net loans outstanding.
Sourcing of our Loans. We primarily obtain new multi-family and commercial real estate loans from established relationships with mortgage brokers operating throughout Southern California. Our real estate bankers work out of our corporate office and are responsible for building and maintaining these relationships. In 2005, we maintained relationships with over 55 brokerage companies of which five could be termed significant. In 2005, the top five brokerage companies accounted for 64.13% of the multi-family and commercial real estate loans originated by the Bank. Within these five brokerage companies, we have funded loans with a total of 32 agents that work within the brokerage companies themselves. Our real estate bankers have relationships with these individuals and seek to maintain the relationship regardless of where these agents are employed. Additionally, our bankers seek to establish relationships with other agents within these brokerage companies that have not done business with us in the past.
Our direct originations, which we are focused on increasing, accounted for 14.09% of our income property loans in 2005. These loans were sourced through referrals from our depository branches and by soliciting these loans directly. Our bankers will continue to focus on maintaining and developing relationships with individual investors, accountants, consultants, commercial real estate investment sales and leasing agents and other banks to further increase the percentage of direct referrals in future periods.
Commercial business loans are sourced by our Business Development Officers and Branch Managers. These bankers call on business owners, accountants, consultants, and various other referral sources to generate new business banking relationships. Upon securing the business banking relationships, they work with the business owner to offer personal banking products and services to the business owner, their families, and the businesses employees as well. Additionally, our Branch Managers work closely with our real estate bankers to capture the full banking needs of our multi-family and commercial real estate loan customers.
SBA loans will be sourced through our newly opened SBA lending office in Pasadena, CA, our web site, and through direct contact by our Business Development Officers and Branch Managers.
Interest Rates on Our Loans. We employ a risk-based pricing strategy on all loans we fund. The interest rates we charge on our loans generally vary based on a number of factors, including the degree of credit risk, size, maturity of the loan, borrower/property management/business expertise, and prevailing market rates for similar types of loans. Depending on market conditions at the time the loan is originated, certain loan agreements will include prepayment penalties. All of the multi-family and commercial real estate loans originated in 2005 had a prepayment penalty provision. Most of our loans are adjustable-rate loans and are based on one of several interest rate indices. Most loans originated by the Bank in 2005, were adjustable-rate loans and had minimum interest rates (floor rates) at which the rate charged may not be reduced further regardless of further reductions in the underlying interest rate index.
Lending Risks on our Loans. The majority of our loans typically involve larger loans to a single borrower that are generally viewed as exposing us to a greater risk than one-to-four family residential lending. The liquidation values of the properties securing our multi-family and commercial real estate loans may be adversely affected by risks generally incidental to interests in real property, such as:
· Changes or continued weakness in general or local economic conditions;
· Changes or continued weakness in specific industry segments;
· Declines in real estate values;
· Declines in rental rates;
· Declines in occupancy rates;
· Increases in other operating expenses (including energy costs);
· The availability of refinancing at lower interest rates or better loan terms;
· Changes in governmental rules, regulations and fiscal policies, including rent control ordinances, environmental legislation and taxation;
· Increases in interest rates, real estate and personal property tax rates; and
· Other factors beyond the control of the borrower or the lender.
We attempt to mitigate these risks through sound and prudent underwriting policies, as well as, a proactive loan review process and our risk management practices. See Lending Activities - Underwriting and Approval Authority for Our Loans.
We will not make loans to any one borrower that is in excess of regulatory limits. Pursuant to Office of Thrift Supervision (OTS) regulations, loans-to-one borrower cannot exceed 15% of the Banks unimpaired capital and surplus. At December 31, 2005, the Banks loans-to-one borrower limit was $8.7 million. See RegulationFederal Savings Institution RegulationLoans-to-One Borrower.
Underwriting and Approval Authority for Our Loans. Our board of directors establishes our lending policies. Each loan must meet minimum underwriting criteria established in our lending policies and must fit within our overall strategies for yield, interest rate risk, and portfolio concentrations. The underwriting and quality control functions are managed through our corporate office. Each loan application is evaluated from a number of underwriting perspectives. For real estate secured loans, these underwriting perspectives include property appraised value, loan-to-value, level of debt service coverage utilizing both the actual net operating income and forecasted net operating income, use and condition of the property, as well as, the borrowers liquidity, income, credit history, net worth, and operating experience. For business loans, underwriting perspectives include historic business cash flows, debt service coverage, loan-to-value ratios of underlying collateral, if any, debt to equity ratios, credit history, business experience, history of business, forecasts of operations, business viability, net worth, and liquidity.
Upon receipt of a completed loan application from a prospective borrower, a credit report and other required reports are ordered and, if necessary, additional information is requested. Prior to processing and underwriting any loan, we issue a letter of interest based on a preliminary analysis by our bankers, which letter details the terms and conditions on which we will consider the loan request. Upon receipt of the signed letter of interest and a deposit fee, we process and underwrite each loan application and prepare all loan documentation wherein the loan has been approved.
Our credit memorandum, which are prepared by our underwriters, includes a description of the prospective borrower and guarantors, the collateral securing the loan, if any, the proposed uses of loan proceeds, as well as, an analysis of the borrowers business and personal financial statements. For loans
secured by real property, the credit memorandum will include an analysis of the historic operating income of the property. Loans secured by real estate require an independent appraisal conducted by a licensed appraiser. All appraisal reports are reviewed by our appraisal department. Our board of directors reviews and approves annually the independent list of acceptable appraisers.
Loans secured by real estate are originated on both a non-recourse and full recourse basis. Business loans are originated as recourse or with full guarantees from key borrowers or borrower principals. On loans facilitated to entities, such as partnerships, limited liability companies, corporations or trusts, we generally seek to obtain personal guarantees from the appropriate managing members, major shareholders, trustees or other appropriate principals. In 2005, 98% of our income property loans to entities were originated with full recourse and/or personal guarantees from principals of the borrowers.
All of our income property loans must satisfy an interest rate sensitivity test in order for the loan origination to be approved without being classified as exceptions; that is, the actual effective income of the property securing the loan must be adequate to achieve a minimum debt service coverage ratio (the ratio of net earnings on a property to debt service) based on a higher qualifying interest rate than the actual interest rate charged on our loans, and must meet the established policy minimums for such loans. Additionally, a stress test of 100 basis points above the qualifying interest rate must be adequate to achieve a minimum 1:1 debt service cover ratio. Following loan approval and prior to funding, our underwriting and processing departments assure that all loan approval terms have been satisfied, that they conform with lending policies (or are properly documented exceptions that have been approved), and that all required documentation is present and in proper form.
Commercial business loans are subject to Bank guidelines regarding appropriate covenants and periodic monitoring requirements which include but are not limited to:
· Capital and lease expenditures
· Capital levels
· Salaries and other withdrawals
· Working capital levels
· Debt to net worth ratios
· Sale of assets
· Change of management
· Change of ownership
· Cash flow requirements
· Profitability requirements
· Debt service ratio
· Collateral coverage ratio
· Current and quick ratios
Subject to the above standards, our board of directors delegate authority and responsibility for loan approvals to management up to $1.0 million for all loans secured by real estate and up to $250,000 for commercial business loans not secured by real estate. Loan approvals at the management level require the approval of at least two members of our Management Loan Committee, consisting of our President and Chief Executive Officer, Chief Credit Officer, and Chief Banking Officer. All loans in excess of $1.0
million, including total aggregate borrowings in excess of $1.0 million, and any commercial business loan not secured by real estate in excess of $250,000 require a majority approval of our Boards Credit Committee, which is comprised of three directors, including our President and Chief Executive Officer.
Multi-family Residential Lending. We originate and purchase loans secured by multi-family residential properties (five units and greater) throughout Southern California. Pursuant to our underwriting policies, multi-family residential loans may be made in an amount up to the lesser of 75% of the appraised value or the purchase price of the underlying property. In addition, we generally require a stabilized minimum debt service coverage ratio of 1.15:1, based on the qualifying loan interest rate. Loans are generally made for terms up to 30 years with amortization periods up to 30 years. As of December 31, 2005, we had $459.7 million of multi-family real estate secured loans, constituting 76.0% of our loan portfolio. Multi-family loans originated in 2005 had an average outstanding balance of $1,109,700, loan-to-value of 66.98%, and debt coverage ratio of 1.16:1 at origination.
Commercial Real Estate Lending. We originate and purchase loans secured by commercial real estate, such as retail centers, small office and light industrial buildings, and other mixed-use commercial properties throughout Southern California. We will also, from time to time, make a loan secured by a special purpose property, such as an auto wash center or motel. Pursuant to our underwriting policies, commercial real estate loans may be made in amounts up to the lesser of 75% of the appraised value or the purchase price of the underlying property. We consider the net operating income of the property and require a debt service coverage ratio of at least 1.25:1, based on a qualifying interest rate. Loans are generally made for terms up to fifteen years with amortization periods up to 30 years. As of December 31, 2005, we had $125.4 million of commercial real estate secured loans, constituting 20.7% of our loan portfolio. Commercial real estate loans originated in 2005 had an average balance of $1,138,000, loan-to-value of 64.84% and debt coverage ratio of 1.24:1 at origination.
Commercial Business Lending. We commenced our commercial business loan program in late 2004. Our Board approved commercial business lending policies allow the Bank to originate six primary loan types which may be secured or unsecured and include:
1. Liquid Collateral/Certificate of Deposits/Stock Secured Loans
2. Seasonal Loans
3. Term Loans
4. Revolving Lines of Credit
5. Single Advance Note
6. Combination Commercial and Real Estate Loan
As of December 31, 2005, we had total commitments of $8.7 million in commercial business loans with a disbursed balance of $3.2 million.
One-to-Four Family Loans. The Banks portfolio of one-to-four family home loans at December 31, 2005 totaled $16.6 million, of which $12.4 million consists of loans secured by first liens on real estate and $4.1 million consists of loans secured by second or junior liens on real estate. In 2005, the Bank originated one new single family loan for $1.9 million.
Loan Servicing. Loan servicing is centralized at our corporate headquarters. Our loan servicing operations are intended to provide prompt customer service and accurate and timely information for account follow-up, financial reporting and loss mitigation. Following the funding of an approved loan, the data is entered into our data processing system, which provides monthly billing statements, tracks payment performance, and effects agreed upon interest rate adjustments. The loan servicing activities include (i) the
collection and remittance of mortgage loan payments, (ii) accounting for principal and interest and other collections and expenses, (iii) holding and disbursing escrow or impounding funds for real estate taxes and insurance premiums, (iv) inspecting properties when appropriate, (v) contacting delinquent borrowers, and (vi) acting as fiduciary in foreclosing and disposing of collateral properties.
When payments are not received by their contractual due date, collection efforts are initiated by our loss mitigation personnel. Accounts delinquent more than 15 days are reviewed by our loss mitigation manager and are assigned to collectors to begin the process of collections. Our collectors begin by contacting the borrower telephonically and progress to sending a notice of intention to foreclose within 30 days of delinquency, and we will initiate foreclosure 30 days thereafter if the delinquent payments are not received in full. Our loss mitigation manager conducts an evaluation of all loans 90 days or more past due by obtaining an estimate of value on the underlying collateral. The evaluation may result in our establishing a specific allowance for that loan or charging off the entire loan, but still continuing with collection efforts.
Loan Portfolio Composition. At December 31, 2005, our net loans receivable held for investment totaled $603.4 million and net loans receivable held for sale totaled $456,000. The types of loans that the Bank may originate are subject to federal law, state law, and regulations.
The following table sets forth the composition of our loan portfolio in dollar amounts and as a percentage of the portfolio at the dates indicated:
(1) Includes second trust deeds.
Loan Maturity. The following table shows the contractual maturity of the Banks gross loans for the period indicated. The table does not reflect prepayment assumptions.
The following table sets forth at December 31, 2005, the dollar amount of gross loans receivable contractually due after December 31, 2006, and whether such loans have fixed interest rates or adjustable interest rates.
The following table sets forth the Banks loan originations, purchases, sales, and principal repayments for the periods indicated:
Delinquencies and Classified Assets. Federal regulations require that the Bank utilize an internal asset classification system to identify and report problem and potential problem assets. The Banks Internal Asset Review (IAR) Manager has responsibility for identifying and reporting problem assets to the Banks Internal Asset Review Committee (IARC), which operates pursuant to the board-approved IAR policy. The policy incorporates the regulatory requirements of monitoring and classifying all assets of the Bank. The Bank currently designates or classifies problem and potential problem assets as Special Mention, Substandard or Loss assets. An asset is considered Substandard if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Substandard assets include those characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. All real estate owned (REO) acquired from foreclosure is classified as Substandard. Assets classified as Loss are those considered uncollectible and of such little value that their continuance as assets without the establishment of a specific loss allowance is not warranted. Assets which do not currently expose the Bank to sufficient risk to warrant classification in one of the aforementioned categories but possess weaknesses are designated Special Mention.
When the Bank classifies an asset, or portions thereof, as Substandard under current OTS policy, the Bank is required to consider establishing a general valuation allowance in an amount deemed prudent by management. The general valuation allowance, which is a regulatory term, represents a loss allowance which has been established to recognize the inherent credit risk associated with lending and investing activities, but which, unlike specific allowances, has not been allocated to particular problem assets. When the Bank classifies one or more assets, or portions thereof, as Loss, it is required either to establish a specific allowance for losses equal to 100% of the amount of the asset so classified or to charge off such amount.
The Banks determination as to the classification of its assets and the amount of its valuation allowances are subject to review by the OTS, which can order the establishment of additional general or specific loss allowances or a change in a classification. The OTS, in conjunction with the other federal banking agencies, adopted an interagency policy statement on the allowance for loan and lease losses. The policy statement provides guidance for financial institutions on both the responsibilities of management for the assessment and establishment of adequate allowances and guidance for banking agency examiners to use in determining the adequacy of general valuation allowances. Generally, the policy statement recommends that institutions have effective systems and controls to identify, monitor and address asset quality problems; that management has analyzed all significant factors that affect the collectability of the portfolio in a reasonable manner; and that management has established acceptable allowance evaluation processes that meet the objectives set forth in the policy statement. While the Bank believes that it has established an adequate allowance for estimated loan losses, there can be no assurance that its regulators, in reviewing the Banks loan portfolio, will not request the Bank to materially increase its allowance for estimated loan losses, thereby negatively affecting the Banks financial condition and earnings at that time. Although management believes that an adequate allowance for estimated loan losses has been established, actual losses are dependent upon future events and, as such, further additions to the level of allowances for estimated loan losses may become necessary.
The Banks IARC reviews the IAR Managers recommendations for classifying the Banks assets quarterly and reports the results of its review to the board of directors. The Bank classifies assets and establishes both a general allowance and specific allowance in accordance with the board-approved Allowance for Loan Losses policy. The following table sets forth information concerning substandard assets, REO and total classified assets at December 31, 2005 for the Company:
At December 31, 2005, the Company had $472,000 of Special Mention assets, $1.7 million of Substandard assets, and $291,000 assets classified as Loss that are offset by a specific allowance of the same amount. The difference between the specific allowance in the above table and the total specific allowance is the specific allowance on accounts that were Substandard at one time and are currently classified either as Special Mention or as Pass.
The following table sets forth delinquencies in the Companys loan portfolio as of the dates indicated:
Nonperforming Assets. At December 31, 2005 and 2004, respectively, we had $1.7 million and $2.5 million of net nonperforming assets, respectively, which included $1.5 million and $2.1 million of net nonperforming loans, respectively. Our current policy is not to accrue interest on loans 90 days or more past due. The decrease in nonperforming assets is primarily due to a low interest rate environment and an increase in housing prices which allowed delinquent customers to refinance or sell their homes, stronger collection efforts, and the discontinuance of the origination of sub-prime credit loans during the year ended December 31, 2000.
Real estate owned (REO) was $211,000 (consisting of eight properties) at December 31, 2005, compared to $351,000 (consisting of 17 properties) at December 31, 2004. Properties acquired through or in lieu of foreclosure are initially recorded at the lower of fair value less cost to sell, or the balance of the loan at the date of foreclosure through a charge to the allowance for loan losses. It is the policy of the Bank to obtain an appraisal and/or a market evaluation on all REO at the time of possession. After foreclosure, valuations are periodically performed by management as needed due to changing market conditions or factors specifically attributable to the properties condition. If the carrying value of the property exceeds its fair value less estimated cost to sell, a charge to operations is recorded. The decline in REO over the periods represented reflects the improvements in asset quality and sales of REO properties.
The following tables set forth information concerning nonperforming loans and REO at the periods indicated:
(1) During the years ended December 31, 2005, 2004, 2003, 2002, and 2001, approximately $75,000, $131,000, $299,000, $313,000, and $555,000, respectively, of interest income related to these loans was included in net income. Additional interest income of approximately $310,000, $317,000, $406,000, $708,000, and $1.7 million, respectively, would have been recorded for the years ended December 31, 2005, 2004, 2003, 2002, and 2001 if these loans had been paid in accordance with their original terms and had been outstanding throughout the applicable period then ended or, if not outstanding throughout the applicable period then ended, since origination.
(2) Foreclosed real estate owned balances are shown net of related loss allowances.
(3) Nonperforming assets consist of nonperforming loans and REO. Nonperforming loans consisted of all loans 90 days or more past due and foreclosures in process less than 90 days and still accruing interest.
(4) A restructured loan is one wherein the terms of the loan were renegotiated to provide a reduction or deferral of interest or principal because of deterioration in the financial position of the borrower. We did not include in interest income any interest on restructured loans during the periods presented.
(5) Gross loans include loans receivable held for investment and held for sale.
Allowance for Loan Losses. We maintain an allowance for loan losses to absorb losses inherent in the loans held for investment portfolio. Loans held for sale are carried at the lower of cost or estimated market value. Net unrealized losses, if any, are recognized in a lower of cost or market valuation allowance by charges to operations. The allowance is based on ongoing, quarterly assessments of probable estimated losses inherent in our loan portfolio. The allowance is increased by a provision for loan losses which is charged to expense and reduced by charge-offs, net of recoveries.
As of December 31, 2005, the allowance for loan losses totaled $3.1 million, compared to $2.6 million at December 31, 2004 and $2.0 million at December 31, 2003. The December 31, 2005 allowance for loan losses, as a percent of nonperforming loans and gross loans, was 180.8% and 0.5%, respectively, compared with 110.8% and 0.6% at December 31, 2004, and 71.5% and 0.8% at December 31, 2003. The specific allowance amount included in the allowance for loan losses totaled $291,000, $345,000 and $430,000, as of December 31, 2005, 2004 and 2003, respectively.
The Banks methodology for assessing the appropriateness of the allowance consists of several key elements, which include the formula allowance, specific allowance for identified problem loans and the unallocated allowance. The formula allowance is calculated by applying loss factors to all loans held for investment.
The loan loss factors for the multi-family loan portfolio are based primarily upon the thrift industrys nationwide and West Region most recent 10 year and 8½ year historic charge-off data, respectively, a peer analysis of other financial institutions engaged in similar lending activities, a quantitative and qualitative analysis of the portfolio and managements past experience with such loan types. Management believes the utilization of industry-wide historic loss data of multi-family loans is more reflective of potential losses due to the fact that the Bank has not had a loss or a delinquency on any of its multi-family loans since it began originating these loan types in the second quarter of 2002. The industrys average annual charge-off loss experience over the last 10 years was 8 basis points on a nationwide level for multi-family loans and 1 basis point for the West Region, which includes California, during the past 8½ year period. The West Regions charge-off data is only available over the past 8½ year time period. However, the Bank used the data for the longer period as a starting point in developing the multi-family loan loss factors. Management has adopted a tiered system that establishes the highest loss factors for loans with a loan-to-value (LTV) ratio greater than 65% at origination and with less than 12 months of payment history (seasoning). Loans that possess a LTV ratio less than 65% at origination and a satisfactory payment history for the past 13 months or more are considered to have less credit risk and, therefore, are assigned a lower loss factor. The tiered system has four categories to address the unique characteristics of the Banks multi-family loan portfolio and are reviewed and updated quarterly.
The loss factors for the commercial real estate loan portfolio are developed and applied in a similar manner as the multi-family loan portfolio and thus considers the thrift industrys nationwide and West Region historic charge-off data, a peer analysis of other financial institutions engaged in similar lending activities, a quantitative and qualitative analysis of the portfolio and managements past experience with such loan types. The industrys average annual charge-off over the last 10 years was 11 basis points on a nationwide level and 3 basis points for the West Region during the past 8½ year period, the only years for which the data is available. Management also considers the past loss experience related to Southern California commercial real estate in establishing loan loss factors for the commercial real estate portfolio.
The loan loss factors for the commercial business loan portfolio is based primarily upon the thrift industrys nationwide and West Region historic charge-off data, a peer analysis of other financial institutions engaged in similar lending activities, a quantitative and qualitative analysis of the portfolio and managements past experience with such loan types. Since this portfolio is relatively unseasoned, the Banks loss experience is nonexistent and, therefore, management relies upon available recent industry data to support the loss factor for this portfolio. The Banks IAR Department has reviewed and analyzed the data for commercial business loans over a period of nine years (1997-2005). The data represents commercial business loan charge-offs on a national and West Region basis for the OTS regulated thrift industry. Based upon this analysis, the IAR Department has determined that for this period, the average annual charge-off rate was 1.22 percent nationwide and 1.62% for the West Region. Management will continue to analyze and evaluate the adequacy of the loss factors for this loan portfolio segment on a quarterly basis.
For the homogeneous single-family residential loan portfolio, the loss factors were developed by the Banks IAR Department using a loss migration analysis over the prior one year period to determine the percentage of loans from a particular classification category that flows through to a realized loss. The formula allowance is calculated based upon the developed loss factors and is assigned to the homogeneous single-family residential loan portfolio by geographic regions, loan pool type and classification.
Specific allowances are established for certain loans where management has identified significant conditions or circumstances related to a credit that management believes indicates the probability that a loss has been incurred in excess of the amount determined by the application of the formula allowance. Furthermore, on all one-to-four family loans secured by first and second deeds of trust that are 90 days or more past due, a market evaluation which includes adjusting the value for the location of the collateral and the Banks historical loss experience for that location is completed. A specific allowance is determined based on the valuation of the collateral underlying the loan and is calculated by subtracting the current market value less estimated selling and holding costs from the loan balance.
The IARC meets monthly to review and monitor conditions in the portfolio and to determine the appropriate allowance for loan losses based on the recommendation of the IAR Department and the analysis performed. To the extent that any of these conditions are evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, the IARCs estimate of the effect of such condition may be reflected as a specific allowance applicable to such credit or portfolio segment. Where any of these conditions is not evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, the IARCs evaluation of the probable loss related to such condition is reflected in the unallocated allowance. By assessing the probable estimated losses inherent in the loan portfolios on a quarterly basis, the Bank is able to adjust specific and inherent loss estimates based upon more recent information that has become available.
The following table sets forth activity in the Banks allowance for loan losses for the periods indicated:
The following table sets forth the Banks allowance for loan losses and the percent of gross loans to total gross loans in each of the categories listed at the dates indicated: