Sierra Bancorp 10-K 2005
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2004
Commission file number: 000-33063
(Exact name of registrant as specified in its charter)
Registrants telephone number, including area code
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 ¨
Check 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. ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes x No ¨
As of June 30, 2004, the last business day of Registrants most recently completed second fiscal quarter, the aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $84 million, based on the closing price reported to the Registrant on that date of $15.85 per share.
Shares of Common Stock held by each officer and director and each person owning more than five percent of the outstanding Common Stock have been excluded in that such persons may be deemed to be affiliates. This determination of the affiliate status is not necessarily a conclusive determination for other purposes.
The number of shares of Common Stock of the registrant outstanding as of January 31, 2005 was 9,722,612.
Documents Incorporated by Reference: Portions of the definitive proxy statement for the 2005 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission pursuant to SEC Regulation 14A are incorporated by reference in Part III, Items 10-14.
TABLE OF CONTENTS
ITEM 1. BUSINESS
Sierra Bancorp (the Company) is a California corporation registered as a bank holding company under the Bank Holding Company Act of 1956, as amended, and is headquartered in Porterville, California. The Company was incorporated in November 2000 and acquired all of the outstanding shares of Bank of the Sierra (the Bank) in August 2001. The Companys principal subsidiary is the Bank, and the Company exists primarily for the purpose of holding the stock of the Bank and of such other subsidiaries it may acquire or establish. The Companys only other direct subsidiaries are Sierra Capital Trust I, which was formed in November 2001 solely to facilitate the issuance of capital trust pass-through securities, and Sierra Statutory Trust II, formed in March 2004 also for the purpose of issuing $15 million in variable-rate capital trust pass-through securities. This additional regulatory capital will allow the Company to stay on track with current expansion plans without any impairment of risk-based capital ratios. While current rates and underwriting fees are substantially lower than when the Company issued its first $15 million in 2001, the cost of this money is still higher than the Company would otherwise pay for shorter-term borrowings from the Federal Home Loan Bank or from brokered deposit markets. The issuance of these trust preferred securities has, therefore, slightly increased the Companys overall funding costs. Pursuant to FASB Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46), Sierra Capital Trust I and Sierra Statutory Trust II are not reflected on a consolidated basis in the financial statements of the Company.
The Companys principal source of income is dividends from the Bank, although supplemental sources of income may be explored in the future. The expenditures of the Company, including (but not limited to) the payment of dividends to shareholders, if and when declared by the Board of Directors, and the cost of servicing debt, will generally be paid from dividends paid to the Company by the Bank.
At December 31, 2004, the Company had consolidated assets of $997 million, deposits of $743 million and shareholders equity of $71 million. The Companys liabilities include $30 million in debt obligations due to Sierra Capital Trust I and Sierra Statutory Trust II, related to capital trust pass-through securities issued by those entities.
References herein to the Company include the Company and its consolidated subsidiary, unless the context indicates otherwise.
The Bank is a California state-chartered bank headquartered in Porterville, California. It was incorporated in September 1977 and opened for business in January 1978, and has grown to be the largest independent bank headquartered in the South San Joaquin Valley. The Bank is a multi-community independent bank that offers a full range of banking services to individuals and businesses primarily in the central and southern sections of Californias San Joaquin Valley. We operate eighteen full service branch offices throughout this geographic footprint, and have received regulatory approvals for a branch in the city of Reedley and another branch in Bakersfield. The Reedley Branch is expected to commence operations in the third quarter of 2005, and the additional Bakersfield branch should come online in the fourth quarter of 2005. Prior to 1997, Bank of the Sierra expanded its branch network exclusively by establishing de novo full-service branch offices and credit centers. In February 1997 we made our first branch purchase of the Dinuba Office of Wells Fargo Bank. Between February 1997 and September 1999 we opened three additional de novo offices in Tulare, Hanford, and Fresno. In May 2000 we added four branches by the acquisition of Sierra National Bank (SNB): one in Bakersfield, another in California City, and two in Tehachapi. The locations of the Banks current offices are:
The Banks gross loan and lease balances at the end of 2004 totaled $696 million. The Banks lending activities are well-diversified and include real estate secured, commercial (including small business), agricultural, and retail loans. Our principal retail lending services include home equity lines, consumer loans, and credit card loans. Agricultural Credit Centers located in Fresno and Porterville provide a complete line of credit services in support of the agricultural activities that are key to the continued economic development of the communities we serve. Ag lending clients include a full range of individual farming customers, small business farming organizations, and major corporate farming units.
In addition, we staff our Fresno, Visalia, Porterville, and Bakersfield offices with real estate lending specialists. These officers are responsible for a complete line of land acquisition and development loans, construction loans for residential and commercial development, and multifamily credit facilities. Secondary market services are provided through the Banks affiliations with Freddie Mac, Fannie Mae and various non-governmental programs. In addition, we have an arrangement with Moneyline Lending Services, Inc. (Moneyline), whereby Moneyline underwrites single-family mortgage loans for qualifying Bank customers referred to them via Bank-branded delivery channels (i.e., Bank branches, the Banks internet site, and a dedicated telephone line).
We also engage in Small Business Administration (SBA) lending and have been designated as an SBA Preferred Lender since 1999. Further, Bank of the Sierra is a participant in the SBAs innovative Community Express program, and was fifth in the nation from 1999 through 2003 for the volume of loans produced, behind the likes of banks such as Wells Fargo, Bank One, and J.P. Morgan.
As of December 31, 2004, the percentage of our total loan portfolio for each of the principal areas in which we directed our lending activities were as follows: (i) loans secured by real estate (71.9%); (ii) commercial and industrial
(including SBA) loans (17.1%); (iii) consumer loans (7.0%); (iv) agricultural loans (1.9%); (v) credit cards (1.6%); and (vi) direct finance leases (.5%). Real estate loans and related activities generated total revenue of $33.4 million in 2004 and $28.0 million in 2003. Real-estate secured loans, loan sales, and loan servicing activities generated approximately 54% of our total interest and other income for 2004, and 53% during 2003.
In addition to loans, we offer a wide range of deposit products for retail and business banking markets including checking accounts, interest bearing transaction accounts, savings accounts, time deposit accounts and retirement accounts. Telephone banking and internet banking with bill-pay are options for our deposit customers. We attract deposits through our customer-oriented product mix, competitive pricing, convenient locations, and drive-up banking, all provided with the highest level of customer service. At December 31, 2004 we had 55,833 deposit accounts totaling approximately $743 million, compared to 51,898 deposit accounts totaling approximately $684 million as of December 31, 2003.
We offer a multitude of other products and services to our customers to complement our lending and deposit services. These include installment note collection, cashiers checks, travelers checks, bank-by-mail, ATM, night depository, safe deposit boxes, direct deposit, automated payroll services, electronic funds transfers, on-line banking, and other customary banking services. During the past few years we have added offsite ATMs, thereby increasing consumer convenience by facilitating cash advances and deposit capabilities not otherwise available at non-branch locations. We currently operate seven offsite ATMs, and also utilize a mobile ATM unit at fairs, exhibitions, and various other community functions within our market area. The most recently opened kiosk-style offsite ATMs commenced operations in late 2003 and October 2004 in Visalia and Tehachapi, respectively. We have a Spanish language option on our own network of ATMs, and shared ATM and Point of Sale (POS) networks allow our customers access to national and international funds transfer networks. In addition, we have established a convenient customer service group accessible by toll-free telephone to answer questions and assure a high level of customer satisfaction.
In order to provide non-deposit investment options we have developed a strategic alliance with Investment Centers of America, Inc. of Bismarck, North Dakota (ICA). Through this arrangement, registered and licensed representatives of ICA provide our customers with convenient access to annuities, insurance products, mutual funds, and a full range of investment products. They conduct business from offices located in our Porterville, Visalia, Tulare, Tehachapi and Fresno branches.
Sierra Real Estate Investment Trust, a Maryland real estate investment trust (REIT) which is a consolidated subsidiary of the Bank, was formed in June 2002 for the primary business purpose of investing in the Banks real-estate related assets, and enhancing and strengthening the Banks capital position and earnings. Our REIT was capitalized in August 2002, when the Bank exchanged real-estate related assets for 100% of the common and preferred stock of the REIT. The Bank subsequently distributed more than 100 shares of REIT preferred stock among its directors and officers in January of 2003. Management has considered using the REIT to issue additional preferred stock to enhance the Companys capital, however based on current market conditions and pricing this is an expensive option in comparison to capital trust pass-through securities. Should it ever be determined that the Company cannot include capital trust pass-through securities in regulatory capital, REIT preferred securities could become a viable substitute.
On December 31, 2003, the California Franchise Tax Board issued an opinion listing bank-owned REITs as potentially abusive tax shelters subject to possible penalties, and stating that REIT consent dividends are not deductible for California state income tax purposes. The Company has received advice from its REIT tax advisor (a national accounting firm) that the law has not changed, and the tax opinion it received on the validity of REIT benefits still stands as issued. The Company felt it prudent, however, to reverse REIT tax benefits accrued on its income statement, and the benefit accrued during 2003 was reversed at the end of 2003. During the second quarter of 2004, amended 2002 tax returns were filed eliminating the REIT benefit originally reflected for 2002. The difference plus interest was paid to the California Franchise Tax Board at that time. That amount was also included in the Companys second quarter 2004 provision for income taxes, net of the associated contingent tax reserve. No assurance can be given that REIT benefits will be available in the future, or that the Company will not be assessed by the Franchise Tax Board for back penalties. It appears that many California banks with REITs, including Bank of the Sierra, have reserved the right to appeal the most recent interpretation of the California Franchise Tax Board, and some have recently initiated a defense of their position that the law was correctly interpreted when REIT tax benefits were initially recognized.
We have not engaged in any material research activities related to the development of new products or services during the last two fiscal years. However, our officers and employees are continually searching for ways to increase public convenience, enhance public access to the electronic payments system, and enable us to improve our competitive position. In January of 2004, for example, we converted our core bank processing and online banking systems to increase efficiency and improve customer service. During 2003 we began offering lease financing as an alternative to loans and implemented an extensive customer service training program, among other things. And, in 2002 the Bank brought its item processing function in-house and simultaneously implemented check imaging, enabling us to take full advantage of electronic check image collection and presentment as the adoption of this technology becomes more widespread. The cost to the Bank for these development, operations, and marketing activities cannot be expressly calculated with any degree of certainty.
We hold no patents or licenses (other than licenses required by appropriate bank regulatory agencies), franchises, or concessions. Our business has a modest seasonal component due to the heavy agricultural orientation of the Central Valley. As our branches in more metropolitan areas such as Fresno and Bakersfield have expanded, however, the agriculture-related base has become less important. We are not dependent on a single customer or group of related customers for a material portion of our deposits, nor is a material portion of our loans concentrated within a single industry or group of related industries. The amounts expended on compliance with new government and regulatory initiatives related to anti-terrorism, corporate responsibility, and customer privacy have not been insignificant; the amount spent specifically for compliance with Sarbanes-Oxley section 404 alone totaled close to $300,000 in 2004. However, as far as can be reasonably determined there has been no material effect upon our capital expenditures, earnings, or competitive position as a result of Federal, state, or local environmental regulation.
In July 2004 the Companys Board of Directors approved a $1 million limited partnership commitment to The Central Valley Fund, L.P., a Small Business Investment Company formed to invest primarily in Californias Central Valley (Redding to Bakersfield). The fund will provide mezzanine capital for small to mid-sized Central Valley businesses to finance later stage growth, strategic acquisitions, ownership transitions and recapitalizations. Referrals from financial institution limited partners are anticipated. A subscription agreement for the Central Valley Fund was executed in February 2005.
Recent Accounting Pronouncements
Information on recent accounting pronouncements is contained in Footnote 2 to the Financial Statements.
The banking business in California in general, and specifically in many of our market areas, is highly competitive with respect to virtually all products and services and has become increasingly more so in recent years. The industry continues to consolidate, and unregulated competitors have entered banking markets with products targeted at highly profitable customer segments. Many largely unregulated competitors are able to compete across geographic boundaries, and provide customers with meaningful alternatives to nearly all significant banking services and products. These competitive trends are likely to continue.
With respect to commercial bank competitors, the business is largely dominated by a relatively small number of major banks with many offices operating over a wide geographic area. For the combined Tulare, Kern, Fresno, and Kings county region, the four counties within which the Company operates, the top seven institutions are all multi-billion dollar entities that control a combined 68.6% of deposit market share based on June 30, 2004 FDIC market share data. Bank of the Sierra, the largest independent community bank on the list, ranks eighth with a 4.6% share of aggregate deposits. In Tulare County, however, where the Bank was originally formed, we rank first for total number of branch locations (9), and second for deposit market share with 17.8% of total deposits, behind only Bank of
America (23.0%). The largest portion of deposits in the combined four-county area also belongs to Bank of America (25.0%), while Wells Fargo is second (12.3%), and Washington Mutual comes in third (9.0%). Union Bank of California, Citibank, Bank of the West, and Fremont Investment & Loan round out the top seven. These banks have, among other advantages, the ability to finance wide-ranging and effective advertising campaigns and to allocate their resources to regions of highest yield and demand. They also have the ability to offer certain services that we do not offer directly but may offer indirectly through correspondent institutions. By virtue of their greater total capitalization, these banks also have substantially higher lending limits than do smaller community banks. For customers whose needs exceed our legal lending limit, we attempt to arrange for loans on a participation basis with other banks.
In addition to other banks, our competitors include savings institutions, credit unions, and numerous non-banking institutions such as finance companies, leasing companies, insurance companies, brokerage firms, and investment banking firms. In recent years, increased competition has also developed from specialized companies that offer wholesale finance, credit card, and other consumer finance services, including on-line banking services and personal financial software. Strong competition for deposit and loan products affects the rates of those products as well as the terms on which they are offered to customers. Mergers between financial institutions have placed additional pressure on other banks within the industry to remain competitive by streamlining their operations, reducing expenses, and increasing revenues. Competition has also intensified due to federal and state interstate banking laws enacted in the mid-1990s, which permit banking organizations to expand into other states. The relatively large and expanding California market has been particularly attractive to out-of-state institutions. The Financial Modernization Act, effective March 11, 2000 (see Regulation and Supervision Financial Modernization Act), has made it possible for full affiliations to occur between banks and securities firms, insurance companies, and other financial companies, and has also intensified competitive conditions.
Our credit card business is subject to an even higher level of competitive pressure than our general banking business. There are a number of major banks and credit card issuers that are able to finance highly visible and extremely successful advertising campaigns with which community banks generally do not have the resources to compete. As a result, our credit card accounts and outstanding balances are likely to increase at a slower rate than for nationwide issuers. Additional competition comes from many non-financial institutions, such as retailers that offer credit cards.
Technological innovations have also resulted in increased competition in financial services markets. Such innovation has, for example, made it possible for non-depository institutions to offer customers automated transfer payment services that previously were considered traditional banking products. In addition, many customers now expect a choice of delivery channels, including telephone, mail, home computer, ATMs, self-service branches, and/or in-store branches. Competitors offering such products include traditional banks as well as savings associations, credit unions, brokerage firms, money market and other mutual funds, asset management groups, finance and insurance companies, internet-only financial intermediaries, and mortgage banking firms.
For many years we have countered rising competition by offering a broad array of products in an innovative and flexible manner. We are able to offer our customers community-oriented, personalized service that cannot always be matched by the major banks. We rely on local promotional activity, personal contacts by our officers, directors, employees, and shareholders, and individualized service provided through accommodative policies. This approach appears to be well-received by the populace of the San Joaquin Valley, who appreciate a high-touch, customer-oriented environment in which to conduct their financial transactions. Other competitive advantages include our retention of drive-up teller windows, which have been eliminated by much of the competition, and our preferred lender or PLP status with the Small Business Administration, which enables us to approve SBA loans faster than many of our competitors. Layered on top of the Companys traditional personal-contact banking philosophy are sophisticated telephone banking, internet banking, and online bill payment capabilities, which were implemented to meet the needs of customers with electronic access requirements and provide automated 24-hour banking. This high-tech and high-touch approach allows individuals to customize access to the Company to their particular preference.
As of December 31, 2004 the Company had 253 full-time and 118 part-time employees. On a full time equivalent basis, the Companys staffing stood at 344 at December 31, 2004, as compared to 326 at December 31, 2003. Staff was added during 2004 for the new office in Clovis, to provide resources in order to maintain satisfactory customer service in growth areas, and to enhance business development activities in certain markets. Our employees are not represented by a union or covered by a collective bargaining agreement. Management of the Company believes its employee relations are satisfactory.
Regulation and Supervision
The Company and the Bank are subject to significant regulation by federal and state regulatory agencies. The following discussion of statutes and regulations is only a brief summary and does not purport to be complete. This discussion is qualified in its entirety by reference to such statutes and regulations. No assurance can be given that such statutes or regulations will not change in the future.
The Companys stock is traded on the Nasdaq National Market under the symbol BSRR, and as such the Company is subject to Nasdaq rules and regulations including those related to corporate governance. The Company is also subject to the periodic reporting requirements of Section 13 of the Securities Exchange Act of 1934 (the Exchange Act) which requires the Company to file annual, quarterly and other current reports with the Securities and Exchange Commission (the SEC). The Company is subject to additional regulations including, but not limited to, the proxy and tender offer rules promulgated by the SEC under Sections 13 and 14 of the Exchange Act; the reporting requirements of directors, executive officers and principal shareholders regarding transactions in the Companys Common Stock and short-swing profits rules promulgated by the SEC under Section 16 of the Exchange Act; and certain additional reporting requirements by principal shareholders of the Company promulgated by the SEC under Section 13 of the Exchange Act. As a publicly traded company which had in excess of $75 million in public float as of June 30, 2004, the Company is classified as an accelerated filer as of the end of the year. This means that commencing with its fiscal year ended December 31, 2004, the Company is also subject to the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 with regard to documenting, testing, and attesting to internal controls over financial reporting.
The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956 and is registered as such with the Federal Reserve Board. A bank holding company is required to file with the Federal Reserve Board annual reports and other information regarding its business operations and those of its subsidiaries. It is also subject to periodic examination by the Federal Reserve Board and is required to obtain Federal Reserve Board approval before acquiring, directly or indirectly, ownership or control of any voting shares of any bank if, after such acquisition, it would directly or indirectly own or control more than 5% of the voting stock of that bank, unless it already owns a majority of the voting stock of that bank.
The Federal Reserve Board has by regulation determined certain activities in which a bank holding company may or may not conduct business. A bank holding company must engage, with certain exceptions, in the business of banking or managing or controlling banks or furnishing services to or performing services for its subsidiary banks. The permissible activities and affiliations of certain bank holding companies were expanded in 2000 by the Financial Modernization Act. (See Financial Modernization Act below.)
The Company and the Bank are deemed to be affiliates of each other within the meaning set forth in the Federal Reserve Act and are subject to Sections 23A and 23B of the Federal Reserve Act. This means, for example, that there are limitations on loans by the Bank to affiliates, and that all affiliate transactions must satisfy certain limitations and otherwise be on terms and conditions at least as favorable to the Bank as would be available for non-affiliates.
The Federal Reserve Board has a policy that bank holding companies must serve as a source of financial and managerial strength to their subsidiary banks. It is the Federal Reserve Banks position that bank holding companies
should stand ready to use their available resources to provide adequate capital to their subsidiary banks during periods of financial stress or adversity. Bank holding companies should also maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting their subsidiary banks.
The Federal Reserve Board also has the authority to regulate bank holding company debt, including the authority to impose interest rate ceilings and reserve requirements on such debt. Under certain circumstances, the Federal Reserve Board may require the Company to file written notice and obtain its approval prior to purchasing or redeeming the Companys equity securities.
As a California state-chartered bank whose accounts are insured by the FDIC up to a maximum of $100,000 per depositor, the Bank is subject to regulation, supervision and regular examination by the California Department of Financial Institutions (the DFI) and the FDIC. In addition, while the Bank is not a member of the Federal Reserve System, it is subject to certain regulations of the Federal Reserve Board. The regulations of these agencies govern most aspects of the Banks business, including the making of periodic reports by the Bank, and the Banks activities relating to dividends, investments, loans, borrowings, capital requirements, certain check-clearing activities, branching, mergers and acquisitions, reserves against deposits and numerous other areas. Supervision and examination of the Bank by the FDIC and any legal actions taken by the FDIC with respect thereto are generally intended to protect depositors and are not intended for the protection of shareholders.
The earnings and growth of the Bank are largely dependent on its ability to maintain a favorable differential or spread between the yield on its interest-earning assets and the rates paid on its deposits and other interest-bearing liabilities. As a result, the Banks performance is influenced by general economic conditions, both domestic and foreign, the monetary and fiscal policies of the federal government, and the policies of the regulatory agencies, particularly the Federal Reserve Board. The Federal Reserve Board implements national monetary policies (such as seeking to curb inflation and combat recession) by means of open-market operations in United States Government securities, adjusting the required level of reserves for financial institutions subject to its reserve requirements, and varying the discount rate applicable to borrowings by banks that are members of the Federal Reserve System. The actions of the Federal Reserve Board in these areas influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and deposits. The nature and impact of any future changes in monetary policies cannot be predicted.
Capital Adequacy Requirements
The Company and the Bank are subject to the regulations of the Federal Reserve Board and the FDIC, respectively, governing capital adequacy. Each of the federal regulators has established risk-based and leverage capital guidelines for the banks or bank holding companies it regulates, which set total capital requirements and define capital in terms of core capital elements, or Tier 1 capital; and supplemental capital elements, or Tier 2 capital. Tier 1 capital is generally defined as the sum of the core capital elements less goodwill and certain other deductions, notably the unrealized net gains or losses (after tax adjustments) on available for sale investment securities carried at fair market value. The following items are defined as core capital elements: (i) common shareholders equity; (ii) qualifying non-cumulative perpetual preferred stock and related surplus (not to exceed 25% of tier 1 capital); and (iii) minority interests in the equity accounts of consolidated subsidiaries. At December 31, 2004, 25% of the Companys Tier 1 capital consisted of trust preferred securities, however no assurance can be given that trust preferred securities will continue to be treated as Tier 1 capital in the future. Tier 2 capital can include: (i) allowance for loan and lease losses (but not more than 1.25% of an institutions risk-weighted assets); (ii) perpetual preferred stock and related surplus not qualifying as core capital; (iii) hybrid capital instruments, perpetual debt and mandatory convertible debt instruments; and (iv) term subordinated debt and intermediate-term preferred stock and related surplus (but not more than 50% of Tier 1 capital). The maximum amount of Tier 2 capital that may be recognized for risk-based capital purposes is limited to 100% of Tier 1 capital, net of goodwill.
The minimum required ratio of qualifying total capital to total risk-weighted assets is 8.0% (Total Risk-Based Capital Ratio), at least one-half of which must be in the form of Tier 1 capital, and the minimum required ratio of
Tier 1 capital to total risk-weighted assets is 4.0% (Tier 1 Risk-Based Capital Ratio). Risk-based capital ratios are calculated to provide a measure of capital that reflects the degree of risk associated with a banking organizations operations for both transactions reported on the balance sheet as assets, and transactions, such as letters of credit and recourse arrangements, which are recorded as off-balance sheet items. Under risk-based capital guidelines, the nominal dollar amounts of assets and credit-equivalent amounts of off-balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain U.S. Treasury securities, to 100% for assets with relatively high credit risk, such as unsecured loans. As of December 31, 2004 and 2003, the Banks Total Risk-Based Capital Ratios were 11.63% and 10.15%, respectively, and its Tier 1 Risk-Based Capital Ratios were 10.48% and 9.17%. As of December 31, 2004 and 2003, the consolidated Companys Total Risk-Based Capital Ratios were 13.30% and 10.88%, respectively, and its Tier 1 Risk-Based Capital Ratios were 11.34% and 9.90%.
The risk-based capital requirements also take into account concentrations of credit (i.e., relatively large proportions of loans involving one borrower, industry, location, collateral or loan type) and the risks of non-traditional activities (those that have not customarily been part of the banking business). The regulations require institutions with high or inordinate levels of risk to operate with higher minimum capital standards, and authorize the regulators to review an institutions management of such risks in assessing an institutions capital adequacy.
Additionally, the risk-based capital regulations include interest rate risk as a factor that the regulators will consider in evaluating a banks capital adequacy. Interest rate risk is the exposure of a banks current and future earnings and equity capital to unfavorable changes resulting from fluctuations in interest rates. While interest risk is inherent in a banks role as financial intermediary, it introduces volatility to earnings and to the economic value of the bank.
The FDIC and the Federal Reserve Board also require the calculation of a leverage capital ratio to supplement risk-based capital guidelines. Banks and bank holding companies that have received the highest rating of the five categories used by regulators to rate banks and are not anticipating or experiencing any significant growth must maintain a ratio of Tier 1 capital (net of all intangibles) to adjusted total assets (Leverage Capital Ratio) of at least 3%. All other institutions are required to maintain a leverage ratio of 4% to 5%. Pursuant to federal regulations, banks must maintain capital levels commensurate with the level of risk to which they are exposed, including the volume and severity of problem loans, and federal regulators may set higher capital requirements when a banks particular circumstances warrant. The Banks Leverage Capital Ratios were 8.48% and 8.20% on December 31, 2004 and 2003, respectively. As of December 31, 2004 and 2003, the consolidated Companys leverage capital ratios were 9.20% and 8.87%, respectively, exceeding regulatory minimums.
For more information on the Companys capital, see Part II, Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operation Capital Resources. Risk-based capital ratio requirements are discussed in greater detail in the following section.
Prompt Corrective Action Provisions
Federal law requires each federal banking agency to take prompt corrective action to resolve the problems of insured financial institutions, including but not limited to those that fall below one or more prescribed minimum capital ratios. The federal banking agencies have by regulation defined the following five capital categories: well capitalized (Total Risk-Based Capital Ratio of 10%; Tier 1 Risk-Based Capital Ratio of 6%; and Leverage Ratio of 5%); adequately capitalized (Total Risk-Based Capital Ratio of 8%; Tier 1 Risk-Based Capital Ratio of 4%; and Leverage Ratio of 4%, or 3% if the institution receives the highest rating from its primary regulator); undercapitalized (Total Risk-Based Capital Ratio of less than 8%; Tier 1 Risk-Based Capital Ratio of less than 4%; or Leverage Ratio of less than 4%, or 3% if the institution receives the highest rating from its primary regulator); significantly undercapitalized (Total Risk-Based Capital Ratio of less than 6%; Tier 1 Risk-Based Capital Ratio of less than 3%; or Leverage Ratio less than 3%); and critically undercapitalized (tangible equity to total assets less than 2%). As of December 31, 2004 and 2003, the Bank was deemed to be well capitalized for regulatory capital purposes. A bank may be treated as though it were in the next lower capital category if after notice and the opportunity for a hearing, the appropriate federal agency finds an unsafe or unsound condition or practice so warrants, but no bank may be treated as critically undercapitalized unless its actual capital ratio warrants such treatment.
At each successively lower capital category, an insured bank is subject to increased restrictions on its operations. For example, a bank is generally prohibited from paying management fees to any controlling persons or from making capital distributions if to do so would make the bank undercapitalized. Asset growth and branching restrictions apply to undercapitalized banks, which are required to submit written capital restoration plans meeting specified requirements (including a guarantee by the parent holding company, if any). Significantly undercapitalized banks are subject to broad regulatory authority, including among other things, capital directives, forced mergers, restrictions on the rates of interest they may pay on deposits, restrictions on asset growth and activities, and prohibitions on paying certain bonuses without FDIC approval. Even more severe restrictions apply to critically undercapitalized banks. Most importantly, except under limited circumstances, not later than 90 days after an insured bank becomes critically undercapitalized the appropriate federal banking agency is required to appoint a conservator or receiver for the bank.
In addition to measures taken under the prompt corrective action provisions, insured banks may be subject to potential actions by the federal regulators for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the issuance of cease and desist orders, termination of insurance of deposits (in the case of a bank), the imposition of civil money penalties, the issuance of directives to increase capital, formal and informal agreements, or removal and prohibition orders against institution-affiliated parties.
Safety and Soundness Standards
The federal banking agencies have also adopted guidelines establishing safety and soundness standards for all insured depository institutions. Those guidelines relate to internal controls, information systems, internal audit systems, loan underwriting and documentation, compensation and interest rate exposure. In general, the standards are designed to assist the federal banking agencies in identifying and addressing problems at insured depository institutions before capital becomes impaired. If an institution fails to meet these standards, the appropriate federal banking agency may require the institution to submit a compliance plan and institute enforcement proceedings if an acceptable compliance plan is not submitted.
Premiums for Deposit Insurance
The FDIC regulations also implement a risk-based premium system, whereby insured depository institutions are required to pay insurance premiums depending on their risk classification. Under this system, insured banks are categorized into one of three capital categories (well capitalized, adequately capitalized, and undercapitalized) and one of three supervisory categories based on federal regulatory evaluations. The three supervisory categories are: financially sound with only a few minor weaknesses (Group A), demonstrates weaknesses that could result in significant deterioration (Group B), and poses a substantial probability of loss (Group C). The capital ratios used by the FDIC to define well capitalized, adequately capitalized and undercapitalized are the same in the FDICs prompt corrective action regulations. The current base assessment rates (expressed as cents per $100 of deposits) are summarized as follows:
In addition, banks must pay an amount toward the retirement of Financing Corporation bonds issued in the 1980s to assist in the recovery of the savings and loan industry. This amount fluctuates but for the first quarter of 2005 is 1.44 cents per $100 of insured deposits.
Community Reinvestment Act
The Bank is subject to certain requirements under the Community Reinvestment Act (CRA). The CRA generally requires federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of its
local communities, including low and moderate income neighborhoods. The CRA further requires the agencies to consider a financial institutions efforts in meeting its community credit needs when evaluating applications for, among other things, domestic branches, consummating mergers or acquisitions, or holding company formations. In measuring a banks compliance with its CRA obligations, the regulators utilize a performance-based evaluation system. They determine CRA ratings based on the banks actual lending, service and investment activities, rather than on the extent to which the institution conducts needs assessments, documents community outreach activities or complies with other procedural requirements. In connection with its assessment of CRA performance, the FDIC assigns a rating of outstanding, satisfactory, needs to improve or substantial noncompliance. The Bank was last examined for CRA compliance in July 2004 when it received a satisfactory CRA Assessment Rating.
Other Consumer Protection Laws and Regulations
The bank regulatory agencies are increasingly focusing attention on compliance with consumer protection laws and regulations. Examination and enforcement has become intense, and banks have been advised to carefully monitor compliance with various consumer protection laws and regulations. The federal Interagency Task Force on Fair Lending issued a policy statement on discrimination in home mortgage lending describing three methods that federal agencies will use to prove discrimination: overt evidence of discrimination, evidence of disparate treatment, and evidence of disparate impact. In addition to CRA and fair lending requirements, the Bank is subject to numerous other federal consumer protection statutes and regulations. Due to heightened regulatory concern related to compliance with consumer protection laws and regulations generally, the Bank may incur additional compliance costs or be required to expend additional funds for investments in the local communities it serves.
Interstate Banking and Branching
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the Interstate Banking Act) regulates the interstate activities of banks and bank holding companies and establishes a framework for nationwide interstate banking and branching. Since June 1, 1997, a bank has generally been permitted to merge with a bank in another state without the need for explicit state law authorization. However, states were given the ability to prohibit interstate mergers with banks in their own state by opting-out (enacting state legislation applying equality to all out-of-state banks prohibiting such mergers) prior to June 1, 1997.
Since 1995, adequately capitalized and managed bank holding companies have been permitted to acquire banks located in any state, subject to two exceptions: first, any state may still prohibit bank holding companies from acquiring a bank which is less than five years old; and second, no interstate acquisition can be consummated by a bank holding company if the acquirer would control more than 10% of the deposits held by insured depository institutions nationwide or 30% percent or more of the deposits held by insured depository institutions in any state in which the target bank has branches. A bank may establish and operate de novo branches in any state in which the bank does not already maintain a branch if that state has enacted legislation to expressly permit all out-of-state banks to establish branches in that state.
In 1995 California enacted legislation to implement important provisions of the Interstate Banking Act discussed above and to repeal Californias previous interstate banking laws, which were largely preempted by the Interstate Banking Act.
The changes effected by Interstate Banking Act and California laws have increased competition in the environment in which the Bank operates to the extent that out-of-state financial institutions directly or indirectly enter the Banks market areas. It appears that the Interstate Banking Act has contributed to accelerated consolidation within the banking industry.
Financial Modernization Act
Effective March 11, 2000, the Gramm-Leach-Bliley Act (also known as the Financial Modernization Act) enabled full affiliations to occur between banks and securities firms, insurance companies, and other financial service providers. This legislation permits bank holding companies to become financial holding companies and thereby
acquire securities firms and insurance companies and engage in other activities that are financial in nature. A bank holding company may become a financial holding company if each of its subsidiary banks is well capitalized and well managed under applicable definitions, and has at least a satisfactory rating under the CRA, by filing a declaration that the bank holding company wishes to become a financial holding company. No regulatory approval will be required for a financial holding company to acquire a company, other than a bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board. The Company has no current intention of becoming a financial holding company, but may do at some point in the future if deemed appropriate in view of opportunities or circumstances at the time.
The Financial Modernization Act defines financial in nature to include securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agency; merchant banking activities; and activities that the Board has determined to be closely related to banking. A national bank (and therefore, a state bank as well) may also engage, subject to limitations on investment, in activities that are financial in nature, other than insurance underwriting, insurance company portfolio investment, real estate development and real estate investment, through a financial subsidiary of the bank, if the bank is well capitalized, well managed and has at least a satisfactory CRA rating. Subsidiary banks of a financial holding company or national banks with financial subsidiaries must continue to be well capitalized and well managed in order to continue to engage in activities that are financial in nature without regulatory actions or restrictions, which could include divestiture of financial subsidiaries. In addition, a financial holding company or a bank may not acquire a company that is engaged in activities that are financial in nature unless each of the subsidiary banks of the financial holding company or the bank has a CRA rating of satisfactory or better.
The Financial Modernization Act also imposes extensive requirements on financial institutions with respect to the privacy of customer information, and modifies other existing laws, including those related to community reinvestment.
USA Patriot Act of 2001
On October 26, 2001, President Bush signed the USA Patriot Act of 2001 (the Patriot Act). Enacted in response to the terrorist attacks in New York, Pennsylvania and Washington, D.C. on September 11, 2001, the Patriot Act is intended to strengthen the ability of U.S. law enforcement agencies and intelligence communities to work cohesively to combat terrorism on a variety of fronts. The impact of the Act on financial institutions is significant and wide ranging. The Act contains sweeping anti-money laundering and financial transparency laws and requires various regulations applicable to financial institutions, including:
The Company has incorporated the requirements of the Patriot Act into its operating procedures, and while these requirements have resulted in an additional time burden the financial impact on the Company is difficult to quantify.
Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley) was enacted to increase corporate responsibility, provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies, and protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. Sarbanes-Oxley includes important new requirements for public companies in the areas of financial disclosure, corporate governance, and the independence, composition and responsibilities of audit committees. Among other things, Sarbanes-Oxley mandates chief executive and chief financial officer certifications of periodic financial reports, additional financial disclosures concerning off-balance sheet items, and speedier transaction reporting requirements for executive officers,
directors and 10% shareholders. In addition, penalties for non-compliance with the Exchange Act were heightened. SEC rules promulgated pursuant to Sarbanes-Oxley impose obligations and restrictions on auditors and audit committees intended to enhance their independence from management, and include extensive additional disclosure, corporate governance and other related rules. Sarbanes-Oxley represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees.
The Company has not experienced any significant difficulties in complying with Sarbanes-Oxley. However, the Company has incurred, and expects to continue to incur, significant costs in connection with its compliance with Section 404 of Sarbanes-Oxley, which requires management to undertake an assessment of the adequacy and effectiveness of the Companys internal controls over financial reporting and requires the Companys auditors to attest to, and report on, managements assessment and the operating effectiveness of these controls. The amount spent specifically for compliance with Sarbanes-Oxley Section 404 totaled close to $300,000 in 2004.
Other Pending and Proposed Legislation
Other legislative and regulatory initiatives which could affect the Company, the Bank and the banking industry in general are pending, and additional initiatives may be proposed or introduced before the United States Congress, the California legislature and other governmental bodies in the future. Such proposals, if enacted, may further alter the structure, regulation and competitive relationship among financial institutions, and may subject the Bank to increased regulation, disclosure and reporting requirements. In addition, the various banking regulatory agencies often adopt new rules and regulations to implement and enforce existing legislation. It cannot be predicted whether, or in what form, any such legislation or regulations may be enacted or the extent to which the business of the Company or the Bank would be affected thereby.
Statements and financial discussion and analysis by management contained throughout this report that are not historical facts are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve a number of risks and uncertainties. Factors that could cause actual results to differ materially from forward-looking statements herein include, without limitation, the factors set forth below.
Poor Economic Conditions in Our Market Areas May Cause Us to Suffer Higher Default Rates on Our Loans and Leases. A substantial majority of our assets and deposits are generated in the San Joaquin Valley in central California. As a result, poor economic conditions in this region could cause us to incur losses associated with higher default rates and decreased collateral values in our loan portfolio. The local economy currently appears to be experiencing a moderate expansion, and while the Company expects continued improvement, no assurance can be given that this will occur.
The San Joaquin Valley has not experienced the same type of growth that has historically occurred in other areas of California, especially those where high-tech industries have taken hold. While this fact minimized the negative impact of the most recent recession, unemployment levels are still relatively high. In the Visalia-Tulare-Porterville Metropolitan Statistical Area (MSA), for example, which is our geographic center and the base of our agriculturally oriented communities, the unemployment rate has consistently averaged around 15.5% for the past several years. While unemployment levels remain relatively high in all of the Companys markets, in recent years some areas in the south and central San Joaquin Valley have experienced substantial commercial growth. The areas relatively inexpensive real estate and central proximity to both Southern and Northern California have attracted a growing number of warehouse and distribution facilities, as well as manufacturing, health, and other service companies. The low cost of housing has also drawn retirees from more expensive areas of California.
Poor Economic Conditions Affecting the Agricultural Industry Could Have an Adverse Effect on Our Customers and Their Ability to Make Payments to Us. The Companys balance of non-performing assets has been relatively high in years past due in large part to persistent agricultural difficulties. Furthermore, a sizable portion of our total loan portfolio consists of loans to borrowers either directly or indirectly involved in the agricultural industry. While a great number of our borrowers may not be individually involved in agriculture, many of the jobs in the San Joaquin Valley are ancillary to the regular production, processing, marketing and sales of agricultural commodities. The ripple effect of lower commodity prices for milk, nuts, olives, grapes, oranges and tree fruit has a tendency to depress land prices, lower borrower income, and decrease collateral values. Weather patterns in particular are of critical importance to row crop, tree fruit, and orange production. A degenerative cycle of weather and commodity prices can impact consumer purchasing power, which has the potential to create further unemployment throughout the San Joaquin Valley. Global competition is another significant issue affecting the agricultural industry. Because of increased global competition and other factors, excess supply and low prices currently characterize the markets for many agricultural products. If current agricultural conditions do not improve, our level of non-performing assets could increase. Such conditions have affected and may continue to adversely affect our borrower base and, by extension, our business.
Concentrations of Real Estate Loans Could Subject Us to Increased Risks in the Event of a Real Estate Recession or Natural Disaster. Our loan portfolio is heavily concentrated in real estate loans, particularly commercial real estate. At December 31, 2004, 72% of our loan portfolio consisted of loans secured by real estate. Between the end of 2000 and the end of 2004, our loans secured by commercial/professional office properties (including construction and development loans) increased from 39% to 48% of total loans, while loans secured by residential properties have decreased from 24% to 18%. In the early 1990s, the entire state of California experienced an economic recession that particularly impacted real estate values and resulted in increases in the level of delinquencies and losses for many financial institutions. Much of our market area seems to have been insulated from the significant fluctuations in real estate prices experienced by other parts of California over the past few decades. However, if a similar real estate recession affects our market areas in the future, the collateral for many of our loans could be reduced in value and the ability of some of our borrowers to pay could decline. Similarly, the occurrence of a natural disaster like those California has experienced in the past, including earthquakes, brush fires, and flooding, could impair the value of the collateral we hold for real estate secured loans and negatively impact our results of operations.
We May Have Difficulty Managing Our Growth. Management intends to leverage the Companys current infrastructure to grow assets, and the addition of new branches has been tentatively planned, although no assurance can be given that this strategy will result in significant growth. Our ability to manage growth will depend primarily on our ability to:
If we fail to achieve these objectives in an efficient and timely manner we may experience disruptions in our business plans, and our financial condition and results of operations could be adversely affected.
Our Earnings are Subject to Interest Rate Risk. The earnings of most financial institutions depend largely on the relationship between the cost of funds, primarily deposits and borrowings, and the yield on earning assets such as loans and investment securities. This relationship, known as the interest rate spread, is subject to fluctuation and is affected by economic, regulatory and competitive factors that influence interest rates, the volume and mix of interest-earning assets and interest-bearing liabilities, and the level of non-performing assets. Many of these factors are beyond our control. Fluctuations in interest rates affect the demand of customers for our products and services, and the Company is subject to interest rate risk to the degree that our interest-bearing liabilities re-price or mature more slowly or more rapidly or on a different basis than our interest-earning assets. Given the current volume, mix, and re-pricing characteristics of the Companys interest-bearing liabilities and interest-earning assets, our interest rate
spread should not change significantly if interest rates rise or fall. However, there are scenarios where fluctuations in interest rates in either direction could have a negative effect on net income. For example, if funding rates rise faster than asset yields in a rising rate environment (i.e., if basis compression occurs), or if we do not actively manage certain loan index rates in a declining rate environment, we would be negatively impacted.
We Operate in a Competitive Market Dominated by Banks and Other Financial Services Providers, Many of Which Have Lower Cost Structures and Offer More Services. In California generally, and in our primary service area specifically, branches of major banks dominate the commercial banking industry. By virtue of their larger capital base, such institutions have substantially greater lending limits than we do, and perform certain functions for their customers, including trust services and international banking, which we are not equipped to offer directly (but some of which we offer indirectly through correspondent relationships). Many of these banks also operate with economies of scale that result in lower operating costs relative to revenue generated.
We also compete with other financial institutions such as savings and loan associations, credit unions, thrift and loan companies, mortgage companies, securities brokerage companies and insurance companies, and with quasi-financial institutions such as money market funds for deposits and loans. Financial services like ours are increasingly offered over the Internet on a national and international basis, and we compete with providers of these services as well. Ultimately, competition can drive down our interest margins and reduce our profitability. It can also make it more difficult for us to continue to increase the size of our loan and deposit portfolios.
You May Have Difficulty Selling Your Shares in the Future If a More Active Trading Market for Our Stock Does Not Develop. Although Sierra Bancorps Common Stock has been listed on the Nasdaq National Market since August 10, 2001 (the effective date of the holding company reorganization) and Bank of the Sierras Common Stock was previously listed on the Nasdaq National Market since June 10, 1999, trading in our stock has not been extensive and cannot be characterized as amounting to an active trading market.
We May Experience Loan and Lease Losses in Excess of Our Allowance for Loan and Lease Losses. We are careful in our loan underwriting process in order to limit the risk that borrowers might fail to repay; nevertheless, losses can and do occur. We create an allowance for estimated loan and lease losses in our accounting records, based on estimates of the following:
We maintain an allowance for loan and lease losses at a level that we believe is adequate to absorb any specifically identified losses as well as any other losses inherent in our loan portfolio. However, changes in economic, operating and other conditions, including changes in interest rates, that are beyond our control, may cause our actual loan losses to exceed our current allowance estimates. If actual losses exceed the amount reserved, it will have a negative impact on our profitability. In addition, the FDIC and the DFI, as part of their supervisory functions, periodically review our allowance for loan and lease losses. Such agencies may require us to increase our provision for loan and lease losses or to recognize further losses, based on their judgments, which may be different from those of our management. Any increase in the allowance required by the FDIC or the DFI could also hurt our business.
Our Directors and Executive Officers Control a Near-Majority of Our Stock, and Your Interests May Not Always be the Same as Those of the Board and Management. As of December 31, 2004, our directors and executive officers, together with their affiliates, beneficially owned approximately 48% of the Banks outstanding voting stock (including vested option shares). As a result, if all of these shareholders were to take a common position, they could most likely control the outcome of most corporate actions, such as:
In some situations, the interests of our directors and executive officers may be different from yours. However, our Board of Directors and executive officers have a fiduciary duty to act in the best interests of the shareholders, rather than in their own best interests, when considering a proposed business combination or any of these types of matters.
Provisions in Our Articles of Incorporation Will Delay or Prevent Changes in Control of Our Corporation or Our Management. These provisions make it more difficult for another company to acquire us, which could reduce the market price of our common stock and the price that you receive if you sell your shares in the future. These provisions include the following:
ITEM 2. PROPERTIES
The Companys administrative headquarters is located at 86 North Main Street, Porterville, California, and is leased through April 2014 from parties unrelated to the Company. It consists of approximately 37,000 square feet in a three-story building of which the Company is sole occupant, and the rent as of December 31, 2004 was $11,082 per month. The Company also owns unencumbered property on which 13 of its 18 current branches are located, including the branches in Porterville, Lindsay, Exeter, Three Rivers, Dinuba, Tulare, Hanford, Tehachapi, and California City. One of the Fresno branches is owned while the other is leased from unrelated parties, as is the case in Bakersfield. Both Visalia branches and the Clovis branch are leased from unrelated parties. In addition, the Company operates a technology center in Porterville which consists of approximately 12,000 square feet in a freestanding single-story building that is leased from unrelated parties. The Bank has six remote ATM locations leased from unrelated parties, although the amount of monthly rent at these locations is minimal.
Management believes that the Companys existing back office facilities are adequate to accommodate the Companys operations for the immediately foreseeable future, although limited branch expansion is planned.
ITEM 3. LEGAL PROCEEDINGS
From time to time, the Company is a party to claims and legal proceedings arising in the ordinary course of business. After taking into consideration information furnished by counsel to the Company as to the current status of these claims or proceedings to which the Company is a party, management is of the opinion that the ultimate aggregate liability represented thereby, if any, will not have a material adverse affect on the financial condition of the Company.
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
(a) Market Information
Sierra Bancorps Common Stock trades on the Nasdaq National Market under the symbol BSRR, and the CUSIP number for our stock is #82620P102. Trading in the Common Stock of the Company has not been extensive and such trades cannot be characterized as amounting to an active trading market. Management is aware of the following securities dealers which make a market in the Companys stock: Brokerage America, New York; Citigroup Global Markets, New York; FTN Midwest Research, Memphis; GVR Company, Chicago; Hill, Thompson, Magid and Co., Chicago; Hoefer & Arnett, San Francisco; Howe Barnes Investments, Chicago; Keefe, Bruyette & Woods, New York; Knight Securities, Jersey City, New Jersey; Merrill Lynch, New York; Monroe Securities, Chicago; Morgan Stanley, New York; Sandler ONeill, New York; The Seidler Companies, Inc., Big Bear, California; Susquehanna Capital Group, Pennsylvania (the Securities Dealers); and UBS Capital Markets, Jersey City, New Jersey.
The following table summarizes trades of the Companys Common Stock, setting forth the approximate high and low sales prices and volume of trading for the periods indicated, based upon information provided by public sources.
On February 20, 2005 there were approximately 2,228 shareholders of the Companys Common Stock. Shareholders of record at the Companys stock transfer agent totaled 674, while street name holders totaled about 1,554.
As a bank holding company that currently has no significant assets other than its equity interest in the Bank, the Companys ability to declare dividends depends primarily upon dividends it receives from the Bank. The Banks dividend practices in turn depend upon legal restrictions, the Banks earnings, financial position, current and anticipated capital requirements, and other factors deemed relevant by the Banks Board of Directors at that time.
The Company paid cash dividends totaling $3.5 million, or $0.37 per share in 2004, and $3.3 million or $0.36 per share in 2003, representing 34% and 38%, respectively, of the prior years earnings. The Companys general dividend policy is to pay cash dividends at approximate peer levels, provided that such payments do not adversely affect the Companys financial condition and are not overly restrictive to its growth capacity. However, no assurance can be given that earnings and/or growth expectations in any given year will justify the payment of such a dividend.
During any period in which the Company has deferred payment of interest otherwise due and payable on its subordinated debt securities, it may not make any dividends or distributions with respect to its capital stock (see Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations Capital Resources).
The power of the Banks Board of Directors to declare cash dividends is also subject to statutory and regulatory restrictions which limit the amount available for cash dividends depending upon the earnings, financial condition and cash needs of the Bank, as well as general business conditions. Under California banking law, the Bank may declare dividends in an amount not exceeding the lesser of its retained earnings or its net income for the last three years (reduced by dividends paid during such period) or, with the prior approval of the California Commissioner of Financial Institutions, in an amount not exceeding the greatest of (i) the retained earnings of the Bank, (ii) the net income of the Bank for its last fiscal year, or (iii) the net income of the Bank for its current fiscal year. The payment of any cash dividends by the Bank will depend not only upon the Banks earnings during a specified period, but also on the Bank meeting certain regulatory capital requirements.
The Companys ability to pay dividends is also limited by state corporation law. The California General Corporation Law prohibits the Company from paying dividends on the Common Stock unless: (i) its retained earnings, immediately prior to the dividend payment, equals or exceeds the amount of the dividend or (ii) immediately after giving effect to the dividend the sum of the Companys assets (exclusive of goodwill and deferred charges) would be at least equal to 125% of its liabilities (not including deferred taxes, deferred income and other deferred liabilities) and the current assets of the Company would be at least equal to its current liabilities, or, if the average of its earnings before taxes on income and before interest expense for the two preceding fiscal years was less than the average of its interest expense for the two preceding fiscal years, at least equal to 125% of its current liabilities.
(d) Stock Repurchases
The Company has a stock repurchase program that has been in effect since July 1, 2003, which allows the repurchase of up to 250,000 shares at managements discretion. The following table provides information concerning the Companys repurchases of its Common Stock during the fourth quarter of 2004:
ITEM 6. SELECTED FINANCIAL DATA
The following table presents selected historical financial information concerning the Company1, which should be read in conjunction with our audited consolidated financial statements, including the related notes and Managements Discussion and Analysis of Financial Condition and Results of Operations, included elsewhere herein. The selected financial data as of December 31, 2004 and 2003, and for each of the years in the three year period ended December 31, 2004, is derived from our audited consolidated financial statements and related notes which are included in this Annual Report. The selected financial data for prior years is derived from our audited financial statements which are not included in this Annual Report.
Selected Financial Data
As of and for the years ended December 31,
(Dollars in thousands, except per share data)
ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This discussion presents Managements analysis of the financial condition of the Company as of December 31, 2004 and December 31, 2003, and the results of operations for each of the years in the three-year period ended December 31, 2004. The discussion should be read in conjunction with the Consolidated Financial Statements of the Company and the Notes related thereto presented elsewhere in this Form 10-K Annual Report (see Item 8 below).
Statements contained in this report or incorporated by reference that are not purely historical are forward looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 as amended, including the Companys expectations, intentions, beliefs, or strategies regarding the future. All forward-looking statements concerning economic conditions, growth rates, income, expenses, or other values as may be included in this document are based on information available to the Company on the date noted, and the Company assumes no obligation to update any such forward-looking statements. It is important to note that the Companys actual results could materially differ from those in such forward-looking statements. Factors that could cause actual results to differ materially from those in forward-looking statements include but are not limited to fluctuations in interest rates, inflation, government regulations, economic conditions, customer disintermediation and competitive product and pricing pressures in the geographic and business areas in which the Company conducts its operations.
Critical Accounting Policies
The Companys financial statements are prepared in accordance with accounting principles generally accepted in the U.S. The financial information contained within these statements is, to a significant extent, based on approximate measures of the financial effects of transactions and events that have already occurred. Critical accounting policies are those that involve the most complex and subjective decisions and assessments, and have the greatest potential impact on the Companys stated results of operations. In Managements opinion, the Companys critical accounting policies deal with the following areas: The establishment of the Companys allowance for loan losses, as explained in detail in the Provision for Loan Losses and Allowance for Loan Losses sections of this discussion and analysis; loan origination costs, which are estimated in aggregate by loan type based on an annual evaluation of expenses (primarily salaries and benefits) associated with successful loan originations and are allocated to individual loans as they are booked, but can actually vary significantly for individual loans depending on the characteristics of such loans; estimated residual values on leases, which have the potential to vary significantly from actual market values at lease termination; and depreciation expense, especially on technology equipment due to the potential impact of unexpected changes in the useful life of such equipment.
Summary of Performance
The Company achieved record earnings in 2004. In fact, net income has increased in 20 of the last 21 years. Net income in 2004 was $13.3 million, an increase of almost $3.0 million, or 29%, over the $10.4 million in net earnings recognized in 2003. Net income in 2003 was $1.5 million higher than 2002 net earnings of $8.8 million. Net income per basic share was $1.41 for 2004, as compared to $1.12 during 2003 and $0.96 in 2002. The Companys Return on Average Assets was 1.47% and Return on Average Equity was 20.50% in 2004, as compared to 1.43% and 18.34%, respectively in 2003, and 1.32% and 17.59%, respectively for 2002.
The most significant single event impacting the Companys results of operations and financial condition in 2004 was the implementation of a leverage strategy. This involved the purchase of over $100 million in mortgage-backed securities that are guaranteed by agencies of the Federal Government, with the bulk of the purchase occurring on April 20, 2004. The purchase was financed primarily with collateralized borrowings from the Federal Home Loan Bank (FHLB), with original maturities ranging from overnight to five years. The leverage transaction also included the purchase of more than $4 million in FHLB stock, a dividend-yielding investment that was necessary to facilitate the increased level of borrowings from that institution. Based on the expected average life of the mortgage-backed securities, we anticipate the return of the majority of invested principal within five years and thus effectively view this as a five-year strategy.
The net interest margin for this transaction averaged an annualized 175 basis points during 2004, although it fluctuates with variances in the amortization of purchase premiums caused by changes in the level of prepayments on the mortgage-backed securities. Net interest income generated by the transaction in 2004 was $1.2 million, which boosted the Companys return on average equity by almost 100 basis points. Because of the addition of a significant level of assets, however, return on average assets for 2004 was approximately 4 basis points lower than it otherwise would have been.
Projected cash flows on the asset and liability sides of the leverage transaction have been matched as closely as possible, however the principal on the mortgage-backed securities could prepay either slower or faster than expected. This introduces a certain level of interest rate risk into the transaction. While no assurance can be given that any specific level of income will be maintained, management evaluated potential risks and rewards and concluded that it was in the best interest of the Company to implement this strategy. It is possible that should interest rate conditions be conducive to a similar undertaking in the future, the Company could purchase additional securities as the balance invested under the current strategy declines.
The following are other noteworthy factors relevant to the Companys results of operations for the most recent three years:
The following are important factors in understanding our financial condition and liquidity, which remain strong:
Results of Operations
The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on interest-bearing liabilities. The second is non-interest income, which primarily consists of customer service charges and fees but also comes from non-customer sources such as loan sales, bank-owned life insurance, and gains on sales from the Companys investment portfolio. The majority of the Companys non-interest expenses are operating costs that relate to providing a full range of banking services to our customers.
Net Interest Income and Net Interest Margin
Net interest income was $43.7 million in 2004, compared to $35.7 million in 2003 and $33.0 million in 2002. This represents an increase of 22% in 2004 over 2003, and an increase of 8% in 2003 over 2002. The level of net interest income depends on several factors in combination, including growth in earning assets, yields on earning assets, the cost of interest-bearing liabilities, the relative volume of total earning assets and total interest-bearing liabilities, and the mix of products which comprise the Companys earning assets, deposits, and other interest-bearing liabilities.
The following Volume and Rate Variances table sets forth the dollar difference in interest earned and paid for each major category of interest-earning assets and interest-bearing liabilities for the noted periods, and the amount of such change attributable to changes in average balances (volume) or changes in average interest rates. Volume variances are equal to the increase or decrease in the average balance times the prior period rate, and rate variances are equal to the increase or decrease in the average rate times the current period average balance. Variances attributable to both volume and rate changes and the variance created by the additional day in 2004 (a leap year) have been allocated to the change in rate.
As shown in the table, volume variances in 2004 relative to 2003 contributed $8.0 million to net interest income, while unfavorable changes in interest rates offset the favorable volume variance by $90,000 for a net increase of $7.9 million in net interest income. The positive volume variance is mainly due to growth in average earning assets, but the volume variance is also impacted by fluctuations in the relative levels of non-earning assets (including cash and due from banks) and non-interest liabilities (including demand deposits). Average non-earning assets fell to 10% of average total assets in 2004 from 12% in the previous year. The average balance of demand deposits, shareholders equity and other liabilities kept pace with growth in average assets, and was at 32% of total average assets for both 2004 and 2003. The reduction in the relative level of non-earning assets contributed to the Companys profitability in 2004. Note that the volume increase in earning assets added $9.4 million to interest income, while the volume increase in interest-bearing liabilities added only $1.3 million to interest expense.
The impact of the leverage strategy can be seen in taxable investments on the asset side, and short-term and long-term borrowings on the liability side. It contributed to the positive volume variance, but had a negative impact on the rate variance. Without the leverage strategy the net rate variance would have been positive, since rate variances caused loan income to decline by only $153,000 but contributed to a $1.1 million drop in interest expense paid on deposits.
The following Distribution, Rate and Yield table shows, for each of the past three years, the annual average balance for each principal balance sheet category, and the amount of interest income or interest expense associated with that category. This table also shows the yields earned on each component of the Companys investment and loan portfolio, the average rates paid on each segment of the Companys interest bearing liabilities, and the Companys net interest margin. The Companys net interest margin, which is tax-equivalent net interest income expressed as a percentage of average earning assets, was 5.46% in 2004. This represents a decline of 24 basis points relative to the 5.71% margin reported for 2003.
A substantial portion of the Companys earning assets are variable-rate loans that re-price immediately when the Companys prime lending rate is changed, versus a large base of core deposits that are generally slower to re-price. This timing difference causes the Company to be slightly asset-sensitive, which means that all else being equal, the
Companys net interest margin will be lower during periods when short-term interest rates are falling and higher when rates are rising. In 2004, as market interest rates were generally increasing, the Companys net interest margin would have increased by approximately 11 basis points to 5.82% if not for the impact of the leverage strategy. In 2003, shorter-term interest rates continued their declining trend of the previous two years, however the establishment of informal floors on certain variable loan rates minimized the impact of falling rates on net interest income. The converse of this hedge for declining rates is that net interest income did not increase as rapidly as it might otherwise have done as rates inched up during 2004. In 2002, floors on loan rates and aggressive reductions in the pricing of deposit products resulted in a fairly consistent net interest margin.
In 2004, the Companys average loan portfolio grew by $86 million, or 16%, with earnings on that growth, net of associated funding costs, providing a considerable contribution to net interest income. With the implementation of the leverage strategy, however, loan balances, which are the highest yielding component of the Companys earning assets, have become a smaller percentage of the Companys average asset base, declining to 70% of assets in 2004 from 76% in 2003. Conversely, average investment balances have increased relative to total assets, to 19% in 2004 from 12% in 2003.
A positive impact on the Companys net interest margin in 2004 resulted from relatively large increases in the average balance of non-interest demand deposits and low-interest savings deposits, which together increased to 38% of average total deposits from 34% in 2003. Enhanced cross-selling efforts and marketing campaigns targeting checking accounts were in effect during much of the year, which contributed to the increase in demand deposit balances in 2004. Because of the leverage strategy and the issuance of additional trust preferred securities, however, relatively higher-cost borrowed funds increased to 14% of total average assets in 2004 from 5% in 2003. In 2003 and 2002 there was a favorable shift in the mix of both the Companys deposits and other interest-bearing liabilities, which helped boost the Companys net interest margin in those years.
Management anticipates that the Companys current net interest margin will not vary significantly under any likely interest rate scenario, and net interest income will continue to increase if loans grow as planned and the loan growth is funded by reasonably priced deposits. However, no assurance can be given that this will, in fact, occur.
Provision for Loan and Lease Losses
Credit risk is inherent in the business of making loans. The Company sets aside an allowance or reserve for loan and lease losses through charges to earnings, which are shown in the income statement as the provision for loan and lease losses. Specifically identifiable and quantifiable losses are immediately charged off against the allowance. The loan and lease loss provision is determined by conducting a monthly evaluation of the adequacy of the Companys allowance for loan and lease losses, and charging the shortfall, if any, to the current months expense. This has the effect of creating variability in the amount and frequency of charges to the Companys earnings. The procedures for monitoring the adequacy of the allowance, as well as detailed information concerning the allowance itself, are included below under Allowance for Loan and Lease Losses.
The Companys provision for loan and lease losses was $3.5 million in 2004, $3.1 million in 2003, and $3.4 million in 2002. In 2004, the provision was $368,000, or 12%, higher than in the previous year despite lower charge-offs and a substantial reduction in non-performing loan balances, due primarily to reserves provided for growth in outstanding loan balances. Because the provision exceeded net charge-offs in 2004, the allowance for loan losses increased by over $2 million during the year. Subsequent to a thorough review of the allowance relative to the current size and composition of the Companys loan and lease portfolio, this increase has been judged by management to be adequate to maintain the allowance at an appropriate level.
Non-interest Income and Non-interest Expense
The Companys results reflect a decline of $161,000, or 2%, in non-interest income for 2004 relative to 2003, mainly because weak growth in service charges on deposits was not substantial enough to offset the aforementioned adverse
adjustment to BOLI income. Non-interest income was $10.3 million in 2004 and $10.4 million in 2003, and declined to 1.3% from 1.6% of average earning assets. Non-interest expense was $29.9 million in 2004 versus $28.3 million in 2003, an increase of $1.6 million, or 6%. However, for those same periods non-interest expense declined as a percentage of average earning assets, falling to 3.7% in 2004 from 4.4% in 2003. Because the increase in net interest plus other income in 2004 was proportionately greater than the increase in non-interest expenses, the Companys overhead efficiency ratio improved substantially. The overhead efficiency ratio represents total non-interest expense divided by the sum of net interest and non-interest income. The provision for loan and lease losses is not factored into the equation. Calculated on a tax-equivalent basis, the Companys overhead efficiency ratio was 54.6% in 2004 as compared to 59.7% in 2003. The following table sets forth the major components of the Companys non-interest income and non-interest expense for the years indicated:
The primary sources of non-interest income for the Company include the following: Service charges on deposit accounts; credit card fees; other service charges, commissions, and fees including ATM fees, check card interchange fees, operating lease income, and other miscellaneous income; income from bank-owned life insurance; gains on the sale of loans; and loan servicing income. At times, the Company has also realized substantial gains on the sale of investment securities and from the sale of loan servicing rights.
While it would appear on the surface that BOLI income has declined in significance relative to overall non-interest income, this is mainly due to a fourth quarter adjustment that reduced BOLI income by $295,000. The income adjustment stems from certain BOLI accounts that had been carried on the Companys books gross of potential surrender charges, but which were written down in 2004 to reflect such surrender charges. While it has not been our intent to sell or otherwise liquidate those policies, and the surrender charges diminish over time and ultimately disappear, accounting guidance received in late 2004 indicated that all BOLI should be reflected on our balance sheet net of any potential surrender charges. A lower average earnings rate on our aggregate BOLI investment during 2004 caused an additional $150,000 decline in BOLI income.
The decline in BOLI income makes other non-interest categories appear to have strengthened their contribution to total non-interest income, however for deposit service charges in particular growth has been virtually nonexistent. Despite fairly significant increases in average transaction account balances, and even though returned item and overdraft charges, a large component of deposit service charges, increased by $532,000, or 17%, service charges on deposit accounts show little change in dollar volume and declined as a percentage of transaction accounts in 2004 relative to 2003. The Companys ratio of service charge income to average transaction accounts (demand and interest-bearing NOW accounts) was 2.3% in 2004 as compared to 2.7% in both 2003 and 2002. This phenomenon is due to growth in accounts that are initially free of service charges. Most financial institutions in the Companys market areas have similar free account offerings, and management views this as a defensive product. The negative service charge impact is overcome by the fact that they provide interest-free funding, expand the Companys customer base, and increase cross-sell opportunities for other Bank products such as consumer loans and relatively low-cost savings accounts.
Other service charges, commissions, and fees also constitute a large portion of non-interest income, and totaled $2.1 million in 2004, $1.9 million in 2003, and $1.0 million in 2002. The largest single increase within this category in 2004 was a $275,000 increase in leasing income, followed by ATM fees and charges which were $164,000 higher. The largest decline was a $96,000 drop in referral fees on mortgage loans, due to weakening mortgage loan activity.
Income from loan sales was $330,000 in 2004, $267,000 in 2003, and $658,000 in 2002. While the Company still originates and sells a certain number of residential mortgage loans (primarily those associated with its all-in-one construction through permanent financing product), in March of 2002 the Company restructured its mortgage lending group to reduce expenses and began outsourcing the majority of its residential mortgage loan origination services to Moneyline Lending, Inc. This resulted in a drop-off in loan sales income, although Moneyline pays the Company referral fees for successfully closed loans. As noted above, Moneyline fees are reflected in other service charges, commissions and fees. With the sale of most of the Companys loan servicing portfolio in 2001, loan servicing income has become less significant and was only $130,000 in 2004, $162,000 in 2003 and $217,000 in 2002.
Gains from the sale of investment securities were negligible in 2004. The $118,000 gain on investment securities in 2003 is primarily comprised of liquidating dividends resulting from the Companys investment in Sphinx, as that company completed its planned dissolution. Sphinx was the shell company remaining after selling its primary earning asset, a core banking system known as Phoenix which was the prior core system utilized by the Company. Other gains from municipal bonds called in 2003 were offset by the Companys write-off of its $40,000 investment in California Bankers Insurance Agency, subsequent to the receipt from them of correspondence alerting the Company to their dissolution. The $280,000 gain in 2002 was also largely due to liquidating dividends from Sphinx.
The other category in non-interest income includes $110,000 in non-recurring gains from the sale of Other Real Estate Owned in 2004, and approximately $175,000 in such gains in 2003. This category also includes rental income from Investment Centers of America, which is in the form of percentage rents based on gross commissions generated, and which did not increase significantly in 2004.
Typically, the largest dollar increase for any single non-interest expense category is in salaries and employee benefits. However, in 2004 this category increased by only $33,000, or 0.2%, relative to 2003. This was in part the result of a $1.2 million increase in salaries related directly to successful loan originations, which were deferred pursuant to FAS 91 and are subsequently being amortized as a reduction of yield over the life of the loans to which they relate. Excluding the impact of deferred loan origination costs, salaries increased by about $729,000, or 6%, which represents a relatively modest increase in view of the branch addition and the enhancement of support staff in 2004. Employee benefits increased by a disproportionate $467,000, or 13%, in 2004, primarily because of a $174,000, or 15%, increase in group health insurance premiums, and a $157,000, or 40%, increase in workers compensation costs.
In 2003 the cost of salaries and benefits increased by 19% relative to the previous year due to regular annual increases of about 5%, plus staff additions and higher benefits costs. The increase includes staffing costs for the branch added in June 2003, and reflects a full year of item processing personnel who came on board in August of 2002. Furthermore, there were selective staff additions in our branches to boost business development activities, and back office staff additions to enhance customer service. The increase in 2003 also includes an approximate $400,000 increase in accruals for salary continuation agreements, which were adopted for certain key employees in the fourth quarter of 2002 in conjunction with the Companys purchase of BOLI. As intended, however, BOLI income more than offset expense accruals for salary continuation agreements and the directors retirement plan. Expenses in 2003 were also impacted by the rising cost of benefits, with workers compensation premiums nearly doubling and group health insurance costs up substantially.
Based on market analysis and peer comparisons, it is managements opinion that the Company can achieve future growth in loans and deposits with staff additions limited to minimum requirements for new branches and nominal growth in support staff. Thus, it is expected that salaries and employee benefits will decline somewhat as a percentage of earning assets over the next few years, although there is no guaranty that this will actually occur. The number of full-time equivalent employees was 344 at the end of 2004, 326 at the end of 2003, and 311 at the end of 2002.
Total rent and occupancy costs, including furniture and equipment expenses, were $6.0 million in 2004, $5.2 million in 2003, and $4.4 million in 2002. The annual increase in these expenses was $789,000, or 15% for 2004, and $809,000, or 18% for 2003, and they rose to 20% of total non-interest expense in 2004 from 18% in 2003. Much of the increase in 2004 is the result of depreciation expense on equipment and software acquired in connection with the conversion of our core processing system at the beginning of 2004. An additional $145,000 of the increase is due to the charge-off of obsolete telephone equipment subsequent to our conversion to VOIP technology in the fourth quarter of 2004. New branches also added over $150,000 to occupancy expense. Expenditures related to the physical security of premises and customer information, while difficult to quantify, also contributed to the increase in occupancy costs in 2004.
Approximately half of the increase in rent and occupancy expense 2003 is related to the inclusion of costs for a full year of the in-house item processing operation, in the form of rent expense and depreciation on the equipment and tenant improvements, whereas in-house item processing was only in operation for about one quarter of 2002. In late 2002 our data processing operations relocated to the same building utilized by item processing, further increasing rent expense. The branch that commenced operations in Fresno in June of 2003 was another factor in the increase in rent and occupancy expense for that year.
Total data processing costs were almost the same in 2004 as in 2003, however they dropped by $1.1 million, or 50%, in 2003 relative to 2002. The reduction in 2003 was due to the elimination of item processing outsourcing costs, which totaled $1.4 million in 2002. Other data processing costs offset this savings to some extent in 2003, increasing by $308,000, or 39%, due mainly to termination fees and other costs associated with the Companys conversion of its core banking and online banking software which were expensed in 2003.
Deposit services costs increased by $114,000, or 11% in 2004, due to higher ATM network and servicing costs, higher check printing costs, and higher courier costs. In 2003, however, deposit services costs fell by $47,000, or 4%, primarily because of lower ATM network costs. Loan services expenses were up by a combined $394,000, or 42%, in 2004, due mainly to higher OREO expenses and a $131,000 provision for unfunded commitments. The cost of loan services declined in 2003 compared to 2002 because of more aggressive collection efforts for appraisal and inspection costs which are included in the loan processing subtotal.
Despite additional consulting and audit expenses incurred in our efforts to comply with Section 404 of the Sarbanes-Oxley Act, other areas were well-controlled and the total cost of professional services increased by only $10,000 in 2004. However, professional services expenses increased by $220,000, or 12%, in 2003. While there were many contributing factors, the 2003 increase can primarily be explained by accruals for a retirement plan for directors that was adopted effective October 1, 2002 in conjunction with the purchase of BOLI.
The other operating costs category includes telecommunications, postage, and other miscellaneous costs, and totaled $2.4 million in 2004, $2.2 million in 2003, and $2.1 million in 2002. Telecommunications expense increased by $66,000, or 9%, in 2004, however with the recent technology upgrade near-term expense increases are expected to be minimal, although no assurance can be given in this regard. Postage expense fell by $74,000 in 2004 due in part to postage for marketing pieces that is now included in advertising and marketing costs, while other operating expenses increased $198,000 primarily from a $145,000 increase in depreciation on operating leases and higher training costs. Other operating expenses for 2003 relative to 2002 include approximately $200,000 more in accruals for estimated operating losses on the Companys investments in low-income housing tax credit funds. The losses are an expected component of these investments, and are factored into the initial assessment of projected returns.
While some level of expense increase is expected in the normal course of business, we are focused on controlling overhead expenses where possible. Improvement is evident in the Companys tax-equivalent overhead efficiency ratio, which dropped to 54.6% in 2004 from 59.7% in 2003 and 61.6% for 2002.
In 2004 the Companys provision for federal and state income taxes was $7.2 million, while the tax provision was $4.4 million and $3.1 million for 2003 and 2002, respectively. This represents 35.0% of income before taxes in 2004, 29.7% in 2003, and 25.8% in 2002. The effective tax rate increased in 2003 relative to 2002 due to the suspended recognition of real estate investment trust (REIT) tax benefits, and increased again in 2004 due in part to a $400,000 REIT adjustment, as explained in greater detail later in this section. Without the adjustment in 2004 the rate would have been 33.0%, which is still higher than in the previous year because most of the $5.8 million increase in pre-tax income in 2004 is taxable at the Companys marginal tax rate of approximately 42%. The Company did invest $1.5 million in additional low-income housing tax credit funds in mid-2004, however the tax credits generated by that specific investment are minimal for the first year.
The Company sets aside its provision for income taxes on a monthly basis. As indicated in Note 9 in the Notes to the Consolidated Financial Statements, the amount of such provision is determined by applying the Companys statutory income tax rates to pre-tax book income as adjusted for permanent differences between pre-tax book income and actual taxable income. These permanent differences include but are not limited to tax-exempt interest income, increases in the cash surrender value of BOLI, California Enterprise Zone deductions, certain expenses that are not allowed as tax deductions, and tax credits.
Tax-exempt interest income is generated primarily by the Companys investments in state, county and municipal bonds, which provided $1.3 million in federal tax-exempt income in 2004 and $1.6 million in 2003. Although not reflected in the investment portfolio, the company also has total investments of $8.8 million in low-income housing
tax credit funds as of December 31, 2004. These investments have generated substantial tax credits for the past few years, with about $965,000 in credits available for the 2004 tax year and $442,000 in tax credits realized in 2003. The investments are expected to generate approximately $8.7 million in aggregate tax credits from 2005 through 2015, however the credits are dependent upon the occupancy level of the housing projects and income of the tenants and cannot be projected with complete certainty.
An additional permanent difference arose as a result of the formation of a REIT which began operations in August 2002. The REIT was formed to provide the Company with greater flexibility in managing its capital, but had the added benefit of providing California income tax benefits. The Company adjusted its tax accrual effective August 2002 to allow for the year-to-date impact of the REIT, and ultimately filed tax returns reflecting the REIT benefit. We continued to recognize this tax benefit through most of 2003. However, because of an adverse interpretation of existing law that was released by the California Franchise Tax Board (FTB) on December 31, 2003, effective as of that date the Company reversed all REIT-related tax benefits recognized during that year and suspended the recognition of those benefits going forward. In addition, in the first quarter of 2004 the Company filed amended 2002 income tax returns excluding the REIT benefit and paid the additional tax and interest resulting from the revised calculation, which added approximately $400,000 to our regular 2004 tax provision. California tax laws relating to REITs have not changed and our REIT tax advisors (a national accounting firm) have affirmed their initial tax opinion, and challenges to the FTBs interpretation are now being asserted. No assurance can be given that the tax benefits originally expected to be generated by the REIT will ultimately be realized, however.
Some items of income and expense are recognized in different years for tax purposes than when applying generally accepted accounting principles, leading to timing differences between the Companys actual tax liability and the amount accrued for this liability based on book income. These temporary differences comprise the deferred portion of the Companys tax expense, which is accumulated on the Companys books as a deferred tax asset or deferred tax liability until such time as it reverses.
A comparison between the summary year-end balance sheets for 2000 through 2004 was presented previously in the table of Selected Financial Data (see Item 6 above). As indicated in that table, the Companys total assets, loans, and shareholders equity have grown each year for the past four years. The Company experienced its most pronounced growth during 2004, with total assets increasing by $196 million, or 24%, due to the aforementioned leverage strategy as well as strong organic loan growth. The increase in assets was also substantial in 2003, with growth of over $100 million, or 14%, due primarily to loan growth. Total assets were $997 million and $802 million at December 31, 2004 and 2003, respectively. The major components of the Companys balance sheet are individually analyzed below, along with off-balance sheet information.
Loan and Lease Portfolio
The Companys loan and lease portfolio represents the single largest portion of invested assets, substantially greater than the investment portfolio or any other asset category, and the quality and diversification of the loan and lease portfolio are important considerations when reviewing the Companys financial condition. The Company is not involved with chemicals or toxins that might have an adverse effect on the environment, thus its primary exposure to environmental legislation is through its lending activities. The Companys lending procedures include steps to identify and monitor this exposure to in an effort to avoid any related loss or liability.
At December 31, 2004, gross loans and leases represented 70% of total assets, compared to 76% and 73% at December 31, 2003 and 2002, respectively. The decline in 2004 stems from a 134% increase in investment balances relative to only a 14% increase in loan balances due primarily to the implementation of the leverage strategy. Management expects that the Companys ratio of loans and leases to assets will average around 71% during 2005, although the ratio also depends upon the relative growth of investments and non-earning assets and could be higher or lower. The ratio of net loans and leases to deposits increased to 92% at the end of 2004 from 88% at the end of 2003.
Overall demand for loans remains relatively strong in many areas within the Companys markets and competition has intensified, especially in Fresno and Bakersfield. To help ensure that we remain competitive, we have added leasing to our array of financing options, and make every effort to be flexible and creative in our approach to structuring loans. More extensive loan-oriented marketing has also been planned.
The Selected Financial Data table in Item 6 above reflects the amount of loans and leases outstanding at December 31st for each year from 2000 through 2004, net of deferred fees and origination costs and the allowance for loan and lease losses. The Loan and Lease Distribution table that follows sets forth the Companys gross loans and leases outstanding and the percentage distribution in each category at the dates indicated. The amounts shown in the table do not reflect any deferred loan fees or deferred origination costs, nor is the allowance deducted.
Loan and Lease Distribution
As displayed in the table, aggregate loan and lease balances increased by $275 million, or 65%, from the end of 2000 to the end of 2004. The Companys branches and other business units generated the bulk of that growth. Participations purchased in 2004 roughly offset the runoff of participations previously purchased, however about $13 million in net growth in 2003 was from commercial real estate loan participations purchased. Overall, loan demand in the Companys immediate market has been weighted toward loans secured by real estate, including commercial and professional buildings and single family dwellings. As a result, these areas have comprised the major portion of the Companys loan growth over the past few years. The most significant shift in the loan portfolio mix over the past five years has been toward real estate loans secured by commercial properties, which increased to 48% of total loans at the end of 2004 from 39% at the end of 2000. Commercial real estate is an important part of the Companys lending focus and is likely to remain so for the immediate future.
Despite an overall trend upward for the past few years, commercial real estate loans fell slightly as a percentage of total loans during 2004 while loans secured by residential properties increased to 18% from 16%. This was due mainly to the recent success of the Companys home equity lines rather than growth in residential mortgage loans, as mortgage loan balances have tapered off subsequent to the outsourcing of most mortgage lending activity in 2002. Commencing in March 2002, the Company began collecting referral fees for directing most of its residential mortgage customers to Moneyline. From March 2002 through December 2002, the Company referred a total of $17 million in successfully completed mortgage loans to Moneyline, with the volume of referrals increasing to $45 million in 2003. With the recent slowdown in refinance activity, total mortgage loan referrals for 2004 were just $18 million.
Loans secured by farmland increased by $12 million, or 49%, in 2004, which boosted those loans to 5% of total loans at the end of 2004 from 4% at the end of 2003. The Company also originates and sells agricultural mortgage loans to certain investors, and the volume of agricultural mortgage loans serviced totaled $21 million as of December 31, 2004. Total loans serviced for others numbered 76 with an aggregate balance of $22 million as of the end of 2004, as compared to 97 loans with an aggregate balance of $33 million at the end of 2003 and 128 loans with an aggregate balance of $43 million at December 31, 2002.
Commercial and industrial loans, including SBA loans, increased by a combined $6 million, or 5%, in 2004. The Companys commercial loans are centered in locally-oriented commercial activities in markets where the Company has a physical presence, and this segment of the portfolio has struggled for growth as the local market has become increasingly competitive and other lenders have been willing to offer terms that do not fit our profit equation. Potential business has been passed over in some instances, and in others the Company has taken real estate collateral as an abundance of caution which causes the loans to be classified as commercial real estate. The Company also has a business unit dedicated to its SBA product and is very active in specific SBA program lending. Further, the Company is designated as an SBA Preferred Lender, which allows greater flexibility to meet small business loan requests with a more timely credit approval process. In the past the Company has sold some of its SBA loans, and while we still have the ability to do so, our intention for the immediate future is to retain the SBA loans we originate.
The consumer loans category represented 7% of total loans and leases outstanding at December 31, 2004, and 7% at December 31, 2003. These balances consist primarily of automobile loans and unsecured lines of credit. Consumer loans increased by $8 million, or 19%, during 2004, a growth rate slightly higher than for the aggregate portfolio. The increase in 2004 came despite the migration of consumer credit to tax-advantaged home equity lines, and was primarily the result of marketing campaigns targeting auto loans.
Agricultural loans stood at 2% of total loans at the end of 2004, a slight decline relative to 2003 but a fairly substantial decline relative to the 4% ratio shown for the end of 2000. The decline in the relative level of agricultural loans over the past few years has been due in part to reduced local plantings in response to foreign competition. However, the Company has also withdrawn from financing production lines, where year-to-year cash flow variations can impede the ability of borrowers to meet contractual repayment terms. With uncertain commodity prices some of our borrowers have experienced declining equity in farming operations, and many are selling farm land for alternate uses such as housing and commercial development.
Credit card loans represented just 2% of total loans and leases outstanding at December 31, 2004, having declined from 3% of total loans and leases at December 31, 2000. Despite this decrease, the credit card segment of the Companys loan product group remains an important part of the Companys relationship-oriented retail lending strategy.
Loan and Lease Maturities
The following maturity table shows the amounts of total loans and leases outstanding as of December 31, 2004, including non-accruing loans. The maturity distribution is based on remaining scheduled principal payments that are due within three months, after three months but less than one year, after one but within five years, or after five years. The principal balance of loans due after one year is indicated by both fixed and floating rate categories.
For a comprehensive discussion of the Companys liquidity position, re-pricing characteristics of the balance sheet, and sensitivity to changes in interest rates, see the Liquidity and Market Risk section.
Off-Balance Sheet Arrangements
In the normal course of business, the Company makes commitments to extend credit to its customers as long as there are no violations of any conditions established in contractual arrangements. These commitments are obligations that represent a potential credit risk to the Company, yet are not reflected in any form within the Companys consolidated balance sheets. Total unused commitments to extend credit were $257 million at December 31, 2004, as compared to $227 million at December 31, 2003. Net of credit card lines available which were $42 million and $43 million at December 31, 2004 and 2003, unused commitments represented 31% and 30% of outstanding gross loans and leases at December 31, 2004 and 2003, respectively. The Companys stand-by letters of credit at December 31, 2004 and 2003 were $20 million and $21 million, respectively.
The effect on the Companys revenues, expenses, cash flows and liquidity from the unused portion of the commitments to provide credit cannot be reasonably predicted, because there is no certainty that the lines of credit will ever be fully utilized. For more information regarding the Companys off-balance sheet arrangements, see Note 11 to the financial statements located elsewhere herein.
At the end of 2004, the Company had contractual obligations for the following payments, by type and period due:
Financial institutions generally have a certain level of exposure to asset quality risk, and could potentially receive less than a full return of principal and interest if a debtor becomes unable or unwilling to repay. Since loans are the most significant assets of the Company and generate the largest portion of its revenues, the Companys management of asset quality risk is focused primarily on loan quality. Banks have generally suffered their most severe earnings declines as a result of customers inability to generate sufficient cash flow to service their debts, or as a result of the downturns in national and regional economies which have brought about declines in overall property values. In addition, certain debt securities that the Company may purchase have the potential of becoming less valuable if the obligors financial capacity to repay deteriorates, and the Companys equity investments could fall in value.
To help minimize credit quality concerns, we have established a sound approach to credit that includes well-defined goals and objectives and well-documented credit policies and procedures. The policies and procedures identify market segments, set goals for portfolio growth or contraction, and establish limits on industry and geographic credit concentrations. In addition, these policies establish the Companys underwriting standards and the methods of monitoring ongoing credit quality. The Companys internal credit risk controls are centered in underwriting practices, credit granting procedures, training, risk management techniques, and familiarity with loan and lease customers as well as the relative diversity and geographic concentration of our loan and lease portfolio.
The Companys credit risk may also be affected by external factors such as the level of interest rates, employment, general economic conditions, real estate values, and trends in particular industries or geographic markets. As a multi-community independent bank serving a specific geographic area, the Company must contend with the unpredictable changes of the California and San Joaquin Valley markets. The Companys asset quality has suffered in the past from the impact of national and regional economic recessions, consumer bankruptcies, weather-related agricultural losses, and depressed prices for agricultural goods. Recently, however, the San Joaquin Valley has experienced healthy commercial and residential growth even as the agricultural industry remains relatively weak. Major companies are discovering the San Joaquin Valley as an ideal location for distribution facilities, jobs are growing at a relatively fast rate, and comparatively low-cost housing has attracted new residents from more expensive regions of California. The Company is optimistic that the local economy will continue to flourish, but no assurance can be given that this will in fact occur.
Non-performing assets are comprised of the following: Loans and leases for which the Company is no longer accruing interest; loans and leases 90 days or more past due and still accruing interest (although they are generally placed on non-accrual when they become 90 days past due); loans and leases restructured where the terms of repayment have been renegotiated, resulting in a deferral of interest or principal; and other real estate owned (OREO). Managements classification of a loan or lease as non-accrual is an indication that there is reasonable doubt as to the full recovery of principal or interest on the loan or lease. At that point, the Company stops accruing income from the interest, reverses any uncollected interest that had been accrued but unpaid, and recognizes interest income only as cash interest payments are received and as long as the collection of all outstanding principal is not in doubt. The loans may or may not be collateralized, and collection efforts are continuously pursued. Loans or leases may be restructured by management when a borrower has experienced some change in financial status causing an inability to meet the original repayment terms and where the Company believes the borrower will eventually overcome those circumstances and make full restitution. OREO consists of properties acquired by foreclosure or similar means that management intends to offer for sale. The following table provides information with respect to components of the Companys non-performing assets at the dates indicated.
Total non-performing balances stood at $5.0 million at the end of 2004, of which over $3.3 million is agriculture-related. The non-performing agriculture loans and OREO stem from issues in our Agriculture Credit Department prior to its reorganization in 2001. At that time, an experienced agriculture lender/manager was hired to monitor problems that were becoming apparent, implement tighter controls, and establish more effective underwriting criteria.
With that accomplished, we are now cautiously expanding the agricultural loan portfolio with loans to creditworthy borrowers, although no assurance can be given that all of those borrowers will continue to pay principal and interest in a timely manner.
The balance of non-performing assets at the end of 2004 represents a decrease of $4.5 million, or 47%, from year-end 2003 levels. The ratio of non-performing assets to total gross loans plus OREO also fell substantially, to 0.71% at the end of 2004 from 1.54% at the end of 2003, and non-performing loans as a percentage of total loans and leases fell to 0.35% from 1.09%. While almost every category of non-performing assets declined in 2004, the main changes were in commercial and industrial loans, which dropped by $2.0 million, agricultural loans, which fell by $725,000, and loans secured by farmland, which were $607,000 lower. The decline in commercial and industrial loans was mainly due to a $1 million relationship that was brought current when the customer collected delinquent payments owed to it under a government contract. The Company also collected a $600,000 balance plus past-due interest under a USDA guarantee, further reducing the balance of non-accruing commercial loans. The balance of agricultural loans and loans secured by farmland declined mainly due to principal pay-downs, but also due in part to the charge-off of balances deemed uncollectible. A mitigating factor when evaluating the Companys non-performing loans is that $1.3 million, or 54%, of the total $2.4 million balance at year-end 2004 is secured by real estate. An additional $458,000, or 19%, is comprised of the guaranteed portion of loans that are backed by the U.S. government.
We recognize that an increase in the dollar amount of non-accrual loans and leases is possible in the normal course of business as we expand our lending activities, and we also expect occasional foreclosures as a last resort in the resolution of some problem credits. At the end of January 2005, we were advised by the borrowers on a $2.5 million loan that they will be unable to comply with current repayment terms because of a dispute over payments due them under a government contract. While the borrowers have been paying interest on the loan, they do not currently have the means to repay principal when due in April 2005. The Company has been assured in writing that the borrowers intend to repay all principal and interest, and we hope to restructure the loan to better enable them to ultimately do so.
Allowance for Loan and Lease Losses
The allowance for loan and lease losses is established through a provision for losses based on managements evaluation of known and inherent risks in the Companys loan and lease portfolio. The allowance is increased by provisions charged against current earnings, and reduced by net charge-offs. Loans and leases are charged off when they are deemed to be uncollectible, while recoveries are generally recorded only when cash payments are received subsequent to the charge off.
We employ a systematic methodology for determining the allowance for loan and lease losses that includes a periodic review process and adjustment of the allowance at least quarterly. Our process includes a review of individual loans and leases that have been specifically identified as problems or have characteristics that could lead to impairment, as well as detailed reviews of other loans and leases (either individually or in pools). Our methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for losses that management believes is appropriate at each reporting date.
Quantitative factors include our historical loss experience, delinquency and charge-off trends, collateral values, changes in non-performing loans and leases, and other factors. Quantitative factors also incorporate known information about individual loans and leases, including borrowers sensitivity to interest rate movements and to other quantifiable external factors, such as commodity price changes and acts of nature (freezes, earthquakes, fires, etc.), that occur in a particular period. Qualitative factors are at least to some extent based on managements judgment and experience. They include an assessment of the general economic environment in our markets and, in particular, the state of agriculture and other key industries in the Central San Joaquin Valley. The way a particular loan or lease might be structured, the extent and nature of waivers of existing loan policies, the results of bank regulatory examinations, model imprecision, and the expected rate of portfolio growth are additional factors that are considered. The table which follows summarizes the activity in the allowance for loan and lease losses for the years indicated:
The Companys allowance for loan and lease losses increased by $2.1 million during 2004 and ended the year at $8.8 million. The loss provision in 2004 totaled $3.5 million, compared to $3.1 million in 2003. Net loans charged off were $1.3 million in 2004 as compared to $2.3 million in 2003. Net loans charged off in 2004 were 0.21% of average loans and leases, compared to 0.43% in 2003. Most of the year-over-year decline in charge-offs was in commercial loans, which fell by over $1 million. In the table, overdrafts account for charge-offs of $254,000 in 2004 but none in previous years, because prior to 2004 losses stemming from overdraft balances were included as operating losses in operating expenses. While uncollectible overdraft balances are now charged off as loan losses against the allowance for loan and lease losses, related overdraft fees and charges are still reflected as operating losses.
The allowance for loan and lease losses increased to 1.27% of total loans and leases at year-end 2004 from 1.10% at the end of 2003. The allowance also increased as a percentage of non-performing loans, growing to 361% at the end of 2004 versus 100% at the end of 2003.
Our methodology for determining the adequacy of the Companys allowance for loan and lease losses is, and has been, consistently followed. However, as we add new products, increase in complexity, and expand our geographic coverage, we expect to enhance our methodology to keep pace with the size and complexity of the loan and lease portfolio. On an ongoing basis we engage outside firms to independently assess our methodology and perform independent credit reviews of our loan and lease portfolio. The Companys external auditors, the FDIC, and the California Department of Financial Institutions also review the allowance for loan and lease losses as an integral part of the examination processes. Management believes that the current methodology is appropriate given our size and level of complexity. Further, management believes that the allowance for loan and lease losses was adequate as of December 31, 2004 to cover known and inherent risks in the portfolio. Fluctuations in credit quality, changes in economic conditions, or other factors could induce us to augment the allowance, however, and no assurance can be given that such factors will not result in increased losses in the loan and lease portfolio in the future.
The following table provides a summary of the allocation of the allowance for loan and lease losses for specific categories at the dates indicated. The allocation presented should not be interpreted as an indication that charges to the allowance for loan and lease losses will be incurred in these amounts or proportions, or that the portion of the allowance allocated to each category represents the total amounts available for charge-offs that may occur within these categories.
The investment securities portfolio had a book value of $198 million at December 31, 2004, compared to $85 million at the end of 2003. It is the second largest component of the Companys interest earning assets, and the structure and composition of this portfolio is important to any analysis of the financial condition of the Company. The investment portfolio serves the following purposes: 1) it provides liquidity for loan balance increases or deposit balance decreases; 2) it provides a source of pledged assets for securing certain deposits and borrowed funds, as may be required by law or by specific agreement with a depositor or lender; 3) it provides a large base of assets, the maturity
and interest rate characteristics of which can be changed more readily than the loan portfolio to better match changes in the deposit base and other funding sources of the Company; 4) it is an alternative interest-earning use of funds when loan demand is weak; and 5) it can enhance the Companys tax position by providing partially tax exempt income.
The Company uses two portfolio classifications for its investments: Held-to-maturity, and Available-for-sale. Accounting rules also allow for a trading portfolio classification, but the Company has no investments that would be classified as such. The held-to-maturity portfolio can consist only of investments that the Company has both the intent and ability to hold until maturity, to be sold only in the event of concerns with an issuers credit worthiness, a change in tax law that eliminates their tax exempt status, or other infrequent situations as permitted by generally accepted accounting principles. Since the Company does not have a trading portfolio, the available-for-sale portfolio is comprised of all securities not included as held-to-maturity.
Even though management currently has the intent and the ability to hold the Companys marketable investments to maturity, they are all currently classified as available-for-sale to allow flexibility with regard to the active management of the Companys investment portfolio. SFAS 133 requires available-for-sale securities to be marked to market on a periodic basis with an offset to accumulated other comprehensive income, a component of equity. Monthly adjustments are made to that account to reflect changes in the market value of the Companys available-for-sale securities.
The Companys investment portfolio is currently composed primarily of: (1) U.S. Treasury and Agency issues for liquidity and pledging; (2) mortgage-backed securities, which in many instances can also be used for pledging, and which generally enhance the yield of the portfolio; (3) state, county and municipal obligations, which provide limited tax free income and pledging potential; and (4) other equity investments. The fourth category includes an equity investment in Farmer Mac stock, which is a required element to allow the Company to sell certain agricultural loans to this quasi-governmental agency. Securities pledged as collateral for repurchase agreements, public deposits and for other purposes as required or permitted by law were $177 million and $66 million at December 31, 2004 and 2003, respectively, with the increase related to securities pledged for leverage strategy borrowings.
In 2004, with the purchase of more than $100 million for the leverage strategy, mortgage-backed securities increased to 80% of the total portfolio from 45% at the end of 2003. U.S. Treasury and Agency bonds declined to 3% of the portfolio at the end of 2004 from 13% at the end of 2003, and municipal bonds fell to 17% of the total portfolio at the end of 2004 from 41% at the end of 2003. In reviewing actual balance changes, mortgage-backed securities increased by $120 million, while U.S. government agency securities fell by $5 million and municipal bonds were down by $2 million in 2004. Most of the decline in agencies was due to maturing bonds that were subsequently replaced with relatively higher-yielding mortgage-backed securities, while the drop in municipal securities was mainly from bonds that were called prior to maturity. The Company was not inclined to replace these with similar investments due to the relatively long duration and low yields of currently available bonds.
As can be seen on the Distribution, Rate & Yield table presented in a previous section, the average tax-equivalent yield earned on total investments declined to 4.19% in 2004 from 4.51% in 2003. Even though shorter-term rates are trending upward, as higher-yielding assets mature and are replaced by instruments with current market yields the portfolio yield is likely to continue to decline slightly.
The following Investment Portfolio table reflects the amortized cost and fair market values for the total portfolio for each of the categories of investments for the past three years.
The investment maturities table below summarizes contractual maturities for the Companys investment securities and their weighted average yields at December 31, 2004. The actual timing of principal payments may differ from remaining contractual maturities, because obligors may have the right to repay certain obligations with or without penalties.