Placer Sierra Bancshares 10-K 2005
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended December 31, 2004
Commission File No. 000-50652
PLACER SIERRA BANCSHARES
(Exact Name of Registrant as Specified in Its Charter)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common stock, no par value
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes x No ¨
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 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 an accelerated filer (as defined in Rule 12b-2 of the act). Yes ¨ No x
The aggregate market value of the voting common stock held by non-affiliates of the registrant, computed by reference to the closing price on the Nasdaq National Market as of December 31, 2004, the last day of the registrants most recently completed fiscal quarter was $217,669,013 million. Registrant does not have any nonvoting common equities.
As of March 15, 2005, there were 14,894,673 shares of registrants common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
The information required by Items 10, 11, 12, 13 and 14 of Part III of this Annual Report on Form 10-K will be found in the Companys definitive Proxy Statement for the 2005 Annual Meeting of Shareholders, to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, within 120 days of December 31, 2004, and such information is incorporated herein by this reference.
PLACER SIERRA BANCSHARES
FORM 10-K ANNUAL REPORT
For the Year Ended December 31, 2004
TABLE OF CONTENTS
Discussions of certain matters contained in this Annual Report on Form 10-K may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended (the Exchange Act), and as such, may involve risks and uncertainties. These forward-looking statements relate to, among other things, expectations of the business environment in which Placer Sierra Bancshares and its subsidiaries operates, projections of future performance, perceived opportunities in the market and statements regarding our mission and vision. Our actual results, performance and achievements may differ materially from the results, performance and achievements expressed or implied in such forward-looking statements. For a discussion of some of the factors that might cause such a difference, see ITEM 1. BUSINESS. Factors That May Affect Future Results of Operations. We do not undertake and specifically disclaim any obligation to update such forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statement.
ITEM 1. BUSINESS
We are a California-based bank holding company for Placer Sierra Bank, a California state-chartered commercial bank with 41 branches operating throughout California. We provide a broad array of financial services to small- to medium-sized businesses, their owners and employees and to consumers. Placer Sierra Bank conducts a portion of its banking business through the following divisions: Sacramento Commercial Bank, Bank of Lodi and Bank of Orange County. Through our 32 Northern California branches, we serve an eight-county area including Placer, Sacramento and El Dorado, commonly known as the greater Sacramento metropolitan region, and the adjacent counties of Amador, Calaveras, Nevada, Sierra, and San Joaquin. Through our nine Southern California branches, we serve both southern Los Angeles and Orange counties. As of December 31, 2004, we have 41 branches, but will soon have 40 branches as we are in the process of closing a recently acquired Sacramento branch that is located near our long established Sacramento branch headquarters.
Placer Sierra Bank, the largest community bank headquartered in the greater Sacramento metropolitan region, has provided financial services to commercial and consumer customers in Northern California for more than 57 years. The banks Southern California branches, known as Bank of Orange County, have provided these services in Southern California for more than 24 years and its Bank of Lodi division has provided services for more than 21 years. We offer our customers the resources of a large financial institution together with the resourcefulness and responsive customer service of a community bank. Through our branches and the use of technology, we offer a broad array of deposit products and services for both commercial and consumer customers, including electronic banking, cash management services, electronic bill payment and investment services. We emphasize relationship banking and focus on generating low cost deposits. We provide a comprehensive set of loan products such as commercial loans and leases, lines of credit, commercial real estate loans, Small Business Administration, or SBA, loans, residential mortgage loans, home equity lines of credit and construction loans, both commercial and residential. Our local decision making, together with our substantial lending limits is intended to give us a competitive advantage and provide a fast and efficient lending process. As of December 31, 2004, the lending limit of Placer Sierra Bank was approximately $35 million for unsecured loans and $58.4 million for unsecured and secured loans and leases combined. At December 31, 2004, we had total assets of $1.779 billion, loans and leases of $1.294 billion, deposits of $1.500 billion and shareholders equity of $191.6 million.
As of December 31, 2004, California Community Financial Institutions Fund Limited Partnership, or the Fund, owned 48.5% of our shares. Our bank was previously a wholly-owned subsidiary of Placer Capital Co., or PCC, which was incorporated in 1999 by the Fund, for the purpose of acquiring Placer Sierra Bank. In December 1999, PCC became a wholly-owned subsidiary of California Community Bancshares, Inc., or CCB. CCB was
restructured in December 2001, which resulted in, among other organizational changes, the formation of our company, Placer Sierra Bancshares, as well as Southland Capital Co., as wholly-owned subsidiaries of CCB. Pursuant to the restructuring, PCC merged into CCB, as a result of which CCB directly acquired all of the shares of Placer Sierra Bank. CCB then contributed all of the shares of Placer Sierra Bank to us, making Placer Sierra Bank our wholly-owned subsidiary. After completing a cash-out merger whereby all the CCB shareholders other than the Fund received cash in exchange for their shares of CCB stock, CCB adopted a plan of liquidation and distributed its assets, primarily our common stock and Southland Capital Co. common stock, to its sole shareholder, the Fund. Consequently, we and Southland Capital Co. became subsidiaries of the Fund at that time.
In August of 2002 SCCs wholly owned subsidiary Bank of Orange County entered into an agreement to acquire Cerritos Valley Bancorp and Cerritos Valley Bank, the wholly owned subsidiary of Cerritos Valley Bancorp, which we collectively refer to as Cerritos. At the time of the acquisition the Fund owned 50.5% of Cerritos and minority shareholders owned 49.5%. The acquisition of Cerritos by Bank of Orange County was accounted for as a step acquisition. The 49.5% interest acquired from the minority shareholders was accounted for as a purchase. The contribution of the Funds interest in Cerritos by Bank of Orange County was accounted for using the as-if-pooling method of accounting, as the entities were under common control.
Southland Capital Co. and Bank of Orange County Acquisition
In May 2004, we acquired Southland Capital Co., the holding company for Bank of Orange County in a transaction structured as a stock-for-stock merger. Through the acquisition, we acquired nine full service branches in Artesia, Downey, Fullerton, Fountain Valley, Norwalk, Orange, Santa Fe Springs, Glendale and Huntington Park, California. Pursuant to the acquisition, Southland Capital Co. merged into us and Bank of Orange County became our subsidiary. In July 2004, Bank of Orange County was merged into our bank. Our bank operates the Southern California branches under a division named Bank of Orange County. Bank of Orange County serves the Los Angeles and Orange County areas.
First Financial Bancorp and Bank of Lodi Acquisition
In December, 2004, we acquired First Financial Bancorp, the parent holding company for Bank of Lodi. Through the acquisition, we acquired nine branches in Sacramento, Lodi, Plymouth, Woodbridge, Lockeford, Elk Grove, San Andreas, Galt and Folsom, California. The acquisition provides for a strong foothold in San Joaquin County, which we believe is currently underserved by existing financial institutions and presents excellent de novo branching opportunities. The market served by these branches is one of rapid customer growth evidenced by First Financial Bancorps growth between December 31, 1999 and September 30, 2004, whereby total assets and total deposits grew at compound annual rates of 14.3% and 12.7%, respectively.
Our Business Strategy
Our goal is to be the premier community banking company for the long-term benefit of our shareholders, customers and employees by increasing shareholder value and providing high-quality customer service. Our principal operating strategy is to continue our asset and earnings growth rates by:
We provide banking and other financial services throughout our targeted Northern and Southern California markets to consumers and to small- and medium-sized businesses, including the owners and employees of those businesses. We offer a broad range of banking products and services including many types of commercial and personal checking and savings accounts and other consumer banking products, including electronic banking products. We offer on-line, real-time cash management services such as check imaging, statement imaging, electronic bill payment, wire transfers and automated clearinghouse debits and credits, among others.
We also originate a variety of loans including secured and unsecured commercial and consumer loans, commercial and residential real estate mortgage loans, SBA loans and residential and commercial construction loans. Special services or requests beyond the lending limits of the bank are arranged through correspondent banks. We have a network of ATMs and offer access to ATM networks through other major banks. The bank issues MasterCard and Visa credit and debit cards through a correspondent bank and is also a merchant depository for cardholder drafts under Visa and MasterCard. We provide non-deposit investment products through a third-party and international banking services through correspondent banks.
We recognize that certain types of loans and leases have inherently more risk than others. For instance, commercial real estate loans have more risk than home mortgages because they are generally larger and often rely on income from multiple business tenants. Commercial term loans to businesses have more risk than automobile loans to consumers because they are generally larger and depend upon the success of often complex businesses. Unsecured loans have more risk than collateralized loans. Through the bank, we concentrate our lending activities in three principal areas:
Real Estate Loans. Real estate loans are comprised of construction loans, miniperm and long-term loans collateralized by first deeds of trust on specific properties, home mortgages and equity lines of credit. Construction loans are comprised of two types:
Home mortgages are principally comprised of 15- and 30- year fixed and adjustable rate loans collateralized by first deeds of trust on owner-occupied one to four family residences. The miniperm loans and long-term loans
finance the purchase and/or ownership of income producing properties. Miniperm loans are generally made with an amortization schedule ranging from 15 to 25 years with a lump sum balloon payment due in one to 10 years. Equity lines of credit are revolving lines of credit collateralized by junior deeds of trust on real properties. They bear a rate of interest that floats with the prime rate and have maturities of ten years.
Our real estate portfolio is subject to certain risks, including:
We strive to reduce the exposure to these risks by:
Commercial Loans and Leases. Commercial loans and leases are made to finance operations, to provide working capital or for specific purposes, such as to finance the purchase of fixed assets, equipment or inventory or for agricultural production. Our policies provide specific guidelines regarding required debt coverage and other important financial ratios. Commercial loans include lines of credit and commercial term loans. Lines of credit are extended to businesses or consumers based on the financial strength and integrity of the borrower and generally (with some exceptions) are collateralized by short-term assets such as accounts receivable or inventory and have a maturity of one year or less. Such lines of credit bear an interest rate that floats with the prime rate or another established index. Commercial term loans are typically made to finance the acquisition of fixed assets, refinance short-term debt originally used to purchase fixed assets or, in rare cases, to finance the purchase of businesses. Commercial term loans generally have terms from one to five years. They may be collateralized by the asset being acquired or other available assets and bear interest which either floats with the prime rate or another established index or is fixed for the term of the loan.
Our commercial loan and lease portfolio is subject to certain risks, including:
We strive to reduce the exposure to these risks by:
Consumer Loans. We provide consumer loans, including personal loans, automobile loans and leases, boat loans, home improvement loans, revolving lines of credit and other loans typically made by banks to individual borrowers.
Our consumer loan portfolio is subject to certain risks, including:
We strive to reduce the exposure to these risks by:
Each loan and lease request is reviewed on the basis of our ability to recover both principal and interest in view of the inherent risks. In addition, loans and leases based on short-term asset values are monitored on a monthly or quarterly basis. In general, we receive and review financial statements of borrowing customers on an ongoing basis during the term of the relationship and respond to any deterioration noted.
Lending Procedures and Credit Approval Process
We maintain a credit approval process which helps reduce our loan and lease losses and loan and lease workout costs. We segregate the loan and lease origination, marketing and sales process from the loan and lease underwriting and approval process. Loan and lease underwriting and approval is centralized at the banks Auburn, California administrative headquarters and at a satellite office in Anaheim, California, which provides for consistency, control, efficiency and better customer service. Loan and lease applications are obtained by business development officers and by branch personnel at the bank and submitted for processing and underwriting. Separate units are responsible for underwriting various types of loans and leases. The banks Northern California Business Lending Group (Auburn, CA) and its Southern California Lending Group (Anaheim, CA) underwrite commercial, commercial real estate and SBA loans and leases, the Residential Loan Department underwrites residential loans and the Consumer Loan Department underwrites consumer loans.
Legal lending limits are calculated in conformance with applicable law, which prohibits a bank from lending to any one individual or entity or its related interests an aggregate amount which exceeds 15% of primary capital plus the allowance for loan and lease losses on an unsecured basis and 25% on a combined secured and unsecured basis. Our primary capital plus allowance for loan and lease losses at December 31, 2004 totaled $233.5 million. At December 31, 2004, the authorized legal lending limits of the bank was approximately $35.0 million for unsecured loans and $58.4 million for unsecured and secured loans and leases combined. Our largest borrower as of December 31, 2004 had an aggregate outstanding loan liability of approximately $16.2 million.
We seek to mitigate the risks inherent in our loan and lease portfolio by adhering to established underwriting practices. These practices include analysis of prior credit histories, financial statements, tax returns and cash flow projections, valuation of collateral based on reports of independent appraisers and verification of liquid assets. Our lending practices are reviewed quarterly by an outside loan review company with a view to ensuring that loans and leases are made in compliance with our lending policies and safe and sound banking practices. Although we believe that our underwriting criteria are appropriate for the various kinds of loans and leases we make, we may incur losses on loans and leases which meet our underwriting criteria, and these losses may exceed the amounts set aside as reserves for such losses in the allowance for loan and lease losses.
We offer a broad array of online banking, cash management services and demand and time deposit products. Our 41-branch network enables us to offer a full range of deposits, loans and leases and personalized services to our targeted commercial and consumer customers.
Our competitive online banking and cash management services include our Account Link online financial management product for individuals and sole proprietors and our Intelligent Banker online corporate cash management solution for businesses. Account Link provides Internet access to financial management tools, permitting our consumer customers to obtain real-time account information, including balances and transaction history, images of checks, transfer funds between accounts at the bank, pay bills online, access loans and credit lines, communicate by email with the bank and export information to financial management software for account reconciliation. Intelligent Banker provides our commercial customers with a 24 hour per day/seven day per week flexible electronic commerce solution that addresses the cash management challenges of our commercial customers. Intelligent Banker has customized security and employed access features and enables our commercial customers to conduct balance inquiries, review their account history and transactions details, obtain check images over the internet, transfer funds between accounts, initiate wire transfers, engage in approved transactions, and process stop payment instructions, check reorders and information requests. Account Link and Intelligent Banker use security and encryption software designed to afford secure online banking and cash management.
We offer a comprehensive suite of demand and time deposits designed to address the varying needs of our commercial customers and the lifestyles of our consumer customers. These products include corporate and consumer savings, checking, money market accounts and certificates of deposit. A number of these products are tailored to address the banking requirements of targeted portions of our customer base such as our checking products for senior citizens and our distinct commercial checking products for:
As a community bank, the banks services are designed to make banking with us easy and convenient. Our traditional branch banking facilities offer a personalized level of service to our commercial and consumer customers. In addition, our ATMs, point-of-sale locations, online banking services, telephonic banking services, direct deposit, night drop, courier services and other deposit-related services accommodate the diverse needs of our commercial and consumer customers in the communities we serve.
No individual or single group of related accounts is considered material in relation to our assets or the banks assets or deposits, or in relation to the overall business of the bank or Placer Sierra Bancshares. However, approximately 83% of our loan and lease portfolio at December 31, 2004 consisted of real estate-related loans including construction loans, miniperm loans, real estate mortgage loans and commercial loans secured by real estate. Moreover, our business activities are currently focused in Northern and Southern California. In Northern California, our business is focused in the counties of Placer, Sacramento and El Dorado, commonly known as the greater Sacramento metropolitan region, and the adjacent counties of Amador, Calaveras, Nevada, Sierra, and San Joaquin. In Southern California, our business is focused in Los Angeles and Orange counties. Consequently, our financial condition, results of operations and cash flows are dependent upon the general trends in the California economy and, in particular, the residential and commercial real estate markets. In addition, the concentration of our operations in the greater Sacramento metropolitan region and in Los Angeles and Orange counties exposes us to greater risk than other banking companies with a wider geographic base in the event of catastrophes such as earthquakes, fires and floods in these regions.
The banking and financial services industry in California generally, and in the Banks market specifically is highly competitive with respect to loans and deposits as well as other banking services. The market is dominated by a relatively small number of large financial institutions with a large number of offices and full-service operations over a wide geographic area. Among the advantages those institutions have in comparison to us are their ability to finance and engage in wide ranging advertising campaigns and to allocate their investment assets to regions of higher yield and demand. They also may offer certain services which are not offered directly by us. By virtue of their greater total capitalization, the major financial institutions have substantially higher lending limits than we do. We also compete with community and regional banks from other areas that are moving into our market. Other entities in both the public and private sectors seeking to raise capital through the issuance and sale of debt or equity securities also provide competition for us in the acquisition of deposits. We also compete with money market funds and issuers of other money market instruments. In recent years, increased competition has also developed from specialized finance and non-finance companies that offer wholesale finance, credit card and other consumer finance services, including on-line banking services and personal finance software. Competition for deposit and loan products remains strong from both banking and non-banking firms and this competition directly affects the rates of those products and the terms on which they are offered to consumers.
Technological innovation continues to contribute to greater competition in domestic and international financial services markets. Technological innovation has, for example, made it possible for non-depository institutions to offer customers automated transfer payment services previously limited to traditional banking products. In addition, customers now expect a choice of several delivery systems and channels, including telephone, mail, home computer, ATMs, self-service branches and in-store branches.
Mergers between financial institutions have placed additional pressure on banks to consolidate their operations, reduce expenses and increase revenues to remain competitive. In addition, competition has intensified due to federal and state interstate banking laws, which permit banking organizations to expand geographically with fewer restrictions than in the past. These laws allow banks to merge with other banks across state lines, thereby enabling banks to establish or expand banking operations in our market. The competitive environment is also significantly impacted by federal and state legislation which make it easier for non-bank financial institutions to compete with us.
Economic factors, along with legislative and technological changes, will have an ongoing impact on the competitive environment within the financial services industry. As an active participant in financial markets, we strive to anticipate and adapt to dynamic competitive conditions, but we cannot assure you as to their impact on our future business, financial condition, results of operations or cash flows or as to our continued ability to anticipate and adapt to changing conditions. In order to compete with other competitors in our primary service area, we attempt to use to the fullest extent possible the flexibility which our independent status permits, including an emphasis on specialized services, local promotional activity and personal contacts.
Economic Conditions, Government Policies, Legislation, and Regulation
Our profitability, like most financial institutions, is primarily dependent on interest rate differentials. In general, the difference between the interest rates paid by us on interest-bearing liabilities, such as deposits and other borrowings, and the interest rates received by us on our interest-earning assets, such as loans extended to our clients and securities held in our investment portfolio, comprise the major portion of our earnings. These rates are highly sensitive to many factors that are beyond our control, such as inflation, recession and unemployment, and the impact which future changes in domestic and foreign economic conditions might have on us cannot be predicted.
Our business is also influenced by the monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Board of Governors of the Federal Reserve System (the Federal Reserve). The Federal Reserve implements national monetary policies (with objectives such as curbing inflation
and combating recession) through its open-market operations in U.S. Government securities by adjusting the required level of reserves for depository institutions subject to its reserve requirements, and by varying the target federal funds and discount rates applicable to borrowings by depository institutions. The actions of the Federal Reserve in these areas influence the growth of bank loans, investments, and deposits and also affect interest rates earned on interest-earning assets and paid on interest-bearing liabilities. The nature and impact on us of any future changes in monetary and fiscal policies cannot be predicted.
From time to time, legislation, as well as regulations, are enacted which have the effect of increasing the cost of doing business, limiting or expanding permissible activities, or affecting the competitive balance between banks and other financial services providers. This legislation may change banking statutes and our operating environment in substantial and unpredictable ways. We cannot predict whether any potential legislation will be enacted, and if enacted, the effect that it, or any implementing regulations, would have on our financial condition or results of operations.
Bank holding companies and banks are extensively regulated under both federal and state law. This regulation is intended primarily for the protection of depositors and the deposit insurance fund and not for the benefit of our shareholders. Set forth below is a summary description of the material laws and regulations which relate to our operations. The description is qualified in its entirety by reference to the applicable laws and regulations.
Placer Sierra Bancshares
As a bank holding company, we are subject to regulation and examination by the Federal Reserve under the Bank Holding Company Act of 1956, as amended, or the BHCA. We are required to file with the Federal Reserve periodic reports and such additional information as the FRB may require. Recent changes to the bank holding company rating system emphasize risk management and evaluation of the potential impact of nondepository entities on safety and soundness.
The Federal Reserve may require us to terminate an activity or terminate control of or liquidate or divest certain subsidiaries, affiliates or investments when the Federal Reserve believes the activity or the control of the subsidiary or affiliate constitutes a significant risk to the financial safety, soundness or stability of our banking subsidiary. The Federal Reserve also has the authority to regulate provisions of certain bank holding company debt, including the authority to impose interest ceilings and reserve requirements on such debt. Under certain circumstances, we must file written notice and obtain Federal Reserve approval prior to purchasing or redeeming our equity securities. Further, we are required by the FRB to maintain certain levels of capital. See Capital Standards.
We are required to obtain prior Federal Reserve approval for the acquisition of more than 5% of the outstanding shares of any class of voting securities or substantially all of the assets of any bank or bank holding company. Prior Federal Reserve approval is also required for the merger or consolidation of the company and another bank holding company.
We are prohibited by the BHCA, except in certain statutorily prescribed instances, from acquiring direct or indirect ownership or control of more than 5% of the outstanding voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or furnishing services to our subsidiaries. However, subject to the prior Federal Reserve approval, we may engage in any, or acquire shares of companies engaged in, activities that the Federal Reserve deems to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.
It is the policy of the Federal Reserve that each bank holding company serve as a source of financial and managerial strength to its subsidiary bank(s) and it may not conduct operations in an unsafe or unsound manner. A bank holding companys failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve to be an unsafe and unsound banking practice or a violation of Federal Reserve regulations or both.
We are also a bank holding company within the meaning of the California Financial Code. As such, we and our subsidiaries are subject to examination by and may be required to file reports with the California Department of Financial Institutions, or DFI.
As a California chartered bank, the bank is subject to primary supervision, periodic examination, and regulation by the DFI. As a member of the Federal Reserve System, the bank is also subject to regulation, supervision and periodic examination by the Federal Reserve. The banks deposits are insured by the Federal Deposit Insurance Corporation, or FDIC, to the maximum amount permitted by law, which is currently $100,000 per depositor in most cases. Insured banks are subject to FDIC regulations applicable to all insured institutions.
If, as a result of an examination of the bank, the Federal Reserve or DFI determines that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, or other aspects of our operations are unsatisfactory or that we are violating or have violated any law or regulation, various remedies are available to the Federal Reserve, including the power to enjoin unsafe or unsound practices, to require affirmative action to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in capital, to restrict our growth, to assess civil monetary penalties, to remove officers and directors, and ultimately to terminate our deposit insurance, which would result in a revocation of the banks charter.
The DFI also possesses broad powers to take corrective and other supervisory actions to resolve the problems of California state chartered banks. These enforcement powers include cease and desist orders, the imposition of fines, the ability to take possession of a bank and the ability to close and liquidate a bank.
Because California permits commercial banks chartered by the state to engage in any activity permissible for national banks, the bank can form subsidiaries to engage in expanded financial activities to the same extent as a national bank. However, in order to form a financial subsidiary, the bank must be well-capitalized and would be subject to the same capital deduction, risk management and affiliate transaction rules as applicable to national banks. Generally, a financial subsidiary is permitted to engage in activities that are financial in nature or incidental thereto, even though they are not permissible for the national bank to conduct directly within the bank. The definition of financial in nature includes, among other items, underwriting, dealing in or making a market in securities, including, for example, distributing shares of mutual funds. The subsidiary may not, however, engage as principal in underwriting insurance, issue annuities or engage in real estate development or investment or merchant banking.
Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 addresses accounting oversight and corporate governance matters, including:
The new legislation and its implementing regulations have resulted in increased costs of compliance, including certain outside professional costs. We anticipate these costs will have a material impact on our operations, due to costs to add regulatory support personnel and costs to ensure effectiveness of internal controls and testing.
USA PATRIOT Act of 2001
In the wake of the tragic events of September 11th, on October 26, 2001, the President signed the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, referred to as the USA PATRIOT Act.
Under the USA PATRIOT Act, financial institutions are subject to prohibitions regarding specified financial transactions and account relationships as well as enhanced due diligence and know your customer standards in their dealings with foreign financial institutions and foreign customers. For example, the enhanced due diligence policies, procedures, and controls generally require financial institutions to take reasonable steps:
Under the USA PATRIOT Act, financial institutions are required to establish and maintain anti-money laundering programs which included
Our bank has implemented comprehensive policies and procedures to address the requirements of the USA PATRIOT Act.
Federal banking rules limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. Pursuant to these rules, financial institutions must provide:
These privacy provisions affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors.
In recent years, a number of states have implemented their own versions of privacy laws. For example, in 2003, California adopted standards that are more restrictive than federal law, allowing bank customers the opportunity to bar financial companies from sharing information with their affiliates.
Payment of Dividends and Other Transfer of Funds
Placer Sierra Bancshares
Our shareholders are entitled to receive dividends when and as declared by our Board of Directors, out of funds legally available therefore, subject to a dividend preference, if any, on preferred shares that may be outstanding and also subject to the restrictions of the California General Corporation Law. The California General Corporation Law provides that a corporation may make a distribution to its shareholders if the corporations retained earnings equal at least the amount of the proposed distribution. The California General Corporation Law further provides that, in the event that sufficient retained earnings are not available for the proposed distribution, a corporation may nevertheless make a distribution to its shareholders if it meets two conditions: (i) the corporations assets equal at least 125% its liabilities and (ii) the corporations current assets equal at least its current liabilities or, alternatively, if the average of the corporations earnings before taxes on income and interest expense for the two preceding fiscal years was less than the average of the corporations interest expense for such fiscal years, the corporations current assets equal at least 125% of current liabilities.
Our principal source of cash revenues is dividends received from the bank.
Placer Sierra Bank
Under state law, the board of directors of a California state chartered bank may declare a cash dividend, subject to the restriction that the amount available for the payment of cash dividends is limited to the lesser of the banks retained earnings, or the banks net income for the latest three fiscal years, less dividends previously paid during that period, or, with the approval of the Commissioner of the DFI, to the greater of the retained earnings of the bank, the net income of the bank for its last fiscal year or the net income of the bank for its current fiscal year.
Federal Reserve regulations also govern the payment of dividends by a state member bank. Under Federal Reserve regulations, dividends may not be paid unless both capital and earnings limitations have been met. First, no dividend may be paid if it would result in a withdrawal of capital or exceed the member banks net profits then on hand, after deducting its losses and bad debts. Exceptions to this limitation are available only upon the prior approval of the Federal Reserve and the approval of two-thirds of the member banks shareholders which, in the case of the bank, would require our approval, as sole shareholder of the bank. Second, a state member bank may not pay a dividend without the prior written approval of the Federal Reserve if the total of all dividends declared in one calendar year, including the proposed dividend, exceeds the total of net income for that year plus the preceding two calendar years less any required transfers to surplus under state or federal law. Under such restrictions, the amount available for payment of dividends to us by the bank totaled $13.8 million at December 31, 2004. However, such amount is further restricted due to the fact that the bank must keep a certain amount of capital in order to be well capitalized as described below in Capital Standards. Accordingly, the amount available for payment of dividends to us by the bank for the bank to remain well capitalized immediately thereafter totaled $2.0 million at December 31, 2004.
The Federal Reserve has broad authority to prohibit a bank from engaging in banking practices which it considers to be unsafe or unsound. It is possible, depending upon the financial condition of the bank in question and other factors, that the Federal Reserve may assert that the payment of dividends or other payments by a member bank is considered an unsafe or unsound banking practice and therefore, implement corrective action to address such a practice.
Accordingly, the future payment of cash dividends by the bank to us will generally depend not only on the banks earnings during any fiscal period but also on the bank meeting certain capital requirements and maintaining an adequate allowance for loan and lease losses.
The Federal Reserve and the FDIC have risk-based capital adequacy guidelines intended to provide a measure of capital adequacy that reflects the degree of risk associated with a banking organizations operations for both transactions reported on the balance sheet as assets and transactions which are reported as off-balance-sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk federal banking agencies, to 200% for assets with relatively high credit risk.
A banking organizations risk-based capital ratio is determined by classifying assets and certain off-balance sheet financial instruments into weighted categories, with higher levels of capital being required for those categories perceived as representing greater risk. Under the capital guidelines, a banks total capital is divided into tiers. Tier 1 capital consists of (1) common equity, (2) qualifying noncumulative perpetual preferred stock, (3) a limited amount of qualifying cumulative perpetual preferred stock and (4) minority interests in the equity accounts of consolidated subsidiaries (including a minority interest in the form of trust-preferred securities), less goodwill and certain other intangible assets. Not more than 25% of qualifying Tier 1 capital may consist of trust-preferred securities. Tier 2 capital consists of hybrid capital instruments, perpetual debt, mandatory convertible debt securities, a limited amount of subordinated debt, preferred stock that does not qualify as Tier 1 capital, a limited amount of the allowance for loan and lease losses and a limited amount of unrealized holding gains on equity securities. Tier 3 capital consists of qualifying unsecured subordinated debt. The sum of Tier 2 and Tier 3 capital may not exceed the amount of Tier 1 capital. The guidelines require a minimum ratio of qualifying total capital to risk-adjusted assets of 8% and a minimum ratio of Tier 1 capital to risk-adjusted assets of 4%. Proposed accounting rules regarding special purpose entities (Fin 46) called into question the regulatory capital treatment of minority interests in the form of trust preferred securities and had the potential of disqualifying such trust preferred securities from Tier 1 capital status. However, in March of 2005, the Federal Reserve published in the Federal Register a final rule that will retain minority interests in the form of trust preferred securities in the Tier 1 capital of bank holding companies, but with stricter quantitative limits and clearer qualitative standards. The final rule will be effective March 31, 2009. Under the final rule the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25 percent of Tier 1 capital elements, net of goodwill. The amount of trust preferred securities and certain other elements in excess of the limit could be included in Tier 2 capital, subject to restrictions. Internationally active bank holding companies would generally be expected to limit trust preferred securities and certain other capital elements to 15 percent of Tier 1 capital elements, net of goodwill. Trust preferred securities currently make up 41.71% of our Tier 1 capital.
In addition to the risk-based guidelines, federal banking regulators require banking organizations to maintain a minimum amount of Tier 1 capital to total assets, referred to as the leverage ratio. For a banking organization rated in the highest of the five categories used by regulators to rate banking organizations, the minimum leverage ratio of Tier 1 capital to total assets must be 3%. In addition to these uniform risk-based capital guidelines and leverage ratios that apply across the industry, the regulators have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios.
A bank that does not achieve and maintain the required capital levels may be issued a capital directive by the FDIC to ensure the maintenance of required capital levels. As discussed above, we are required to maintain certain levels of capital, as is the bank. The minimum regulatory capital guidelines for an institution and for an institution to be considered well capitalized as well as our actual capitalization on a consolidated basis and for the bank as of December 31, 2004 are set forth under ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Capital Resources. As of December 31, 2004, we exceeded each of the capital requirements to be deemed well capitalized. As of December 31, 2004, we own the common stock of trusts that have issued $52 million of trust preferred securities. These securities are currently included in our Tier 1 capital for purposes of determining our Tier 1 and total risk-based capital ratios. As discussed above, effective March 31, 2009, we will be required to use a more restrictive formula to determine the amount of trust preferred securities that can be included in regulatory Tier 1 capital. We have determined that our Tier 1 capital ratios would remain above the well-capitalized level had the modification of the capital regulations been in effect at December 31, 2004. We expect our Tier 1 capital ratios will be at or above the well capitalized levels on March 31, 2009. For more information, see ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Capital Resources.
In addition, federal banking regulators may set capital requirements higher than the minimums described above for financial institutions whose circumstances warrant it. For example, a financial institution experiencing or anticipating significant growth may be expected to maintain capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets.
Basel Committee on Banking Supervisions (Basel II Capital Framework)
The current international regulators agreement on risk-based capital are to be replaced over the next several years by a new Basel II Framework for Capital Adequacy. These international capital standards would require certain large and internationally active U.S. banking organizations to implement a more risk-sensitive approach for regulatory capital standards, utilizing internal estimates of certain risk parameters. Other banks would/could adopt the procedures on a voluntary basis. The US bank regulatory agencies are expected to continue to issue substantial guidance to domestic US banks on the options and process for implementing Basel II. The costs and time required for us to fully implement Basel II in the future are uncertain, but could be significant.
Prompt Corrective Action and Other Enforcement Mechanisms
Federal banking agencies possess broad powers to take corrective and other supervisory action to resolve the problems of insured depository institutions, including but not limited to those institutions that fall below one or more prescribed minimum capital ratios. Each federal banking agency has promulgated regulations defining the following five categories in which an insured depository institution will be placed, based on its capital ratios: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. At December 31, 2004, the bank exceeded the required ratios for classification as well capitalized.
An institution that, based upon its capital levels, is classified as well capitalized, adequately capitalized, or undercapitalized may be treated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, determines that an unsafe or unsound condition or an unsafe or unsound practice warrants such treatment. At each successive lower capital category, an insured depository institution is subject to more restrictions. The federal banking agencies, however, may not treat a significantly undercapitalized institution as critically undercapitalized unless its capital ratio actually warrants such treatment.
In addition to measures taken under the prompt corrective action provisions, commercial banking organizations may be subject to potential enforcement actions by the federal regulators for unsafe or unsound
practices in conducting their businesses or for violations of any law, rule, regulation, or any condition imposed in writing by the agency or any written agreement with the agency. Finally, pursuant to an interagency agreement, the FDIC can examine any institution that has a substandard regulatory examination score or is considered undercapitalizedwithout the express permission of the institutions primary regulator.
Safety and Soundness Standards
The federal banking agencies have adopted guidelines designed to assist the federal banking agencies in identifying and addressing potential safety and soundness concerns before capital becomes impaired. The guidelines set forth operational and managerial standards relating to:
In addition, the federal banking agencies have also adopted safety and soundness guidelines with respect to asset quality and earnings standards. These guidelines provide six standards for establishing and maintaining a system to identify problem assets and prevent those assets from deteriorating. Under these standards, an insured depository institution should:
These guidelines also set forth standards for evaluating and monitoring earnings and for ensuring that earnings are sufficient for the maintenance of adequate capital and reserves.
Premiums for Deposit Insurance
Through the Bank Insurance Fund, or BIF, the FDIC insures our customer deposits up to prescribed limits for each depositor. The amount of FDIC assessments paid by each BIF member institution is based on its relative risk of default as measured by regulatory capital ratios and other factors. Specifically, the assessment rate is based on the institutions capitalization risk category and supervisory subgroup category. An institutions capitalization risk category is based on the FDICs determination of whether the institution is well capitalized, adequately capitalized or less than adequately capitalized. An institutions supervisory subgroup category is based on the FDICs assessment of the financial condition of the institution and the probability that FDIC intervention or other corrective action will be required.
FDIC-insured depository institutions pay an assessment rate equal to the rate assessed on deposits insured by the Savings Association Insurance Fund.
The assessment rate currently ranges from zero to 27 cents per $100 of domestic deposits. The FDIC may increase or decrease the assessment rate schedule on a semi-annual basis. Due to continued growth in deposits and some recent bank failures, the BIF is nearing its minimum ratio of 1.25% of insured deposits as mandated by law. If the ratio drops below 1.25%, it is likely the FDIC will be required to assess premiums on all banks. Any increase in assessments or the assessment rate could have a material adverse effect on our business, financial condition, results of operations or cash flows, depending on the amount of the increase. Furthermore, the FDIC is authorized to raise insurance premiums under certain circumstances.
The FDIC is authorized to terminate a depository institutions deposit insurance upon a finding by the FDIC that the institutions financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the institutions regulatory agency. The termination of deposit insurance for the bank would have a material adverse effect on our business, financial condition, results of operations or cash flows.
All FDIC-insured depository institutions must pay an annual assessment to provide funds for the payment of interest on bonds issued by the Financing Corporation, a federal corporation chartered under the authority of the Federal Housing Finance Board. The bonds, commonly referred to as FICO bonds, were issued to capitalize the Federal Savings and Loan Insurance Corporation. The FDIC established the FICO assessment rates effective for the fourth quarter of fiscal 2004 at approximately 1.46 cents for each $100 of assessable deposits. The FICO assessments are adjusted quarterly to reflect changes in the assessment bases of the FDICs insurance funds and do not vary depending on a depository institutions capitalization or supervisory evaluations.
Extensions of Credit to Insiders and Transactions with Affiliates
The Federal Reserve Act and Federal Reserve Regulation O place limitations and conditions on loans or extensions of credit to:
Loans and leases extended to any of the above persons must comply with loan-to-one-borrower limits, require prior full board approval when aggregate extensions of credit to the person exceed specified amounts, must be made on substantially the same terms (including interest rates and collateral) as, and follow credit-underwriting procedures that are not less stringent than, those prevailing at the time for comparable transactions with non-insiders, and must not involve more than the normal risk of repayment or present other unfavorable features. In addition, Regulation O provides that the aggregate limit on extensions of credit to all insiders of a bank as a group cannot exceed the banks unimpaired capital and unimpaired surplus. Regulation O also prohibits a bank from paying an overdraft on an account of an executive officer or director, except pursuant to a written pre-authorized interest-bearing extension of credit plan that specifies a method of repayment or a written pre-authorized transfer of funds from another account of the officer or director at the bank.
The bank also is subject to certain restrictions imposed by federal law on any extensions of credit to, or the issuance of a guarantee or letter of credit on behalf of, any affiliates, the purchase of, or investments in, stock or other securities thereof, the taking of such securities as collateral for loans, and the purchase of assets of any affiliates. Such restrictions prevent any affiliates from borrowing from us unless the loans are secured by marketable obligations of designated amounts. Further, such secured loans and investments by us to or in any affiliate are limited, individually, to 10.0% of our capital and surplus (as defined by federal regulations), and
such secured loans and investments are limited, in the aggregate, to 20.0% of our capital and surplus. Some of the entities included in the definition of an affiliate are parent companies, sister banks, sponsored and advised companies, investment companies whereby the banks affiliate serves as investment advisor, and financial subsidiaries of the bank. Additional restrictions on transactions with affiliates may be imposed on us under the prompt corrective action provisions of federal law. See Prompt Corrective Action and Other Enforcement Mechanisms.
Consumer Protection Laws and Regulations
The bank regulatory agencies are focusing greater attention on compliance with consumer protection laws and their implementing regulations. Examination and enforcement have become more intense in nature, and insured institutions have been advised to monitor carefully compliance with such laws and regulations. The bank is subject to many federal consumer protection statutes and regulations, some of which are discussed below.
The Community Reinvestment Act, or CRA, is intended to encourage insured depository institutions, while operating safely and soundly, to help meet the credit needs of their communities. The CRA specifically directs the federal regulatory agencies, in examining insured depository institutions, to assess a banks record of helping meet the credit needs of its entire community, including low- and moderate-income neighborhoods, consistent with safe and sound banking practices. The CRA further requires the agencies to take a financial institutions record of meeting its community credit needs into account when evaluating applications for, among other things, domestic branches, mergers or acquisitions, or holding company formations. The agencies use the CRA assessment factors in order to provide a rating to the financial institution. The ratings range from a high of outstanding to a low of substantial noncompliance. In its last examination for CRA compliance, as of March 3, 2003, the bank was rated satisfactory.
The Fair Credit Reporting Act, as amended by the Fair and Accurate Credit Transactions Act, or FACT, requires financial firms to help deter identity theft, including developing appropriate fraud response programs, and give consumers more control of their credit data. It also reauthorizes a federal ban on state laws that interfere with corporate credit granting and marketing practices. In connection with FACT, financial institution regulatory agencies proposed rules that would prohibit an institution from using certain information about a consumer it received from an affiliate to make a solicitation to the consumer, unless the consumer has been notified and given a chance to opt out of such solicitations. A consumers election to opt out would be applicable for at least five years.
The Check Clearing for the 21st Century Act, or Check 21, facilitates check truncation and electronic check exchange by authorizing a new negotiable instrument called a substitute check, which is the legal equivalent of an original check. Check 21, effective October 28, 2004, does not require banks to create substitute checks or accept checks electronically; however, it does require banks to accept a legally equivalent substitute check in place of an original.
The Equal Credit Opportunity Act, or ECOA, generally prohibits discrimination in any credit transaction, whether for consumer or business purposes, on the basis of race, color, religion, national origin, sex, marital status, age (except in limited circumstances), receipt of income from public assistance programs, or good faith exercise of any rights under the Consumer Credit Protection Act.
The Truth in Lending Act, or TILA, is designed to ensure that credit terms are disclosed in a meaningful way so that consumers may compare credit terms more readily and knowledgeably. As a result of the TILA, all creditors must use the same credit terminology to express rates and payments, including the annual percentage rate, the finance charge, the amount financed, the total of payments and the payment schedule, among other things.
The Fair Housing Act, or FH Act, regulates many practices, including making it unlawful for any lender to discriminate in its housing-related lending activities against any person because of race, color, religion, national
origin, sex, handicap or familial status. A number of lending practices have been found by the courts to be, or may be considered, illegal under the FH Act, including some that are not specifically mentioned in the FH Act itself.
The Home Mortgage Disclosure Act, or HMDA, grew out of public concern over credit shortages in certain urban neighborhoods and provides public information that will help show whether financial institutions are serving the housing credit needs of the neighborhoods and communities in which they are located. The HMDA also includes a fair lending aspect that requires the collection and disclosure of data about applicant and borrower characteristics as a way of identifying possible discriminatory lending patterns and enforcing anti-discrimination statutes.
The term predatory lending, much like the terms safety and soundness and unfair and deceptive practices, is far-reaching and covers a potentially broad range of behavior. As such, it does not lend itself to a concise or a comprehensive definition. But typically predatory lending involves at least one, and perhaps all three, of the following elements:
Federal Reserve regulations aimed at curbing such lending significantly widen the pool of high-cost home-secured loans covered by the Home Ownership and Equity Protection Act of 1994, a federal law that requires extra disclosures and consumer protections to borrowers. Lenders that violate the rules face cancellation of loans and penalties equal to the finance charges paid.
Finally, the Real Estate Settlement Procedures Act, or RESPA, requires lenders to provide borrowers with disclosures regarding the nature and cost of real estate settlements. Also, RESPA prohibits certain abusive practices, such as kickbacks, and places limitations on the amount of escrow accounts. Penalties under the above laws may include fines, reimbursements and other penalties. Due to heightened regulatory concern related to compliance with the CRA, TILA, FH Act, ECOA, HMDA and RESPA generally, the bank may incur additional compliance costs or be required to expend additional funds for investments in its local community.
Interstate Banking and Branching
Banks have the ability, subject to certain state restrictions, to acquire by acquisition or merger branches outside their home states. The establishment of new interstate branches is also possible in those states with laws that expressly permit it. Interstate branches are subject to certain laws of the states in which they are located. Competition may increase further as banks branch across state lines and enter new markets.
Change in Control
The BHCA, and the Change in Bank Control Act of 1978, as amended, together with regulations of the Federal Reserve, require that, depending on the particular circumstances, either FRB approval must be obtained or notice must be furnished to the FRB and not disapproved prior to any person or entity acquiring control of a state member bank, such as the bank, subject to exemptions for some transactions. Control is conclusively presumed to exist if an individual or entity acquires 25% or more of any class of voting securities of the bank. Control is rebuttably presumed to exist if an entity acquires 10% or more but less than 25% of any class of voting
securities and either the entity has registered securities under Section 12 of the Securities Exchange Act of 1934, as amended, or the Exchange Act, or no other person will own a greater percentage of that class of voting securities immediately after the transaction.
Federal Home Loan Bank System
The bank is a member of the Federal Home Loan Bank of San Francisco, or FHLB-SF. Among other benefits, each Federal Home Loan Bank, or FHLB, serves as a reserve or central bank for its members within its assigned region. Each FHLB is financed primarily from the sale of consolidated obligations of the FHLB system. Each FHLB makes available loans or advances to its members in compliance with the policies and procedures established by the Board of Directors of the individual FHLB. As an FHLB member, the bank is required to own capital stock in the FHLB-SF. At December 31, 2004, we were in compliance with the stock requirement.
Federal Reserve System
The Federal Reserve requires all depository institutions to maintain non-interest bearing reserves at specified levels against their transaction accounts (primarily checking, NOW, and Super NOW checking accounts) and non-personal time deposits. At December 31, 2004, we were in compliance with these requirements.
As of December 31, 2004, Placer Sierra Bancshares on a consolidated basis had approximately 523 full time equivalent employees.
Our website address is www.plsb.com. We make available free of charge on our website our annual report on Form 10-K, our quarterly report on Form 10-Q and our current reports on Form 8-K as soon as reasonably practicable after we file such reports with the SEC. None of the information on or hyperlinked from our website is incorporated into this Annual Report on Form 10-K.
Factors That May Affect Future Results of Operations
In addition to the other information contained in this report, the following risks may affect us. If any of these risks occurs, our business, financial condition or operating results could be adversely affected.
Failure to realize anticipated cost savings from the First Financial Bancorp and the Bank of Lodi transaction could adversely affect our performance.
In December 2004, we acquired First Financial Bancorp and its wholly-owned subsidiary Bank of Lodi. Bank of Lodi was merged with and into our bank, Placer Sierra Bank. We expect the merger of Bank of Lodi with and into our bank will generate expense reductions of between approximately 35% and 45% of First Financial Bancorps pre-acquisition total non-interest expenses. We intend to achieve these expense reductions by eliminating redundant staff and duplicative operations, technology, and outside services, consolidation of facilities and through realization of limited additional purchasing efficiencies. We may fail to realize some or all of these anticipated cost savings, and the time frame to achieve such cost savings may be longer than anticipated.
Changes in economic conditions could materially hurt our business.
Our business is directly affected by factors such as economic, political and market conditions, broad trends in industry and finance, legislative and regulatory changes, changes in government monetary and fiscal policies
and inflation, all of which are beyond our control. We are particularly affected by economic conditions in the state of California. Deterioration in economic conditions could result in the following consequences, any of which could have a material adverse effect on our business, financial condition, results of operations and cash flows:
In view of the concentration of our operations and the collateral securing our loan portfolio in both Northern and Southern California, we may be particularly susceptible to the adverse effects of any of these consequences, any of which could have a material adverse effect on our business, financial condition, results of operations and cash flows.
Our growth and expansion, including our recent acquisition of Southland Capital Co. and Bank of Orange County and our acquisition of First Financial Bancorp and Bank of Lodi may strain our ability to manage our operations and our financial resources.
Our financial performance and profitability depend on our ability to execute our corporate growth strategy. In addition to seeking deposit and loan and lease growth in our existing markets, we intend to pursue expansion opportunities through strategically placed new branches, by acquiring community banks in identified strategic markets, or by acquiring branch locations that we find attractive. Continued growth, however, may present operating and other problems that could adversely affect our business, financial condition, results of operations and cash flows. Accordingly, there can be no assurance that we will be able to execute our growth strategy or maintain the level of profitability that we have recently experienced.
Our growth may place a strain on our administrative, operational and financial resources and increase demands on our systems and controls. We plan to pursue opportunities to expand our business through internally generated growth and acquisitions. We anticipate that our business growth may require continued enhancements to and expansion of our operating and financial systems and controls and may strain or significantly challenge them. The process of consolidating the businesses and implementing the strategic integration of any acquired businesses, including Southland Capital Co. and Bank of Orange County and First Financial Bancorp and Bank of Lodi, with our existing business may take a significant amount of time. It may also place additional strain on our resources and could subject us to additional expenses. We cannot assure you that we will be able to integrate these businesses successfully or in a timely manner. In addition, our existing operating and financial control systems and infrastructure may not be adequate to maintain and effectively monitor future growth.
Our continued growth may also increase our need for qualified personnel. We cannot assure you that we will be successful in attracting, integrating and retaining such personnel. The following risks, associated with our growth, could have a material adverse effect on our business, financial condition, results of operations and cash flows:
We face risks associated with acquisitions, including the Southland Capital Co. and Bank of Orange County and First Financial Bancorp and Bank of Lodi mergers, relating to difficulties in integrating combined operations, potential disruption of operations and related negative impact on earnings, and incurrence of substantial expenses.
Growth through acquisitions represents a component of our business strategy and we have recently pursued this element of our business strategy through the Southland Capital Co. and Bank of Orange County and First Financial Bancorp and Bank of Lodi mergers. We expect to continue to seek to acquire banks and branches in strategic markets. The Southland Capital Co. and Bank of Orange County and First Financial Bancorp and Bank of Lodi mergers are, and any future acquisitions will be, accompanied by the risks commonly encountered in acquisitions. These risks include, among other things:
We cannot assure you that we will be successful in overcoming these risks or any other problems encountered in connection with acquisitions. We cannot assure you that our integration of acquired banks or branches operations will be successfully accomplished. Our inability to improve the operating performance of acquired banks and branches or to integrate successfully their operations could have a material adverse effect on our business, financial condition, results of operations and cash flows. In addition, as we proceed with acquisitions in which the consideration consists of cash, a substantial portion of our available cash will be used to consummate the acquisitions.
The purchase price of banks or branches that might be attractive acquisition candidates for us may significantly exceed the fair values of their net assets. As a result, material goodwill and other intangible assets would be required to be recorded. In connection with acquisitions, we could incur substantial expenses, including the expenses of integrating the business of the acquired bank or branch with our existing business.
We expect that competition for appropriate candidates may be significant. We may compete with other banks or financial service companies with similar acquisition strategies, many of which may be larger or have greater financial and other resources than we have. We cannot assure you that we will be able to successfully identify and acquire suitable banks or branches on acceptable terms and conditions.
We are dependent on key personnel and the loss of one or more of those key personnel may materially and adversely affect our prospects.
Competition for qualified employees and personnel in the banking industry is intense and there are a limited number of qualified persons with knowledge of and experience in the California community banking industry. The process of recruiting personnel with the combination of skills and attributes required to carry out our strategies is often lengthy. Our success depends to a significant degree upon our ability to attract and retain qualified management, loan origination, finance, administrative, marketing and technical personnel and upon the continued contributions of our management and personnel. In particular, our success has been and continues to be highly dependent upon the abilities of our senior executive management team of Messers Ronald W. Bachli, Randall E. Reynoso, and David E. Hooston, who have expertise in community banking and experience in the
markets we serve and have targeted for future expansion. We are also dependent upon a number of other key executives who are California natives or are long-time residents and who are integral to implementing our business plan. The loss of the services of any one of our senior executive management team or other key executives could have a material adverse effect on our business, financial condition, results of operations and cash flows.
Our balance sheet is asset sensitive. Our business is subject to interest rate risk and variations in interest rates may negatively affect our financial performance.
Changes in the interest rate environment may reduce our profits. A substantial portion of our income is derived from the differential or spread between the interest earned on loans, securities and other interest-earning assets, and interest paid on deposits, borrowings and other interest-bearing liabilities. At December 31, 2004 our balance sheet was asset sensitive and, as a result, our net interest margin tends to expand in a rising interest rate environment and decline in a falling interest rate environment. Because of the differences in the maturities and repricing characteristics of our interest-earning assets and interest-bearing liabilities, changes in interest rates do not produce equivalent changes in interest income earned on interest-earning assets and interest paid on interest-bearing liabilities, Accordingly, fluctuations in interest rates could adversely affect our interest rate spread and, in turn, our profitability. In addition, loan volumes are affected by market interest rates. Rising interest rates, generally, are associated with a lower volume of loan originations while lower interest rates are usually associated with higher loan originations. Conversely, in rising interest rate environments, loan repayment rates may decline and in falling interest rate environments, loan repayment rates may increase. Although we have been successful in generating new loans and leases during the year ended 2004, the continuation of historically low interest rate levels may cause additional refinancing of commercial real estate and 1-4 family residence loans, which may depress our loan volumes or cause rates on loans to decline. In addition, an increase in the general level of interest rates may adversely affect the ability of certain borrowers to pay the interest on and principal of their obligations or reduce the amount they wish to borrow. Accordingly, changes in levels of market interest rates could materially and adversely affect our net interest spread, asset quality, loan origination volume, business, financial condition, results of operations and cash flows.
The types of loans in our portfolio have a higher degree of risk and a downturn in our real estate markets could hurt our business.
A downturn in our real estate markets could hurt our business because many of our loans are secured by real estate. Real estate values and real estate markets are generally affected by changes in national, regional or local economic conditions, fluctuations in interest rates and the availability of loans to potential purchasers, changes in tax laws and other governmental statutes, regulations and policies and acts of nature. If real estate prices decline, the value of real estate collateral securing our loans could be reduced. Our ability to recover on defaulted loans by foreclosing and selling the real estate collateral would then be diminished and we would be more likely to suffer losses on defaulted loans. The median sales price of a single family home in California increased 22% from March 2003 to March 2004 and home sales increased 4% during the same period. The rise in price is attributed to an increase in demand for homes, coupled with a shortage of supply of new homes across the state. If there is a significant decline in real estate values, especially in California, the collateral for our loans will provide less security. Real estate values could also be affected by, among other things, earthquakes and national disasters particular to California. Any such downturn could have a material adverse effect on our business, financial condition, results of operations and cash flows.
If we cannot attract deposits, our growth may be inhibited.
We plan to increase significantly the level of our assets, including our loan portfolio. Our ability to increase our assets depends in large part on our ability to attract additional deposits at competitive rates. We intend to seek additional deposits by offering deposit products that are competitive with those offered by other financial institutions in our markets and by establishing personal relationships with our customers. We cannot assure you
that these efforts will be successful. Our inability to attract additional deposits at competitive rates could have a material adverse effect on our business, financial condition, results of operations and cash flows.
Our allowance for loan and lease losses may not be adequate to cover actual losses.
A significant source of risk arises from the possibility that losses could be sustained because borrowers, guarantors, and related parties may fail to perform in accordance with the terms of their loans and leases. The underwriting and credit monitoring policies and procedures that we have adopted to address this risk may not prevent unexpected losses that could have a material adverse effect on our business, financial condition, results of operations and cash flows. Unexpected losses may arise from a wide variety of specific or systemic factors, many of which are beyond our ability to predict, influence, or control.
Like all financial institutions, we maintain an allowance for loan and lease losses to provide for loan and lease defaults and non-performance. Our allowance for loan and lease losses may not be adequate to cover actual loan and lease losses, and future provisions for loan and lease losses could materially and adversely affect our business, financial condition, results of operations and cash flows. The allowance for loan and lease losses reflects our estimate of the probable losses in our loan and lease portfolio at the relevant balance sheet date. Our allowance for loan and lease losses is based on prior experience, as well as an evaluation of the known risks in the current portfolio, composition and growth of the loan and lease portfolio and economic factors. The determination of an appropriate level of loan and lease loss allowance is an inherently difficult process and is based on numerous assumptions. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates, that may be beyond our control and these losses may exceed current estimates. Federal and state regulatory agencies, as an integral part of their examination process, review our loans and leases and allowance for loan and lease losses. While we believe that our allowance for loan and lease losses is adequate to cover current losses, we cannot assure you that we will not increase the allowance for loan and lease losses further or that regulators will not require us to increase this allowance. Either of these occurrences could have a material adverse affect our business, financial condition, results of operations and cash flows.
We rely on communications, information, operating and financial control systems technology from third-party service providers, and we may suffer an interruption in or break of those systems that may result in lost business and we may not be able to obtain substitute providers on terms that are as favorable if our relationships with our existing service providers are interrupted.
We rely heavily on third-party service providers for much of our communications, information, operating and financial control systems technology, including customer relationship management, general ledger, deposit, servicing and loan origination systems. Any failure or interruption or breach in security of these systems could result in failures or interruptions in our customer relationship management, general ledger, deposit, servicing and/or loan origination systems. We cannot assure you that such failures or interruptions will not occur or, if they do occur, that they will be adequately addressed by us or the third parties on which we rely. The occurrence of any failures or interruptions could have a material adverse effect on our business, financial condition, results of operations and cash flows. If any of our third-party service providers experience financial, operational or technological difficulties, or if there is any other disruption in our relationships with them, we may be required to locate alternative sources of such services, and we cannot assure you that we could negotiate terms that are as favorable to us, or could obtain services with similar functionality as found in our existing systems without the need to expend substantial resources, if at all. Any of these circumstances could have a material adverse effect on our business, financial condition, results of operations and cash flows.
We face strong competition from financial service companies and other companies that offer banking services which could hurt our business.
We conduct our banking operations exclusively in California. Increased competition in our markets may result in reduced loans and deposits. Ultimately, we may not be able to compete successfully against current and
future competitors. Many competitors offer the banking services that we offer in our service areas. These competitors include national banks, regional banks and other community banks. We also face competition from many other types of financial institutions, including savings and loan associations, finance companies, brokerage firms, insurance companies, credit unions, mortgage banks and other financial intermediaries. In particular, our competitors include several major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous locations and mount extensive promotional and advertising campaigns. Additionally, banks and other financial institutions with larger capitalization and financial intermediaries not subject to bank regulatory restrictions may have larger lending limits which would allow them to serve the credit needs of larger customers. Areas of competition include interest rates for loans and deposits, efforts to obtain loan and deposit customers and a range in quality of products and services provided, including new technology-driven products and services. Technological innovation continues to contribute to greater competition in domestic and international financial services markets as technological advances enable more companies to provide financial services. We also face competition from out-of-state financial intermediaries that have opened loan production offices or that solicit deposits in our market areas. If we are unable to attract and retain banking customers, we may be unable to continue our loan growth and level of deposits and our business, financial condition, results of operations and cash flows may be adversely affected.
Concentrated ownership of our common stock creates a risk of sudden changes in our share price.
As of December 31, 2004, the Fund owned approximately 48.5% of our common stock. The sale by the Fund of a significant portion of its remaining holdings could have a material adverse effect on the market price of our common stock. We entered into a registration rights agreement which requires us to register our shares held by the Fund, subject to certain conditions and limitations contained in that agreement.
Our future ability to pay dividends is subject to restrictions. As a result, capital appreciation, if any, of our common stock may be your sole source of gains in the future.
Since we are a holding company with no significant assets other than the bank, we currently depend upon dividends from the bank as our sole source of liquidity. Our ability to pay dividends is also subject to the restrictions of the California Corporations Code. The ability of the bank to pay dividends or make other capital distributions to us is subject to the regulatory authority of the Board of Governors of the Federal Reserve System, or the Federal Reserve, and the California Department of Financial Institutions, or the DFI.
As of December 31, 2004, the bank could have paid approximately $13.8 million in dividends without the prior approval of the Federal Reserve or the DFI. The amount the bank may pay in dividends is further restricted due to the fact that the bank must maintain a certain amount of capital to be considered a well capitalized institution. For more information see ITEM 1. BUSINESS. Supervision and RegulationCapital Standards and Payment of Dividends and Other Transfer of Funds. Accordingly, the amount available for payment of dividends to us by the bank for the bank to remain well capitalized immediately thereafter totaled $2.0 million at December 31, 2004.
From time to time, we may become a party to financing agreements or other contractual arrangements that have the effect of limiting or prohibiting us or the bank from declaring or paying dividends. Our holding company expenses and obligations with respect to our trust preferred securities and corresponding junior subordinated deferrable interest debenture issued by us may limit or impair our ability to declare or pay dividends.
On a stand-alone basis, we rely on dividends from the bank as our sole source of liquidity. Absent this liquidity, our ability to pay operating expenses and interest on our outstanding debt would be materially adversely affected.
Only a limited trading market exists for our common stock which could lead to price volatility
Our common stock was designated for quotation on the Nasdaq National Market in August of 2004 and trading volumes have been modest. The limited trading market for our common stock may cause fluctuations in the market value of our common stock to be exaggerated leading to price volatility in excess of that which would occur in a more active trading market of our common stock. In addition, even if a more active market in our common stock develops, we cannot assure you that such a market will continue or that shareholders will be able to sell their shares.
If we fail to maintain an effective system of internal and disclosure control, we may not be able to accurately report our financial results or prevent fraud. As a result, current and potential stockholders could lose confidence in our financial reporting, which would harm our business and the trading price of our securities.
Effective internal and disclosure controls are necessary for us to provide reliable financial reports and effectively prevent fraud and to operate successfully as a public company. If we cannot provide reliable financial reports or prevent fraud, our reputation and operating results would be harmed. We are in the process of beginning a review and analysis of our internal control over financial reporting for Sarbanes-Oxley compliance. As part of that process we may discover material weaknesses or significant deficiencies in our internal control as defined under standards adopted by the Public Company Accounting Oversight Board, or PCAOB, that require remediation. Under the PCAOB standards, a material weakness is a significant deficiency or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. A significant deficiency is a control deficiency or combination of control deficiencies, that adversely affect a companys ability to initiate, authorize, record, process, or report external financial data reliably in accordance with generally accepted accounting principles such that there is a more than remote likelihood that a misstatement of a companys annual or interim financial statements that is more than inconsequential will not be prevented or detected.
As a result of weaknesses that may be identified in our internal controls, we may also identify certain deficiencies in some of our disclosure controls and procedures that we believe require remediation. If we discover weaknesses, we will make efforts to improve our internal and disclosure controls. However, there is no assurance that we will be successful. Any failure to maintain effective controls or timely effect any necessary improvement of our internal and disclosure controls could harm operating results or cause us to fail to meet our reporting obligations, which could affect our ability to remain listed with the Nasdaq National Market. Ineffective internal and disclosure controls could also cause investors to lose confidence in our reported financial information, which would likely have a negative effect on the trading price of our securities.
ITEM 2. PROPERTIES
Our corporate headquarters is based in Sacramento, California. As of December 31, 2004, we had a total of 49 properties, consisting of 41 branch offices, 5 operation and service centers, and 3 other properties, of which one is subleased and the other two are in the process of being subleased. We own 11 branch locations and the others are leased. Of our operation and service centers, we own 2 locations, we rent 2 locations and our Auburn, California administrative offices are owned by the bank, but the property on which the offices are located are leased. While we have 41 branches as of December 31, 2004, we are in the process of closing a recently acquired Sacramento branch that is located near our long-established Sacramento corporate headquarters. When that branch is closed, we intend to sublease the premises. We believe our premises are currently adequate for our business. However, if we are able to capitalize on acquisition opportunities, we may require a larger administrative facility.
ITEM 3. LEGAL PROCEEDINGS
From time to time, we are party to claims and legal proceedings arising in the ordinary course of business. Our management evaluates our and/or the banks exposure to the cases individually and in the aggregate and
provides for potential losses on such litigation if the amount of the loss is estimable and the loss is probable. We believe that there are no material litigation matters at the current time. However, litigation is inherently uncertain and no assurance can be given that any current or future litigation will not result in any loss which might be material to us. The following describes a recently settled case.
During the fourth quarter of 2004, we settled a lawsuit involving the Reed Slatkin Investment Club, in which Bank of Orange County, a division of our bank, was a named defendant along with Union Bank of California and Comerica Bank-California. On December 30, 2004, the United States District Court Judge signed an order dismissing all claims against Bank of Orange County and the other banks. The complaint was filed on September 5, 2002 in the United States District Court, Central District of California by the trustee of the bankruptcy estate of Red Slatkin and a complex putative class of individuals and entities who were allegedly defrauded by Slatkin and the defendants. The initial complaint sought a multimillion dollar amount in damages. The banks were named in the suit based on the various banks alleged support of and participation in Mr. Slatkins fraudulent activities discovered in 2001, and the banks alleged role as administrator for investors custodial accounts. To settle all class claims, Bank of Orange County and the other banks agreed to pay $26.5 million to an escrow fund. Of the $26.5 million settlement amount, Bank of Orange County agreed to pay $3 million with its insurance carrier paying $2.8 million and Bank of Orange County funding the remaining $200,000. Before funding the escrow, the banks entered into an agreement, which released all claims between the banks, including any indemnification claims. The funds are still in escrow, pending approval of the allocation of the funds to the various class claims by the United States District Court Judge.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to our shareholders, through the solicitation of proxies or otherwise, during the fourth quarter of the year ended December 31, 2004.
Marketplace Designation, Sales Price Information and Holders
On August 10, 2004, our common stock was designated for quotation on the Nasdaq National Market and trades under the symbol PLSB. The following table summarizes the high and low closing sale prices for each quarterly period ended since August 10, 2004 for our common stock, as traded on and reported by the Nasdaq National Market:
As of March 15, 2005, the closing price of our common stock on the Nasdaq National Market was $24.25 per share. As of that date, we believe, based on the records of our transfer agent, that there were approximately 43 record holders of our common stock.
Our shareholders are entitled to receive dividends when and as declared by our Board of Directors, out of funds legally available therefore, subject to a dividend preference, if any, on preferred shares that may be outstanding and also subject to the restrictions of the California General Corporation Law. For more information see ITEM 1. BUSINESS. Supervision and RegulationPayment of Dividends and Other Transfer of Funds.
Our ability to pay dividends is also limited by certain covenants contained in the indentures relating to trust preferred securities that have been issued by four business trusts and the debentures underlying the trust preferred securities. We own the common stock of the four business trusts. The indentures provide that if an Event of Default (as defined in the indentures) has occurred and is continuing, or if we are in default with respect to any obligations under our guarantee agreement which covers payments of the obligations on the trust preferred securities, or if we give notice of any intention to defer payments of interest on the debentures underlying the trust preferred securities, then we may not, among other restrictions, declare or pay any dividends (other than a dividend payable by our bank to us as its holding company) with respect to our common stock. See Note 11 to our Notes to Consolidated Financial Statements for more information about the indentures and the trust preferred securities.
Since January 1, 2004, we have declared the following dividends:
We believe that we will be able to continue paying quarterly dividends, however, we can provide no assurance that we will continue to declare dividends on a quarterly basis or otherwise. The declaration of dividends by the Company is subject to the discretion of our Board of Directors. Our Board of Directors will take into account such matters as general business conditions, our financial results, capital requirements, contractual, legal and regulatory restrictions on the payment of dividends by us to our shareholders or by our subsidiaries to
the holding company, and such other factors as our Board of Directors may deem relevant. See ITEM 1. BUSINESS. Supervision and RegulationPayment of Dividends and Other Transfer of Funds of this Annual Report on Form 10-K for a discussion of potential regulatory limitations on our receipt of funds from our regulated subsidiaries.
Recent Sales of Unregistered Securities
During the three-year period ended December 31, 2004, we issued the following securities, none of which have been registered under the Securities Act. All share numbers and per share prices have been adjusted to reflect our February 2003, 1-for-2 reverse stock split.
1. In September 2003, we issued 1,000 shares of common stock to Daryl Foreman, a past director of our former parent company, at an exercise price of $9.00 per share, upon exercise of a stock option.
2. In May 2003, we issued an aggregate of 285,357 shares of our common stock to Ronald W. Bachli as consideration for his employment. Of these shares, 166,666 were issued as compensation, 83,333 were issued at $9.00 per share for an aggregate purchase price of $750,000 and 35,358 were issued pursuant to the exercise of options, at an exercise price of $9.00 per share, for aggregate consideration of $318,000.
3. In May 2003, we issued an aggregate of 120,666 shares of our common stock to David E. Hooston as consideration for his employment. Of these shares, 75,000 were issued as compensation, 11,111 were issued at $9.00 per share for an aggregate purchase price of $100,000 and 34,555 were issued pursuant to the exercise of options, at an exercise price of $9.00 per share, for aggregate consideration of $390,555.
4. In December 2003, we issued an aggregate of 45,233 shares of our common stock to Randall E. Reynoso as consideration for his employment. Of these shares, 25,000 were issued as compensation and 20,233 were issued pursuant to the exercise of options, at an exercise price of $9.00 per share, for aggregate consideration of $182,000.
5. From July 1, 2002 to August 16, 2004, we issued to our employees, officers, directors and consultants options to purchase an aggregate of 1,114,030 shares of common stock at a weighted average exercise price of $9.57 per share pursuant to our 2002 Stock Option Plan. From October 1, 2002 to August 16, 2004, we issued an aggregate of 234,440 shares of common stock pursuant to option exercises, at exercise prices of $9.00 per share, not including the shares described in paragraph 2 above or paragraph 8 below.
6. On May 25, 2004, Southland Capital Co. was merged into us. Pursuant to the merger, we issued 5,249,181 shares of our common stock to the seven stockholders of Southland Capital Co. In connection with the merger, we also assumed outstanding options which, pursuant to the amended and restated agreement and plan of merger relating to such merger, were converted into options to acquire 685,044 shares of our common stock. Through August 16, 2004, we issued 117,267 shares of common stock upon the exercise of certain of these options, at an exercise price of $7.82 per share.
7. During the fourth quarter of 2004, we issued $10.3 million of Floating Rate Junior Subordinated Debentures to our subsidiary, Placer Statutory Trust III.
None of the transactions described above involved any underwriters, underwriting discounts or commissions, or any public offering, and we believe that each transaction, if deemed to be a sale of a security, was exempt from the registration requirements of the Securities Act by virtue of Section 4(2) thereof or Regulation D promulgated thereunder, as transactions by an issuer not involving a public offering. The issuance of shares pursuant to the exercise of stock options described in paragraphs 2, 3, 4, and 5 above were exempt from the registration requirements of the Securities Act in reliance on Rule 701 promulgated under Section 3(b) of the Securities Act as transactions by an issuer pursuant to compensatory benefit plans and contracts relating to
compensation as provided under such Rule 701. The recipients of securities in each transaction described in paragraphs 1-9 above represented their intention to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof and acknowledged that the securities were issued in a transaction not registered under the Securities Act, such securities were restricted as to transfers and appropriate legends were affixed to the share certificates and instruments issued in such transactions.
Use of Proceeds
On August 10, 2004, the registration statement on Form S-1, registration file number 333-112778, relating to our initial public offering of 5,730,000 shares of common stock, was declared effective. The offering commenced on August 11, 2004. The offering with respect to those 5,730,000 shares was terminated on August 16, 2004, with the underwriters purchasing 5,230,000 shares from a selling shareholder and 500,000 shares from us. The underwriters exercised a portion of their over-allotment option on September 8, 2004 and purchased 68,194 shares of common stock from us and 713,306 shares of common stock from a selling shareholder on September 13, 2004. The underwriters over-allotment option was terminated as of September 13, 2004. The underwriters were Friedman Billings Ramsey; Keefe, Bruyette & Woods; and RBC Capital Markets.
We registered a total of 6,589,500 shares of common stock, including 859,500 shares reserved for issuance in the event of exercise of the underwriters over-allotment option. The aggregate price of the registered shares at the $20.00 offering price was $131,790,000. A total of 6,511,500 shares of common stock were sold, at an aggregate offering price of $130,230,000. We incurred expenses for underwriters commissions of $796,000 and other expenses of the offering totaling $3,401,000. The net offering proceeds to us after deducting the foregoing expenses was approximately $7,167,000.
On September 7, 2004, we entered into an Agreement and Plan of Merger with First Financial Bancorp pursuant to which we agreed to acquire First Financial Bancorp, the parent holding company for Bank of Lodi, NA. Bank of Lodi was merged with and into our bank. The merger closed on December 10, 2004. We used $46.4 million of our existing capital, including the entire net proceeds of the offering, to pay the merger consideration.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth our statistical information for each of the years in the five-year period ended December 31, 2004. The financial data presented includes the effect of our acquisition of Southland Capital Co. as if the merger had occurred on January 1, 2000. This data should be read in conjunction with our audited consolidated financial statements as of December 31, 2004 and 2003 and for each of the years in the three-year period ended December 31, 2004 and related Notes to Consolidated Financial Statements contained in ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis is intended to provide greater details of our results of operations and financial condition and should be read in conjunction with the information under Selected Financial Information and our consolidated financial data included elsewhere in this document. Certain statements under this caption constitute 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, which involve risks and uncertainties. Our actual results may differ significantly from the results discussed in such forward-looking statements. Factors that might cause such a difference include, but are not limited to, economic conditions, competition in the geographic and business areas in which we conduct our operations, fluctuation in interest rates, credit quality and government regulation and other factors discussed in this annual report on Form 10-K for the year ended December 31, 2004 under ITEM 1. BUSINESS. Factors That May Affect Future Results of Operations. We do not undertake, and specifically disclaim, any obligation to update any forward-looking statements to reflect the occurrences of unanticipated events or circumstances after the date of such statements.
Who We Are
We are the bank holding company for Placer Sierra Bank, a California state-chartered commercial bank. Our bank conducts a portion of its banking business through the following divisions: Sacramento Commercial Bank, Bank of Lodi and Bank of Orange County. The bank has one active subsidiary, Central Square Company, Inc., which derives its income from a third-party provider of non-deposit investment products and, until December 31, 2002, was engaged in divestment of various real property investments.
How We Generate Revenues
Our bank derives its income primarily from interest received on real estate-related loans and leases, commercial loans and leases and consumer loans and interest on investment securities and, to a lesser extent, fees from the sale and referral of loans and fees received in connection with servicing loans and deposit products and through a subsidiary, Central Square Company, Inc., from the sales of non-deposit investment products through a third-party provider. The banks major expenses are salaries and benefits, the interest it pays on deposits and borrowings and general operating expenses.
Our Principal Products and Services and Locations of Operations
We provide banking and other financial services throughout our targeted Northern and Southern California markets to consumers and to small- and medium-sized businesses, including the owners and employees of those businesses. We offer a broad range of banking products and services including many types of commercial and personal checking and savings accounts and other consumer banking products, including electronic banking products. We also originate a variety of loans including secured and unsecured commercial and consumer loans, commercial and residential real estate mortgage loans, SBA loans and construction loans, both commercial and residential.
We have 32 Northern California branches that serve the greater Sacramento metropolitan region and adjacent counties. We have nine Southern California branches that serve both Los Angeles and Orange counties.
How Economic Factors Impact Us
We are subject to competition from other financial institutions and our operating results, like those of other financial institutions operating in California, are significantly influenced by economic conditions in California, including the strength of the real estate market. In addition, both the fiscal and regulatory policies of the federal
government and regulatory authorities that govern financial institutions and market interest rates impact the banks financial condition, results of operations and cash flows.
The earnings and growth of the bank are subject to the influence of domestic and foreign economic conditions, including inflation, recession and unemployment. The earnings of the bank are affected not only by general economic conditions but also by the monetary and fiscal policies of the United States and federal agencies, particularly the Federal Reserve. The Federal Reserve can and does implement national monetary policy, such as seeking to curb inflation and combat recession, by its open market operations in United States Government securities and by its control of the discount rates applicable to borrowings by banks from the Federal Reserve. The actions of the Federal Reserve in these areas influence the growth of bank loans and leases, investments and deposits and affect the interest rates charged on loans and leases and paid on deposits. The Federal Reserves policies have had a significant effect on the operating results of commercial banks and are expected to continue to do so in the future. The nature and timing of any future changes in monetary policies are not predictable.
One of our strategic objectives is to geographically focus our activities in Californias faster growing metropolitan regions. Consistent with this objective, we acquired First Financial Bancorp in December of 2004 and Southland Capital Co. in May of 2004. In November of 2003, we sold five of the banks branches that were located in remote Sierra Nevada locations.
In May of 2004, we acquired Southland Capital Co. and its subsidiary Bank of Orange County to participate in the high growth Southern California banking market. Bank of Orange County has always been a community-focused commercial bank with core relationship-based depositors and borrowers. In connection with the Southland Capital Co. acquisition, Southland merged into us, and Bank of Orange County became our subsidiary. We merged Bank of Orange County into the bank in July 2004 and operate it as a division of the bank, under the name Bank of Orange County. The Southland merger was a stock-for-stock transaction whereby the shareholders of Southland received 0.5752 of a share of our common stock for each outstanding share of Southland common stock. Immediately prior to the acquisition of Southland, our principal shareholder, the Fund, owned 99.75% of Southland and 93.18% of us. The acquisition was principally accounted for as a combination of companies under common control similar to a pooling of interests. Thus, our historical consolidated financial statements presented herein include the financial results of Southland and its subsidiary, Bank of Orange County, as if the merger occurred on January 1, 2002. Our acquisition of the 0.25% minority interest in Southland was accounted for using the purchase method of accounting. The excess of the purchase price over the estimated fair value of the 0.25% minority interest in the net assets acquired was approximately $92,000, which was recorded as goodwill.
In December of 2004, we acquired First Financial Bancorp, parent company of Bank of Lodi, to begin our northern California expansion southward through the high growth California central valley. The fair value of assets of First Financial Bancorp totaling $345.7 million were incorporated in our balance sheet on December 10, 2004 upon closing of the acquisition. The acquisition was accounted for under the purchase method of accounting. Bank of Lodi operated nine branches located in Sacramento, El Dorado, San Joaquin, Amador, and Calaveras Counties in Northern California. We operate eight of the acquired branches under the brand name Bank of Lodi, a division of the bank, while we rebranded one acquired branch under our banks name.
Our Opportunities, Challenges and Risks
Our strategy is to be the premier banking company for the long-term benefit of our shareholders, customers and employees. We believe we have opportunities for internal loan and deposit growth, because our primary operations are located in two of the best growth markets in Northern and Southern California and we plan to position our company to take full advantage of these markets.
The banks primary Northern California operations are in the Sacramento region, one of the fastest growing markets in the country. Since 1995, the annual population growth rate has been 2.4%, mostly due to migration from other California and U.S. urban areas. High growth rates in the Sacramento regions labor force and employment are due to several factors, including a higher percentage of the population available for employment as persons relocate to take advantage of economic opportunities in the region. Another factor is a fairly low unemployment rate, which, according to the U.S. Department of Labor, Bureau of Labor Statistics, averaged approximately 4.9% in December 2004 in Sacramento County, where the majority of the regional population reside. The average national unemployment rate in December 2004 was approximately 5.1%.
In addition, our Southern California operations serve the Los Angeles and Orange county areas. Los Angeles and Orange counties are the first and second largest counties, respectively, in California. In terms of numeric population growth, from 2001 to 2002, Los Angeles County ranked first and Orange County ranked seventh out of over 3,000 U.S. counties. Although housing costs in Los Angeles and Orange counties are not low, the population in these counties continues to grow. In terms of unemployment, in December 2004, according to the U.S. Department of Labor, Bureau of Labor Statistics, the Orange County unemployment rate of 2.7% ranked first for lowest unemployment rate among metropolitan areas with populations over 1 million.
Despite our position of being in two of the best growth markets in California, we face the risk of being particularly sensitive to changes in the California economy. In particular, real estate values could be affected by earthquakes, fires and other natural disasters in California. If the economy weakens, it could cause loan demand to decline and also affect our core deposit growth. Geographic distance between our operations may also hinder our consistency and efficiency.
We believe we have additional opportunities for growth by identifying potential acquisition candidates and acting on those opportunities. During 2004, we identified and acted on two acquisition opportunities when we acquired both First Financial Bancorp and Southland Capital Co. The ability to successfully identify potential acquisition candidates and marshal our resources to take advantage of those opportunities is another challenge for us. Even if we are able to marshal our resources to take advantage of acquisition opportunities, there can be no assurance that we will be able to effectively manage our growth or successfully integrate acquired institutions. Further, as we attempt to capitalize on our growth opportunities, another challenge will be to attract and retain talented people. Competition for qualified employees and personnel in the banking industry is high and there are a limited number of qualified persons with knowledge of and experience in the California banking community.
Critical Accounting Policies
Our accounting policies are integral to understanding the financial results reported. Our most complex accounting policies require managements judgment to ascertain the valuation of assets, liabilities, commitments and contingencies. We have established detailed policies and control procedures that are intended to ensure valuation methods are well controlled and consistently applied from period to period. In addition, the policies and procedures are intended to ensure that the process for changing methodologies occurs in an appropriate manner. The following is a brief description of our current accounting policies involving significant management valuation judgments.
Allowance for Loan and Lease Losses
The allowance for loan and lease losses represents our best estimate of losses inherent in the existing held-for-investment loan and lease portfolio. The allowance for loan and lease losses is increased by the provision for loan and lease losses charged to expense and reduced by loans and leases charged off, net of recoveries.
We evaluate our allowance for loan and lease losses periodically. We believe that the allowance for loan and lease losses is a critical accounting estimate because it is based upon managements assessment of various factors affecting the collectibility of the loans and leases, including current economic conditions, past credit
experience, delinquency status, the value of the underlying collateral, if any, and a continuing review of the portfolio of loans and leases.
We determine the appropriate level of the allowance for loan and lease losses primarily through an analysis of the various components of the loan and lease portfolio, including all significant credits on an individual basis. We segment the loan and lease portfolio into as many components as practical. Each component would normally have similar characteristics, such as risk classification, past due status, type of loan or lease, industry or collateral.
We cannot provide you with any assurance that further economic difficulties or other circumstances which would adversely affect our borrowers and their ability to repay outstanding loans and leases will not occur which would be reflected in increased losses in our loan and lease portfolio, which could result in actual losses that exceed reserves previously established.
Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities, requires that available-for-sale securities be carried at fair value. We believe this is a critical accounting estimate in that the fair value of a security is based on quoted market prices or if quoted market prices are not available, fair values are extrapolated from the quoted prices of similar instruments. Adjustments to the available-for-sale securities fair value impact the consolidated financial statements by increasing or decreasing total assets and shareholders equity.
Deferred Income Taxes
Deferred income taxes reflect the estimated future tax effects of temporary differences between the reported amount of assets and liabilities for financial reporting purposes and such amounts as measured by tax laws and regulations. We use an estimate of future earnings to support our position that the benefit of our deferred tax assets will be realized. If future income should prove non-existent or less than the amount of the deferred tax assets within the tax years to which they may be applied, the asset may not be realized and a valuation allowance would have to be recognized, which would reduce our net income.
Impairment of Goodwill
Goodwill represents the excess of the purchase price over the fair value of net assets acquired. In accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, goodwill is not amortized but is evaluated for impairment at least annually. The impairment evaluation is based on determination of the appropriate reporting unit and the assignment of applicable assets and liabilities. We then determine the fair value of the reporting units assets and liabilities as compared to the reporting units carrying value. If the carrying amount of goodwill were to exceed its fair value, an impairment loss would be recognized in the income statement.
Results of Operations
Net income for the year ended December 31, 2004, was $13.0 million, or $0.90 per diluted share. This compares to net income of $15.3 million, or $1.13 per diluted share, for the year ended December 31, 2003 and net income of $9.2 million, or $0.70 per diluted share for the year ended December 31, 2002.
Our financial results for 2004 were significantly impacted by our acquisition of Southland Capital Co. in May of 2004, which was accounted for as combination of companies under common control similar to a pooling of interests. Our 2004 financial results were also significantly impacted by our liquidity strategy which is described below.
Acquisition of Southland Capital Co.
Our acquisition of Southland Capital Co. was accounted for as a combination of companies under common control similar to a pooling of interests because of the Funds ownership of 93.18% of Placer Sierra Bancshares and 99.75% of Southland Capital Co. at the time of the merger. Accordingly, $2.3 million ($1.5 million after tax) of merger expenses associated with the acquisition and $3.8 million ($2.2 million after tax) of losses incurred upon the liquidation of the investment portfolio of Bank of Orange County were taken against income.
A series of events generated excess liquidity in 2004. First, just prior to our acquisition of Southland Capital Co., Bank of Orange County liquidated approximately $72 million of investment securities to prepare for balancing the liquidity and overall asset and liability position of Bank of Orange County and Placer Sierra Bank post merger. Second, in the third and fourth quarters of 2004 additional liquidity was generated from the maturity and early calls of approximately $104.1 million of securities at Placer Sierra Bank. We maintained this excess liquidity for two reasons. The first was to retain up to $50 million in order to execute the $50 million all cash acquisition of First Financial Bancorp and its subsidiary Bank of Lodi, which closed on December 10, 2004. Second, we decided to withhold reinvestment of the balance of the liquidity until after the 2004 Presidential election was concluded when it was perceived there would be less uncertainty in the direction of the Treasury markets. By year end, we had deployed our excess liquidity through execution of the acquisition of First Financial Bancorp and by purchasing approximately $169.4 million of agency securities with an average yield of 4.27% and an average life and duration of 5.08 years and 4.36 years, respectively.
Key Performance Indicators GAAP Basis
The following table presents our GAAP basis key performance indicators:
Key Performance Indicators Operating Basis
We believe that the presentation of our operating earnings excluding the merger related costs, investment security restructuring loss, and gains from sales of branches is important to gaining an understanding of the financial performance of our core banking operations. Accordingly, the following table shows operating earnings, which is a non-GAAP basis presentation of our key performance indicators.
Operating earnings for the year ended 2004 totaled $16.8 million, or $1.16 per diluted share, which is a $2.3 million, or a 16.2% increase over operating earnings for the year ended 2003, which totaled $14.4 million, or $1.07 per diluted share. Operating earnings for the year ended December 31, 2002 totaled $9.1 million, or $0.69 per diluted share.
The reconciliation of the GAAP net income to the non-GAAP operating earnings for the years ended December 31, 2004, 2003 and 2002, includes four significant items:
Net Interest Income
Net interest income is the difference between interest earned on assets and interest paid on liabilities. Net interest margin is net interest income expressed as a percentage of average interest-earning assets. Our balance sheet is asset sensitive, and as a result, our net interest margin tends to expand in a rising interest rate environment and decline in a falling interest rate environment. The majority of our earning assets are tied to market rates, such as the prime rate, and therefore rates on our earning assets generally reprice along with a movement in market rates while interest-bearing liabilities, mainly deposits, tend to reprice more slowly and usually incorporate only a portion of the movement in market rates.
The following table presents, for the periods indicated, the distribution of average assets, liabilities and shareholders equity, as well as the net interest income from average interest-earning assets and the resultant yields expressed in percentages. Non-accrual loans are included in the calculation of average loans and leases while non-accrued interest thereon is excluded from the computation of yields earned.
The following tables show the change in interest income and interest expense and the amount of change attributable to variances in volume, rates and the combination of volume and rates based on the relative changes of volume and rates:
2004 Compared to 2003
Net interest income increased 6.6%, or $3.9 million, to $62.4 million for the year ended December 31, 2004 from $58.5 million for 2003. The increase in net interest income is the result of a 4.7%, or $56.6 million increase in average earning assets, combined with a shift to higher yielding loans and leases held for investment which increased to 80.6% of average earning assets in 2004 as compared to 72.6% of average earning assets in 2003. The increase in net interest income also reflects the growth in lower cost average core deposits (all deposit categories other than time certificates of deposit) which increased 3.9%, or $35.9 million, to $960.2 million for 2004 from $924.4 million for 2003, and a decline in the rates paid on certificates of deposits which combined to decrease the total cost of deposits to 0.60% for the year ended December 31, 2004 from 0.71% in 2003. Our net interest margin of 4.92% in 2004 would have been higher if not for our liquidity strategy during the second half of 2004 resulting from and related to the acquisitions of Southland Capital Co. and First Financial Bancorp and the uncertainties in the Treasury markets preceding the 2004 Presidential election.
Interest income increased 4.4%, or $3.0 million, to $71.8 million for the year ended December 31, 2004, from $68.8 million for 2003. The yield on total interest-earning assets for the year ended December 31, 2004, remained essentially unchanged at 5.67% compared to 5.68% for 2003. While our 2004 liquidity strategy required us to retain significant liquidity, we were successful in shifting our mix of interest-earning assets away from lower-yielding federal funds sold and investments and into relatively higher-yielding loans and leases. This is reflected by a 16.3%, or $143.1 million, increase in average loans and leases held for investment and a 25.0%, or $28.1 million, decrease in average federal funds sold for the year ended December 31, 2004. The yield on average loans declined to 6.19% for the year ended December 31, 2004 from 6.61% in 2003, as a result of new loans originated at rates lower than our existing portfolio and the refinancing of some of our existing loans. The yield on investment securities increased by 31 basis points to 4.62% for the year ended December 31, 2004, from 4.31% for 2003, reflecting a larger percentage of total investments being held in higher yielding U.S. agency securities.
Interest expense on all interest-bearing liabilities decreased by 8.1%, or $831,000, to $9.4 million for the year ended December 31, 2004, as compared to $10.3 million for 2003. A substantial percentage of our funding sources are non-interest bearing demand deposits which represented 33.7% of average total deposits for the year ended December 31, 2004, compared to 32.2% for the year ended December 31, 2003. Interest expense on interest-bearing deposits decreased by 13.1%, or $1.1 million, to $7.3 million for the year ended December 31, 2004 as compared to $8.4 million for 2003. This was primarily due to existing certificates of deposits renewing at lower rates and our ability to keep rates on new certificates of deposits and rates on all transaction accounts low during a period when short-term market rates were generally increasing, as reflected by the increase in short-term market rates in 2004 by 1.50%.
2003 Compared to 2002
Net interest income increased 7.3%, or $4.0 million, to $58.5 million for the year ended December 31, 2003 from $54.5 million for 2002. The increase in net interest income is principally the result of a decline in total interest expense by 43.3%, or $7.9 million, which was centered principally in a decline in interest expense on deposits. This was offset by a 5.3%, or $3.9 million, decrease in total interest income centered principally in a decline in interest income on loans and leases held for investment by 8.2%, or $5.2 million. The composition of average earning assets changed favorably with higher yielding loans and securities replacing federal funds. The decline in rates on deposits and other interest-bearing liabilities and the decline in yields on earning assets is due to the decline in the interest rate environment in 2003.
Interest income decreased 5.3%, or $3.9 million, to $68.8 million for the year ended December 31, 2003 from $72.7 million for 2002. The yield on total interest-earning assets for the year ended December 31, 2003 decreased to 5.68% from 6.12% for 2002. The decrease in the average yield on interest-earning assets resulted from a general decline in all interest rates. The yield on average loans and leases held for investment declined to
6.61% for the year ended December 31, 2003 from 7.33% in 2002, as a result of new loans originated at rates lower than our existing portfolio and the refinancing of some of our existing loans. Average loans and leases held for investment, net of deferred fees and costs, increased by 1.7%, or $14.8 million, to $878.1 million for 2003 from $863.2 million for 2002. The yield on investment securities increased by 75 basis points to 4.31% for the year ended December 31, 2003 from 3.56% for 2002, reflecting managements restructuring of the investment securities portfolio during 2003 into longer maturity instruments.
Interest expense on all interest-bearing liabilities decreased by 43.3%, or $7.9 million, to $10.3 million for the year ended December 31, 2003 as compared to $18.1 million for 2002. A substantial percentage of our funding sources are non-interest bearing demand deposits which represented 32.2% of average total deposits for the year ended December 31, 2003, an increase from 29.4% for 2002. Increasing the percentage of non-interest bearing demand deposits to total deposits, coupled with the broad decline in the cost of interest-bearing deposits, lowered the overall cost of deposits to 0.71% for the year ended December 31, 2003 from 1.34% for 2002. Interest expense on interest-bearing deposits decreased by 47.0%, or $7.5 million, to $8.4 million for the year ended December 31, 2003 as compared to $15.9 million for 2002. This was primarily due to a general decline in the interest rate environment in 2003, our ability to reduce the percentage of more expensive time deposits in our deposit portfolio, and lowering our rates paid on all interest-bearing accounts to rates paid by the bottom quartile of institutions in our markets.
Provision for (Credit to) the Allowance for Loan and Lease Losses
The provision for loan and lease losses is a charge against earnings in that year. The provision is that amount required to maintain the allowance for loan and lease losses at a level which, in managements judgment, is adequate to absorb loan and lease losses inherent in the loan and lease portfolio. In periods when the allowance for loan and lease losses is determined to exceed the amount required, a credit to the allowance for loan and lease losses is recorded.
2004 Compared to 2003
The provision for loan and lease losses was $560,000 for 2004, as compared to a credit to the allowance for loan and lease losses of $6,000 during 2003. The provision for loan and lease losses during 2004 reflects growth in the held for investment loan and lease portfolio and the increase in the amount of net loan and lease charge-offs. During 2004, we experienced net loan and lease charge-offs of $1.6 million as compared to net loan and lease recoveries of $899,000 for 2003. This increase in net loan and lease charge-offs was partially offset by a decrease in non-performing loans and leases as a percentage of total loans and leases held for investment to 0.22% at December 31, 2004 from 0.31% at December 31, 2003. The decline in non-performing assets during 2004 principally resulted from $1.3 million in charge-offs related to a single customer whose loans were classified as non-performing at December 31, 2003.
2003 Compared to 2002
We recorded credits to the allowance for loan and lease losses of $6,000 during 2003 and $485,000 during 2002. In 2003, we had net recoveries on loans previously charged-off totaling $899,000, or 0.10% of average loans and leases held for investment. In 2002, we had net recoveries on loans previously charged-off totaling $572,000, or 0.07% of average loans and leases held for investment. The principal source of these net recoveries was loans charged off in 2001 and 2000. Net loans charged off by us in 2001 totaled $5.1 million, or 0.60% of loans and leases held for investment and $1.8 million, or 0.23%, in 2000. The charge-offs in 2001 and 2000 were principally related to loans charged off by Cerritos Valley Bank, which Bank of Orange County acquired in 2002.
See Critical Accounting Policies, Financial ConditionAllowance for Loan Losses, and Note 2 to our Consolidated Financial Statements.
The following table summarizes non-interest income by category for the periods indicated:
2004 Compared to 2003
Total non-interest income decreased to $10.6 million in 2004, compared to $16.0 million in 2003 primarily due to the restructuring of Bank of Orange Countys investment securities portfolio in 2004 and the gain on sale of branches in the fourth quarter of 2003. Excluding the $3.8 million loss from restructuring Bank of Orange Countys investment portfolio in 2004 and the $1.5 million gain on sale of branches in 2003, non-interest income would have been $14.4 million in both years. Service charges on deposit accounts decreased by 8.4%, or $579,000, to $6.3 million for 2004 as compared to $6.9 million for 2003 primarily due to the sale of five branches in the fourth quarter of 2003 and the 2004 increase in earnings credits on business accounts resulting from an increase in short-term interest rates during the year. These credits are the basis for credits against such service charges. Referral and other loan-related fees increased by 15.8%, or $398,000, as our loan referral program was more fully implemented. Gain on sale of loans declined between periods reflecting our decision to retain 1-4 family home loans for our portfolio as compared to selling them as in prior periods. Other income increased $1.0 million to $1.4 million for the year ended December 31, 2004, compared to $442,000 in 2003. This was primarily due to the full recovery in 2004 of a $528,000 operational loss charged-off in 2003 and a gain of $397,000 recorded from life insurance proceeds.
2003 Compared to 2002
Total non-interest income increased by $535,000, or 3.5%, to $16.0 million in 2003 from $15.5 million in 2002. The increase includes a $1.5 million gain on sale of branches in 2003. We also reported a gain on sale of branches of $254,000 in 2002. Although this revenue source is reported for both 2003 and 2002, we believe it is not typically recurring. Income from service charges and fees on deposit accounts increased 7.9% to $6.9 million in 2003 from $6.4 million in 2002, while average balances in transaction accounts (demand deposits, money market and interest-bearing demand accounts) increased 9.5% in 2003 as compared to 2002. The smaller increase in revenues from transaction accounts as compared to average outstanding transaction account balances reflects the impact of the growth in the banks business depositors as a percentage of total depositors. Service charges on these accounts typically are more a function of account activity than of average balance. In the aggregate, income from referral and other-loan related fees, loan servicing, and gain on sale of loans declined 15.5% to $3.6 million in 2003 from $4.2 million in 2002 as we focused on retaining loans in our portfolio to offset refinancing activity in our commercial real estate and 1-4 single family residence loan portfolios.
The following table summarizes non-interest expense by category for the periods indicated:
2004 Compared to 2003
Non-interest expense totaled $51.7 million for 2004, compared to $50.7 million for 2003. The increase in 2004 is due primarily to merger related expenses of $2.3 million incurred with the acquisition of Southland Capital Co. and its subsidiary Bank of Orange County. Excluding merger costs, non-interest expense decreased to $49.4 million, a decrease of 2.6%, or $1.3 million.
Salaries and employee benefits expense increased by 3.8%, or $942,000, to $25.4 million in 2004 as compared to $24.5 million in 2003 due to an increase in personnel associated with our increased size, complexity, revenue growth goals and an increase in the cost of employee benefits and insurance. Loan-related costs were significantly lower in 2004 due to a reduction of our allowance for losses related to undisbursed loan and lease commitments. Other non-interest expense decreased by 24.1%, or $712,000, in 2004 due to a $528,000 operational loss charged-off in 2003.
Amortization of intangibles decreased from $2.1 million in 2003 to $1.9 million in 2004 as the core deposit intangible is amortized using a method that approximates the expected run-off of the deposit base. The amortization of intangibles includes $72,000 related to the amortization of favorable lease rights in each of 2004 and 2003. We annually test our intangibles for impairment. No impairment was recognized in 2004 or 2003.
2003 Compared to 2002
Total non-interest expense decreased $5.6 million, or 9.9%, to $50.7 million in 2003 from $56.3 million in 2002. The decrease was principally the result of non-recurring merger costs of $1.6 million in 2002 associated with the merger of Cerritos Valley Bank with and into Bank of Orange County and a decrease in executive stock grant compensation costs from $3.4 million in 2002 to $388,000 in 2003. Stock grant compensation costs in 2002 related to one-time stock purchase and grant agreements entered into in consideration of the chief executive officer and chief financial officer entering into employment agreements with us during that period. The executive stock grant compensation costs in 2003 related to a one-time stock purchase and grant agreement entered into in consideration of the president of Placer Sierra Bank entering into an employment agreement during that period. Occupancy and equipment costs declined $785,000 in 2003 when compared to 2002, or 9.9%, as we realized the benefits of fully depreciated assets associated with upgrades to our facilities and data processing systems. Other
expense increased $918,000, or 45.0%, in 2003 to $3.0 million from $2.0 million in 2002, principally as a result of an operational charge-off of $528,000 in late 2003. The operational charge-off in late 2003 resulted from a misdirected wire transfer between two of Bank of Orange Countys deposit customers for which Bank of Orange County management had significant doubt as to its ultimate recovery.
Amortization of intangibles decreased from $2.5 million in 2002 to $2.1 million in 2003 as the core deposit intangible is amortized using a method that approximates the expected run-off of the deposit base. The amortization of intangibles includes $72,000 related to the amortization of favorable lease rights in each of 2003 and 2002. We annually test our intangibles for impairment. No impairment was recognized in 2003 or 2002.
Provision for Income Taxes
We recorded tax provisions of $7.7 million, $8.4 million and $4.8 million for the years ended December 31, 2004, 2003 and 2002, respectively. Our effective tax rates were 37.1%, 35.5% and 34.0%, for the periods indicated, as compared to the expected effective tax rate of 42.1%. The difference from the expected rate in all years is largely due to the nontaxable nature of income from municipal securities and bank owned life insurance policies, as well as a reversal in 2002 of valuation allowances against deferred tax assets associated with Bank of Orange Countys acquisition of Cerritos Valley Bank.
Our total assets at December 31, 2004 were $1.779 billion, an increase of 27.3%, compared to $1.397 billion at December 31, 2003. Our earning assets at December 31, 2004 totaled $1.555 billion, an increase of 28.3%, compared to $1.212 billion at December 31, 2003. Total deposits at December 31, 2004 and 2003 were $1.500 billion, an increase of 31.9%, compared to $1.137 billion. This increase is primarily the result of the acquisition of First Financial Bancorp and its subsidiary Bank of Lodi in December of 2004 combined with the continued organic growth of our existing loan and lease portfolio and deposit base.
Loans and Leases
The following table sets forth the amount of our loans and leases outstanding at the end of each of the years indicated. We had no foreign loans or energy-related loans as of the dates indicated.
Total gross loans and leases held for investment were $1.297 billion at December 31, 2004, an increase of 36.0%, compared to $953.4 million at December 31, 2003. Excluding the impact of the addition of First Financial Bancorps loan and lease portfolio of $217.4 million, our lending portfolio grew 13.2% or $125.8 million. Our lending portfolio also grew between December 31, 2002 and 2003 despite unprecedented loan pay-offs by real estate borrowers who refinanced their properties during 2003 at the lowest interest rates in almost 45 years. Our total gross loans and leases held for investment at December 31, 2003 were $953.4 million, compared to $876.7 million at December 31, 2002, an increase of 8.8% or $76.7 million.
Real estate-mortgage loans were $892.1 million at December 31, 2004, an increase of 34.0%, compared to $665.7 million at December 31, 2003. Excluding the impact of the addition of First Financial Bancorps loan and lease portfolio of $134.3 million of real estate-mortgage loans, real estate-mortgage loans grew 13.8% or $92.1 million. During both 2004 and 2003, the growth occurred primarily in commercial real estate term and home equity loans.
Real estate-construction loans were $184.3 million at December 31, 2004, an increase of 58.8%, compared to $116.1 million at December 31, 2003. Excluding the impact of the addition of First Financial Bancorps loan and lease portfolio of $23.6 million of real estate-construction loans, real estate-construction loans grew 38.5% or $44.7 million. Growth in 2004 and 2003 occurred principally in owner-builder residential construction loans and in commercial real estate construction loans.
Commercial loans were $167.0 million at December 31, 2004, an increase of 25.9%, compared to $132.7 million at December 31, 2003. Excluding the impact of the addition of First Financial Bancorps loan and lease portfolio of $41.8 million of commercial loans, commercial loans decreased 5.6% or $7.5 million. The decrease during 2004 was the result of caution on the part of commercial borrowers who continue to utilize their credit arrangements at historically low percentages.
Agricultural loans were $17.4 million at December 31, 2004, compared to $256,000 at December 31, 2003. Excluding the impact of the addition of First Financial Bancorps loan and lease portfolio of $17.1 million of agricultural loans, agricultural loans grew 18.4% or $47,000.
Consumer loans were $11.1 million at December 31, 2004 and 2003. Excluding the impact of the addition of First Financial Bancorps loan and lease portfolio of $622,000 of consumer loans, consumer loans decreased 5.4% or $598,000. Consumer loans are predominantly automobile-related. The organic decrease in the consumer loan portfolio is the result of the banks decision not to compete with rates and terms offered by captive finance subsidiaries of major automobile manufacturers.
Leases receivable and other loans were $24.6 million at December 31, 2004, compared to $27.6 million at December 31, 2003. This decrease in leases receivable and other loans of $3.0 million, or 10.9%, is principally related to the decline in originations which reflects our unwillingness to extend credit at the current low market rates.
As of December 31, 2004, a concentration of loans existed in loans collateralized by real estate, comprising 83% of total loans. Although management believes the loans within this concentration have no more than the normal risk of collectibility, a substantial decline in the performance of the economy in general or a decline in real estate values in the banks primary market areas, in particular, could have an adverse impact on collectibility, increase the level of real estate-related non-performing loans, or have other adverse effects which alone or in the aggregate could have a material adverse effect on our business, financial condition, results of operations and cash flows.
We believe that our commercial real estate loan underwriting policies and practices result in prudent extensions of credit, but recognize that our lending activities result in relatively high reported commercial real
estate lending levels. Commercial real estate loans include certain loans which represent low-to-moderate risks and certain loans which represent higher risks.
We set limitations on our exposure in commercial real estate lending activities and employ monitoring tools and reporting consistent with sound industry practices. We segment our commercial real estate mortgage and construction loan portfolio into low-to-moderate risk and higher risk loan categories and limit the aggregate of higher risk commercial real estate mortgage and construction loans outstanding to no more than 300% of the sum of Tier 1 capital plus the allowance for loan and lease losses. We further limit our total commercial real estate loans to no more than 550% of the sum of Tier 1 capital plus the allowance for loan and lease losses.
Higher risk commercial real estate mortgage and construction loans are defined as non-owner occupied construction and land development loans, non-farm non-residential commercial real estate mortgage loans with loan-to-value ratios over 50%, multi-family real estate mortgage loans with loan-to-value ratios over 50% and SBA 504 real estate mortgage loans with loan-to-value ratios over 50%. At December 31, 2004 this category of loans comprised 488% of our Tier 1 capital plus the allowance for loan and lease losses.
The following table shows the amounts of loans and leases held for investment outstanding as of December 31, 2004 which, based on scheduled repayments of principal are due in one year or less, more than one year through five years, and more than five years. Demand or other loans having no stated maturity and no stated schedule of repayments are reported as due in one year or less. The table also presents, for loans and leases with maturities over one year, an analysis with respect to fixed interest rate loans and leases and floating interest rate loans and leases.
Generally, loans and leases are placed on non-accrual status when they become 90 days or more past due or at such earlier time as management determines timely receipt of interest to be in doubt. Accrual of interest is discontinued on a loan or lease when management believes, after considering economic and business conditions and collection efforts, that the borrowers financial condition is such that collection of interest is doubtful. The following table summarizes the loans and leases for which the accrual of interest has been discontinued and loans and leases more than 90 days past due and still accruing interest, including those loans and leases that have been restructured, and other real estate, which we refer to as OREO:
Impaired Loans and Leases
Impaired loans and leases are loans and leases for which it is probable that we will not be able to collect all amounts due according to the original contractual terms of the loan or lease agreement. The category of impaired loans and leases is not coextensive with the category of non-accrual loans and leases, although the two categories overlap. Non-accrual loans and leases are those loans or leases on which the accrual of interest is discontinued when collectibility of principal and interest is uncertain or payments of principal or interest have become contractually past due 90 days. Management may choose to place a loan or lease on non-accrual status due to payment delinquency or uncertain collectibility, while not classifying the loan or lease as impaired if it is probable that we will collect all amounts due in accordance with the original contractual terms of the loan or lease.
In determining whether or not a loan or lease is impaired, we apply our normal loan and lease review procedures on a case-by-case basis taking into consideration the circumstances surrounding the loan or lease and borrower, including the collateral value, the reasons for the delay, the borrowers prior payment record, the amount of the shortfall in relation to the principal and interest owed and the length of the delay. We measure impairment on a loan-by-loan basis using either the present value of expected future cash flows discounted at the loans or leases effective interest rate or at the fair value of the collateral if the loan or lease is collateral dependent, less estimated selling costs. Loans or leases for which an insignificant shortfall in amount of payments is anticipated, but where we expect to collect all amounts due, are not considered impaired.
Loans and leases aggregating $2.7 million at December 31, 2004, $2.9 million at December 31, 2003 and $2.8 million at December 31, 2002 have been designated as impaired. The total allowance for loan and lease losses related to these impaired loans and leases was $606,000 at December 31, 2004, $1.1 million at December 31, 2003 and $671,000 at December 31, 2002.
The amount of interest income that we would have recorded on non-accrual loans and leases had the loans and leases been current totaled $175,000 for 2004, $162,000 for 2003, and $181,000 for 2002. All payments received on loans classified as non-accrual are applied first to principal; accordingly, interest income on such loans and leases was not significant for the years ended December 31, 2004, 2003 and 2002.
At December 31, 2004, we had one OREO property with an aggregate carrying value of $657,000. During 2004, we recorded a $148,000 write down of the OREO property to fair value yet management believes the property is readily marketable. At December 31, 2003, we had one OREO property with an aggregate carrying value of $805,000 compared to $1.5 million of OREO properties at December 31, 2002.
We record OREO properties at amounts which are approximately equal to the fair market value of the properties based on current independent appraisals reduced by estimated selling costs. A valuation allowance for losses on other real estate is maintained to provide for temporary declines in value. The allowance is established through a provision for losses on other real estate which is included in other non-interest expense. Subsequent gains or losses on sales or writedowns resulting from permanent impairments are recorded in other income or expense as incurred.
At December 31, 2004, all loans which management has serious doubts as to the ability of the borrower to comply with the present loan repayment terms were classified as non-accrual.
Allowance for Loan and Lease Losses
The allowance for loan and lease losses is maintained at a level which, in managements judgment, is adequate to absorb loan and lease losses inherent in the loan and lease portfolio. The amount of the allowance is based on managements evaluation of the collectibility of the loan and lease portfolio, historical loss experience, and other significant factors affecting loan and lease portfolio collectibility. These other significant factors include the level and trends in delinquent, non-accrual and adversely classified loans and leases, trends in volume and terms of loans and leases, levels and trends in credit concentrations, effects of changes in underwriting standards, policies, procedures and practices, national and local economic trends and conditions, changes in capabilities and experience of lending management and staff and other external factors including industry conditions, competition and regulatory requirements.
Our methodology for evaluating the adequacy of the allowance for loan and lease losses has two basic elements: first, the identification of impaired loans and leases and the measurement of impairment for each individual loan identified; and second, a method for estimating an allowance for all other loans and leases.
A loan or lease is considered impaired when it is probable that we will be unable to collect all contractual principal and interest payments due in accordance with terms of the loan or lease agreement. Losses on individually identified impaired loans or leases that are not collateral dependent are measured based on the present value of expected future cash flows discounted at the original effective interest rate of each loan or lease. For loans that are collateral dependent, impairment is measured based on the fair value of the collateral less estimated selling costs.
In estimating the general allowance for loan and lease losses, we group the balance of the loan and lease portfolio into segments that have common characteristics, such as loan or lease type, collateral type or risk rating. Loans typically segregated by risk rating are those that have been assigned risk ratings using regulatory definitions of special mention, substandard, and doubtful. Loans graded loss are generally charged off immediately.
For each general allowance portfolio segment, we apply loss factors to calculate the required allowance. These loss factors are based upon three years of historical loss rates, adjusted for qualitative factors affecting loan
and lease portfolio collectibility as described above. Qualitative adjustment factors are expressed in basis points and adjust historical loss factors downward up to 40 basis points and upward up to 75 basis points.
The specific allowance for impaired loans and leases and the general allowance are combined to determine the required allowance for loan and lease losses. The amount calculated is compared to the actual allowance for loan and lease losses at each quarter end and any shortfall is covered by an additional provision for loan and lease losses. As a practical matter, our allowance methodology may show that an unallocated allowance exists at quarter end. Any such amounts exceeding a minor percentage of the allowance will be removed from the allowance for loan and lease losses by a credit to the provision for loan and lease losses as of quarter end.
The table below summarizes loans and leases held for investment, average loans and leases held for investment, non-performing loans and leases and decreases in the allowance for loan and lease losses arising from charge-offs and additions to the allowance from provisions charged to operating expense, recoveries and the allowance acquired in acquisitions:
The allowance for loan and lease losses of $16.2 million at December 31, 2004 represented 1.25% of total loans and leases held for investment, net of deferred fees and costs, and 558.81% of non-performing loans and leases as of that date. At December 31, 2003, the allowance for loan and lease losses totaled $13.3 million, or 1.40% of total loans and leases held for investment, net of deferred fees and costs, and 447.60% of non-performing loans and leases as of that date. At December 31, 2002, the allowance for loan and lease losses totaled $12.5 million, or 1.42% of total loans and leases held for investment, net of deferred fees and costs, and 341.47% of non- performing loans and leases. Net charge-offs to average loans and leases held for investment were 0.15% for the year ended December 31, 2004 compared to net recoveries of 0.10% for the year ended December 31, 2003. See Critical Accounting Policies, and Note 5 of the Notes to Consolidated Financial Statements.
In 2004, total loan and lease charge-offs increased to $2.6 million from $1.0 million in 2003 and $1.7 million in 2002. The increase in total loan and lease charge-offs in 2004 is primarily related to the charge off of one significant commercial loan, while the decrease in total loan and lease charge-offs in 2003 is the result of a decline in commercial loan charge-offs.
Commercial loan charge-offs of $2.2 million in 2004 were higher than charge-offs of $258,000 in 2003 and $1.1 million in 2002. The increase in 2004 is related to the charge-off of one significant commercial loan. The decrease in 2003 is primarily the results of efforts made, beginning in 2000, to eliminate from the commercial loan portfolio borrowers believed to be less likely to withstand a potential economic downturn. The decrease is also a result of the decline in commercial loans, from $169.3 million at December 31, 2002 to $132.7 million at December 31, 2003.
In allocating our allowance for loan and lease losses, management has considered the credit risk in the various loan and lease categories in the banks portfolio. As such, the allocations of the allowance for loan and lease losses are based upon average historical net loan and lease loss experience and the other factors discussed above. While every effort has been made to allocate the allowance to specific categories of loans, management believes that any allocation of the allowance for loan and lease losses into loan categories lends an appearance of exactness that does not exist. The following table indicates managements allocation of the allowance and the percent of loans in each category to total loans and leases as of each of the following dates. The allocated and unallocated portions of the allowance for loan and lease losses are available to the entire loan portfolio.
Investment Securities Available for Sale
The market value of our investment securities available for sale at December 31, 2004 totaled $249.9 million compared to $219.3 million at December 31, 2003 and $222.8 million at December 31, 2002. We
increased our investment portfolio during the fourth quarter of 2004, after maintaining a higher level of liquidity during the period leading up to the acquisition of First Financial Bancorp. Our portfolio of investment securities during 2004, 2003, and 2002 consisted predominately of U.S. Government agencies.
We manage our investment portfolio principally to provide liquidity and balance our overall interest rate risk. To a lesser extent, we manage our investment portfolio to provide earnings with a view to minimizing credit risk.
The market value of our portfolio of investment securities available for sale at December 31, 2004, 2003 and 2002 was as follows:
The following table shows the maturities of investment securities at December 31, 2004 and the weighted average yields of such securities, excluding the benefit of tax-exempt securities:
At December 31, 2004, other securities of $5.4 million included $4.0 million of equity securities for which there is no maturity date.
Additional information concerning investment securities is provided in Note 4 to our Consolidated Financial Statements.
Total deposits were $1.500 billion at December 31, 2004, an increase of 31.9%, compared to $1.137 billion at December 31, 2003. The increase in total deposits is primarily attributable to the acquisition of First Financial Bancorp. Average deposits were $1.213 billion for the year ended December 31, 2004, an increase of 2.1%, compared to $1.188 billion for the year ended December 31, 2003. Average non-interest bearing deposits were $409.3 million for the year ended December 31, 2004, an increase of 6.9%, compared to $382.9 million for the year ended December 31, 2003. Excluding the impact of First Financial Bancorps deposits and sale of five
branches in 2003, average deposits increased 5.0% for the year ended December 31, 2004, while average non-interest bearing deposits increased 9.1%.
Total deposits were $1.500 billion at December 31, 2004, compared to $1.137 billion at December 31, 2003. The 31.9% increase in total deposits is also primarily attributable to First Financial Bancorp and the acquisition of its deposits, which totaled $266.8 million at December 31, 2004. Excluding the impact of the acquisition of First Financial Bancorp total deposits grew by 8.5%, or $96.1 million, including growth in non-interest bearing deposits of 13.4%, or $50.8 million.
The following table shows the average amount and average rate paid on the categories of deposits for each of the periods indicated:
Additionally, the following table shows the maturities of time certificates of deposit of $100,000 or more at December 31, 2004:
We enter into sales of securities under agreements to repurchase which are short term in nature. Borrowings of this type increased noticeably in the fourth quarter of 2003. Management elected to repay most of these borrowings during the first quarter of 2004 and by December 31, 2004, short-term borrowings had decreased by $25.0 million to $16.3 million. The borrowings were repaid with funds generated through the issuance of time certificates of deposit.
Junior Subordinated Deferrable Interest Debentures
We own the common stock of four business trusts that have issued an aggregate of $52.0 million in trust preferred securities fully and unconditionally guaranteed by us. The entire proceeds of each respective issuance of trust preferred securities were invested by the separate business trusts into junior subordinated deferrable interest debentures issued by us, with identical maturity, repricing and payment terms as the respective issuance of trust preferred securities. The aggregate amount of junior subordinated debentures issued by us is $53.6 million, with the maturity dates for the respective debentures ranging from 2031 through 2034. We may redeem
the respective junior subordinated deferrable interest debentures earlier than the maturity date, with certain of the debentures being redeemable beginning in 2006 and others being redeemable beginning in 2007 and 2009. For more information about the trust preferred securities and the debentures see Note 11 to our Notes to Consolidated Financial Statements.
Current risk-based regulatory capital standards generally require banks and bank holding companies to maintain a ratio of core or Tier 1 capital (consisting principally of common equity and, for bank holding companies, a specified percentage of trust preferred securities) to risk-weighted assets of at least 4%, a ratio of Tier 1 capital to adjusted average assets (leverage ratio) of at least 4% and a ratio of total capital (which includes Tier 1 capital plus certain forms of subordinated debt, a portion of the allowance for loan and lease losses and preferred stock) to risk-weighted assets of at least 8%. Risk-weighted assets are calculated by multiplying the balance in each category of assets by a risk factor, which ranges from zero for cash assets and certain government obligations to 100% for some types of loans, and adding the products together.
The regulatory capital guidelines as well as the actual capital ratios for Placer Sierra Bank and us as of December 31, 2004 are as follows:
As of December 31, 2004, we exceeded each of the capital requirements to be deemed well capitalized. We own the common stock of four trusts that have issued $52 million of trust preferred securities. These securities are currently included in our Tier 1 capital for purposes of determining our Tier 1 and total risk-based capital ratios. Effective March 31, 2009, we will be required to use a more restrictive formula to determine the amount of trust preferred securities that may be included in regulatory Tier 1 capital. At that time, we will be allowed to include in Tier 1 capital an amount of trust preferred securities equal to no more than 25% of the sum of all core capital elements, which is generally is defined as shareholders equity, less goodwill and any related deferred income tax liability. The regulations currently in effect only limit the amount of trust preferred securities that may be included in Tier 1 capital to 25% of the sum of core capital elements without a deduction for goodwill. We have determined that our Tier 1 capital ratios would remain above the well-capitalized level had the modification of the capital regulations been in effect at December 31, 2004. We expect that our Tier 1 capital
ratios will be at or above the existing well capitalized levels on March 31, 2009, the first date on which the modified capital regulations must be applied. For more information about the proposed regulations see Item 1. BUSINESS. Supervision and Regulation.
Off Balance Sheet Arrangements
The definition of off-balance sheet arrangements includes any transaction, agreement or other contractual arrangement to which an entity is a party under which we have:
We are a party to financial instruments with off-balance sheet risk. We have entered into commitments to extend credit and standby letters of credit. At December 31, 2004, our commitments to extend credit and standby letters of credit totaled $379.6 million. Commitments which result in a funded loan will increase our profitability through net interest income. Therefore, during the year, we manage our overall liquidity taking into consideration funded and unfunded commitments as a percentage of our liquidity sources. Our liquidity sources, as described in Liquidity, have been and are expected to be sufficient to meet the cash requirements of our lending activities. For a further description of these financial instruments which qualify as off-balance sheet arrangements, see Note 12 of our Notes to Consolidated Financial Statements.
For a description of variable interest entities which qualify as off-balance sheet arrangements, see Note 2 and Note 11 of our Notes to Consolidated Financial Statements, which discuss four statutory trusts (of which we own 100% of the common stock) that were formed solely for the purpose of issuing trust preferred securities.
The following table sets forth our significant contractual obligations at December 31, 2004:
The following table sets forth our other significant commitments at December 31, 2004:
Management believes that the level of liquid assets is sufficient to meet our current and presently anticipated funding needs on a consolidated basis.
Placer Sierra Bancshares
On a stand-alone basis, we rely on dividends from the bank as our main source of liquidity. As of December 31, 2004, the maximum amount available for dividend distributions by the bank to us under these restrictions was approximately $13,763,000. However, such amount is further restricted due to the fact that the bank must keep a certain amount of capital in order to be well capitalized. Accordingly, the amount available for payment of dividends to us by the bank for the bank to remain well capitalized immediately thereafter totaled $2,000,000 at December 31, 2004.
Placer Sierra Bank
The bank relies on deposits as the principal source of funds and, therefore, must be in a position to service depositors needs as they arise. Management attempts to maintain a loan-to-deposit ratio (total loans held for sale plus total loans and leases held for investment to total deposits) below 90% and a liquidity ratio (liquid assets, including cash and due from banks, Federal funds sold, investment securities not pledged as collateral less FHLB funds purchased expressed as a percentage of total deposits) above 15%. The loan-to-deposit ratio was 86.1% at December 31, 2004, 83.8% at December 31, 2003 and 73.5% at December 31, 2002. The liquidity ratio was 15.6% at December 31, 2004, 21.3% at December 31, 2003 and 27.6% at December 31, 2002.
Our deposits tend to be cyclical, decreasing at the beginning of each year and increasing over the balance of the year. In addition, while occasional fluctuations in the balances of a few large depositors may cause temporary increases and decreases in liquidity, we have not experienced difficulty in dealing with such fluctuations from existing liquidity sources.
Based upon our existing business plan, management believes that the level of liquid assets is sufficient to meet the banks current and presently anticipated funding needs. Liquid assets of the bank represented approximately 13.1% of total assets at December 31, 2004. If the level of liquid assets (our primary liquidity) does not meet our liquidity needs, other available sources of liquid assets (our secondary liquidity), including the purchase of Federal funds, sales of securities under agreements to repurchase, sales of loans, discount window borrowings from the Federal Reserve Bank and $78.4 million under a line of credit with the Federal Home Loan Bank of San Francisco at December 31, 2004, could be employed to meet those current and presently anticipated funding needs.
Our liquidity may be impacted negatively, however, by several other factors, including expenses associated with unforeseen or pending litigation.
Quantitative and Qualitative Disclosures About Market Risk
Market risk is the risk of loss in a financial instrument arising from adverse changes in market prices and rates, foreign currency exchange rates, commodity prices and equity prices. Our market risk arises primarily from interest rate risk inherent in our lending and deposit taking activities. To that end, management actively monitors and manages our interest rate risk exposure. We do not have any market risk sensitive instruments entered into for trading purposes. We manage our interest rate sensitivity by matching the re-pricing opportunities on our earning assets to those on our funding liabilities. Management uses various asset/liability strategies to manage the re-pricing characteristics of our assets and liabilities designed to ensure that exposure to interest rate fluctuations is limited within our guidelines of acceptable levels of risk-taking. Hedging strategies, including the terms and pricing of loans and deposits and managing the deployment of our securities are used to reduce mismatches in interest rate re-pricing opportunities of portfolio assets and their funding sources.
Interest rate risk is addressed by our Asset Liability Management Committee, or the ALCO, which is comprised of certain members of our senior management and a board member. The ALCO monitors interest rate risk by analyzing the potential impact on the net portfolio of equity value and net interest income from potential changes in interest rates, and considers the impact of alternative strategies or changes in balance sheet structure. The ALCO manages our balance sheet in part to maintain the potential impact on net portfolio of equity value and net interest income within acceptable ranges despite changes in interest rates.
Our exposure to interest rate risk is reviewed on at least a quarterly basis by the ALCO and our board of directors. Interest rate risk exposure is measured using interest rate sensitivity analysis to determine our change in net portfolio of equity value and net interest income in the event of hypothetical changes in interest rates. If potential changes to net portfolio of equity value and net interest income resulting from hypothetical interest rate changes are not within board-approved limits, the board may direct management to adjust the asset and liability mix to bring interest rate risk within board-approved limits.
Market Value of Portfolio Equity
We measure the impact of market interest rate changes on the net present value of estimated cash flows from our assets, liabilities and off-balance sheet items, defined as market value of portfolio equity, using a simulation model. This simulation model assesses the changes in the market value of interest rate sensitive financial instruments that would occur in response to an instantaneous and sustained increase or decrease (shock) in market interest rates.
The following table presents forecasted changes in the market value of portfolio equity using a base market rate and the estimated change to the base scenario given an immediate and sustained upward and downward movement in interest rates of 100 and 200 basis points at December 31, 2004.
Market Value of Portfolio Equity
(Dollars in thousands)
The computation of prospective effects on the market value of portfolio equity from hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, asset prepayments and deposit decay, and should not be relied upon as indicative of actual results. Further, the computations do not contemplate any actions we may undertake in response to changes in interest rates. Actual amounts may differ from the projections set forth above should market conditions vary from the underlying assumptions.
Net Interest Income Simulation
In order to measure interest rate risk at December 31, 2004, we used a simulation model to project changes in net interest income that result from forecasted changes in interest rates. This analysis calculates the difference between net interest income forecasted using a rising and a falling interest rate scenario and a net interest income forecast using a base market interest rate derived from the current treasury yield curve. The income simulation model includes various assumptions regarding the re-pricing relationships for each of our products. Many of our assets are floating rate loans, which are assumed to re-price immediately, and to the same extent as the change in market rates according to their contracted index. Some loans and investment vehicles include the opportunity of prepayment (embedded options), and accordingly the simulation model uses national indexes to estimate these prepayments and reinvest their proceeds at current yields. Our non-term deposit products re-price more slowly, usually changing less than the change in market rates and at our discretion.
This analysis indicates the impact of changes in net interest income for the given set of rate changes and assumptions. It assumes no growth in the balance sheet and that its structure will remain similar to the structure at year end. It does not account for all factors that impact this analysis, including changes by management to mitigate the impact of interest rate changes or secondary impacts such as changes to our credit risk profile as interest rates change. Furthermore, loan prepayment rate estimates and spread relationships change regularly. Interest rate changes create changes in actual loan prepayment rates that will differ from the market estimates incorporated in this analysis. Changes that vary significantly from the assumptions may have significant effects on our net interest income.
For the rising and falling interest rate scenarios, the base market interest rate forecast was increased or decreased on an instantaneous and sustained basis.
Sensitivity of Net Interest Income
December 31, 2004
(Dollars in thousands)
Another way to measure the impact that future changes in interest rates will have on net interest income is through a cumulative gap measure. The gap represents the net position of assets and liabilities subject to re-pricing in specified time periods.
The following table sets forth the distribution of re-pricing opportunities of our interest-earning assets and interest-bearing liabilities, the interest rate sensitivity gap (that is, interest rate sensitive assets less interest rate sensitive liabilities), cumulative interest-earning assets and interest-bearing liabilities, the cumulative interest rate sensitivity gap, the ratio of cumulative interest-earning assets to cumulative interest-bearing liabilities and the cumulative gap as a percentage of total assets and total interest-earning assets as of December 31, 2004. The table also sets forth the time periods during which interest-earning assets and interest-bearing liabilities will mature or may re-price in accordance with their contractual terms. The interest rate relationships between the re-priceable assets and re-priceable liabilities are not necessarily constant and may be affected by many factors, including the behavior of customers in response to changes in interest rates. This table should, therefore, be used only as a guide as to the possible effect changes in interest rates might have on our net interest margins.