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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1998
Commission File Number: 0-12499
First Financial Bancorp
(Exact name of registrant as specified in its charter)
California 94-28222858
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
701 South Ham Lane, Lodi, California 95242
(Address of principal executive offices) (Zip Code)
(209)-367-2000
(Registrant's 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. [ X ] Yes [ ] No
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
As of January 31, 1999, there were 1,349,292 shares of Common Stock, no
par value, outstanding. The aggregate market value of the Common Stock held by
non-affiliates of the registrant was approximately $11,356,000 (based on the
$11.50 average of bid and ask prices per share on February 2, 1999.)
Part of Form 10-K into
Documents Incorporated by Reference which Incorporated
- ----------------------------------- ------------------
Proxy Statement for the Annual Meeting of
Shareholders to be held on May 18, 1999. Part III, Items 10, 11, 12, 13
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1
FIRST FINANCIAL BANCORP
1998 FORM 10-K
TABLE OF CONTENTS
PART 1
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ITEM 1. BUSINESS ..............................................................3
General ..............................................................3
The Bank .............................................................3
Bank Services ........................................................3
Sources of Business ..................................................4
Competition ..........................................................4
Employees ............................................................5
Supervision and Regulation ...........................................5
The Company .................................................5
The Bank ....................................................6
Officers ....................................................6
Recent Legislation and Regulations Affecting Banking ........7
ITEM 2. PROPERTIES ............................................................9
ITEM 3. LEGAL PROCEEDINGS ....................................................10
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ..................10
Part II
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ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS ..................................................10
ITEM 6. SELECTED FINANCIAL DATA ..............................................11
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS ............................................11
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ..........................33
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE ..................................33
PART III
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ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ...................33
ITEM 11 EXECUTIVE COMPENSATION ...............................................33
ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT .......33
ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS .......................33
PART IV
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ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K .....34
Signatures ...................................................................63
Index to Exhibits ...........................................................64
2
PART I
ITEM 1. BUSINESS
General:
First Financial Bancorp (the "Company") was incorporated under the laws of the
State of California on May 13, 1982, and operates principally as a bank holding
company for its wholly owned subsidiary, Bank of Lodi, N.A. (the "Bank"). The
Company is registered under the Bank Holding Company Act of 1956, as amended.
The Bank is the principal source of income for the Company. The Bank owns the
office building where the Bank's Lodi Branch and administrative offices are
located, and the Company owns the land upon which the Bank's Woodbridge Branch
is located. The Company receives income from the Bank under the lease associated
with the Woodbridge property. The Company also holds all of the capital stock of
Western Auxiliary Corporation (WAC), a California Corporation which functions as
trustee on deeds of trust securing mortgage loans originated by the Bank. All
references herein to the "Company" include the Bank and WAC, unless the context
otherwise requires.
The Bank:
The Bank was organized on May 13, 1982 as a national banking association. The
application to organize the Bank was accepted for filing by the Comptroller of
the Currency (the "OCC") on September 8, 1981, and preliminary approval to
organize was granted on March 27, 1982. On July 18, 1983 the Bank received from
the OCC a Certificate of Authority to Commence the Business of Banking.
Subsequently, the Bank opened branch offices in Woodbridge and Lockeford,
California. Effective February 22, 1997, the Bank acquired the Galt, Plymouth
and San Andreas offices of Wells Fargo Bank. A loan production office in Folsom,
California was opened in January, 1998, and a full-service branch was opened in
Elk Grove, California in August, 1998.
The Bank's headquarters is located at 701 South Ham Lane, Lodi, California.
There is a loan production office in Folsom, California and branch offices are
located in Woodbridge, Lockeford, Galt, Plymouth, San Andreas, and Elk Grove,
California. The Bank's primary service area, from which the Bank attracts 75% of
its business, is the city of Lodi and the surrounding area. This area is
estimated to have a population approaching 70,000 persons, with a median annual
family income of approximately $30,000. The area includes residential
developments, neighborhood shopping centers, business and professional offices
and manufacturing and agricultural concerns.
Bank Services:
The Bank offers a wide range of commercial banking services to individuals and
business concerns located in and around its primary service area. These services
include personal and business checking and savings accounts (including
interest-bearing negotiable order of withdrawal ("NOW") accounts and/or accounts
combining checking and savings accounts with automatic transfers), and time
certificates of deposit. The Bank also offers extended banking hours at its
drive-through window, night depository and bank-by-mail services, and travelers'
checks (issued by an independent entity). Each branch location has a 24 hour ATM
machine, and the Bank has 24 hour telephone banking and bill paying services.
The Bank issues MasterCard credit cards and acts as a merchant depository for
cardholder drafts under both VISA and MasterCard. In addition, it provides note
and collection services and direct deposit of social security and other
government checks.
During 1998, the Bank entered into an agreement with Investment Centers of
America to offer stocks, bonds, mutual funds, annuities and insurance products
through offices located on-site at Bank branches. The first Investment Centers
of America office was established at the Lodi branch location, and additional
offices are planned for Elk Grove and Folsom.
The Bank engages in a full complement of lending activities, including
commercial, Small Business Administration (SBA), residential mortgage,
consumer/installment, and short-term real estate loans, with particular emphasis
on short and medium-term obligations. Commercial lending activities are directed
principally toward businesses whose demand for funds falls within the Bank's
lending limit, such as small to medium-sized professional firms, retail and
wholesale outlets and manufacturing and agricultural concerns. Consumer lending
is oriented primarily to the needs of the Bank's customers, with an emphasis on
automobile financing and leasing. Consumer loans also include loans for boats,
home improvements, debt consolidation, and other personal needs. Real estate
loans include short-term "swing" loans and construction loans. Residential
mortgages are generally sold into the secondary market for these loans. SBA
loans are made available to small to medium-sized businesses.
3
Sources of Business:
Management seeks to obtain sufficient market penetration through the full range
of services described above and through the personal solicitation of the Bank's
officers, directors and shareholders. All officers are responsible for making
regular calls on potential customers to solicit business and on existing
customers to obtain referrals. Promotional efforts are directed toward
individuals and small to medium-sized businesses. The Bank's customers are able
in their dealings with the Bank to be served by bankers who have commercial loan
experience, lending authority, and the time to serve their banking needs quickly
and competently. Bankers are assigned to customers and not transferred from
office to office as in many major chain or regional banks. In order to expedite
decisions on lending transactions, the Bank's loan committee meets on a regular
basis and is available where immediate authorization is important to the
customer.
The risk of non-payment (or deferred payment) of loans is inherent in commercial
banking. Furthermore, the Bank's marketing focus on small to medium-sized
businesses may involve certain lending risks not inherent in loans to larger
companies. Smaller companies generally have shorter operating histories, less
sophisticated internal record keeping and financial planning capabilities, and
greater debt-to-equity ratios. Management of the Bank carefully evaluates all
loan applicants and attempts to minimize its credit risk through the use of
thorough loan application and approval procedures.
Consistent with the need to maintain liquidity, management of the Bank seeks to
invest the largest portion of the Bank's assets in loans of the types described
above. Loans are generally limited to less than 75% of deposits and capital
funds. The Bank's surplus funds are invested in the investment portfolio, made
up of both taxable and non-taxable debt securities of the U.S. government, U.S.
government agencies, states, and municipalities. On a day to day basis, surplus
funds are invested in federal funds and other short-term money market
instruments.
Competition:
The banking business in California generally, and in the northern portion of
central California where the Bank is located, is highly competitive with respect
to both loans and deposits and is dominated by a relatively small number of
major banks with branch office networks and other operating affiliations
throughout the State. The Bank competes for deposits and loans with these banks,
as well as with savings and loan associations, thrift and loan associations,
credit unions, mortgage companies, insurance companies and other lending
institutions. Among the advantages certain of these institutions have over the
Bank are their ability (i) to finance extensive advertising campaigns, (ii) to
allocate a substantial portion of their investment assets in securities with
higher yields (not available to the Bank if its investments are to be
diversified) and (iii) to make funds available for loans in geographic regions
with the greatest demand. In competing for deposits, the Bank is subject to the
same regulations with respect to interest rate limitations on time deposits as
other depository institutions. See "Supervision and Regulation" below.
Many of the major commercial banks operating in the Bank's service area offer
certain services, such as international banking and trust services, which are
not offered directly by the Bank, and such banks, by virtue of their greater
capitalization, have substantially higher lending limits than the Bank. In
addition, other entities, both public and private, seeking to raise capital
through the issuance and sale of debt and equity securities compete with the
Bank for the acquisition of funds for deposit.
In order to compete with other financial institutions in its primary service
area, the Bank relies principally on local promotional activities, personal
contacts by its officers, directors, employees and shareholders, extended hours
and specialized services. The Bank's promotional activities emphasize the
advantages of dealing with a locally-owned and headquartered institution
sensitive to the particular needs of the community. The Bank also assists
customers in obtaining loans in excess of the Bank's lending limit or services
not offered by the Bank by arranging such loans or services in participation
with or through its correspondent banks.
The State Bank Parity Act, effective January 1, 1996, eliminated certain
existing disparities between California state chartered banks and national
banking associations, such as the Bank, by authorizing the California
Commissioner of Financial Institutions (the "Commissioner") to address such
disparities through a streamlined rule-making process.
4
Employees:
As of December 31, 1998, the Company employed 97 full-time equivalent employees,
including four executive officers. Management believes that the Company's
relationship with its employees is good.
Supervision and Regulation
The Company
The common stock of the Company is subject to the registration requirements of
the Securities Act of 1933, as amended, and the qualification requirements of
the California Corporate Securities Law of 1968, as amended. The Company is also
subject to the periodic reporting requirements of Section 13(d) of the
Securities Exchange Act of 1934, as amended, which include, but are not limited
to, annual, quarterly and other current reports with the Securities and Exchange
Commission.
The Company is a bank holding company registered under the Bank Holding Company
Act of 1956 (the "Act") and is subject to supervision by the Board of Governors
of the Federal Reserve System (the "Board"). As a bank holding company, the
Company must file with the Board quarterly reports, annual reports, and such
other additional information as the Board may require pursuant to the Act. The
Board may also make examinations of the Company and its subsidiaries.
The Act requires prior approval of the Board for, among other things, the
acquisition by a bank holding company of direct or indirect ownership or control
of more than 5% of the voting shares, or substantially all the assets, of any
bank, or for a merger or consolidation by a bank holding company with any other
bank holding company. The Act also prohibits the acquisition by a bank holding
company or any of its subsidiaries of voting shares, or substantially all the
assets, of any bank located in a state other than the state in which the
operations of the bank holding company's banking subsidiaries are principally
conducted, unless the statutes of the state in which the bank to be acquired is
located expressly authorize such acquisition.
With certain limited exceptions, a bank holding company is prohibited from
acquiring direct or indirect ownership or control of more than 5% of the voting
shares of any company that is not a bank or bank holding company and from
engaging directly or indirectly in any activity other than banking or managing
or controlling banks or furnishing services to, or performing services for, its
authorized subsidiaries. A bank holding company may, however, engage in or
acquire an interest in a company that engages in activities that the Board has
determined to be so closely related to banking or to managing or controlling
banks as to be properly incident thereto. In making such a determination, the
Board is required to consider whether the performance of such activities
reasonably can be expected to produce benefits to the public, such as greater
convenience, increased competition, or gains in efficiency, which outweigh
possible adverse effects, such as undue concentration of resources, decreased or
unfair competition, conflicts of interest or unsound banking practices. The
Board is also empowered to differentiate between activities commenced de novo
and activities commenced by the acquisition, in whole or in part, of a going
concern.
Additional statutory provisions prohibit a bank holding company and any
subsidiary banks from engaging in certain tie-in arrangements in connection with
the extension of credit, sale or lease of property or furnishing of services.
Thus, a subsidiary bank may not extend credit, lease or sell property, or
furnish any services, or fix or vary the consideration for any of the foregoing
on the condition that: (i) the customer must obtain or provide some additional
credit, property or service from or to such bank other than a loan, discount,
deposit or trust service; or (ii) the customer must obtain or provide some
additional credit, property or service from or to the company or any other
subsidiary of the company; or (iii) the customer may not obtain some other
credit, property to service from competitors, except reasonable requirements to
assure soundness of the credit extended. These anti-tying restrictions also
apply to bank holding companies and their non-bank subsidiaries as if they were
banks.
The Company's ability to pay cash dividends is subject to restrictions set forth
in the California General Corporation Law. The Bank is a legal entity separate
and distinct from the Company, and is subject to various statutory and
regulatory restrictions on its ability to pay dividends to the Company. See Note
13(c) to the financial statements for further information regarding the payment
of cash dividends by the Company and the Bank.
The Company is a bank holding company within the meaning of Section 3700 of the
California Financial Code. As such, the Company and its subsidiaries are subject
to examination by, and may be required to file reports with, the Commissioner.
Regulations have not yet been proposed or adopted to implement the
Commissioner's powers under this statute.
5
The Bank:
The Bank, as a national banking association whose deposit accounts are insured
by the Federal Deposit Insurance Corporation (the "FDIC") up to the maximum
legal limits and the Bank is subject to regulation, supervision, and regular
examination by the OCC. The Bank is a member of the Federal Reserve System, and,
as such, is subject to certain provisions of the Federal Reserve Act and
regulations issued by the Board. The Bank is also subject to applicable
provisions of California law, insofar as they are not in conflict with, or
preempted by, federal law. The regulations of these various agencies govern most
aspects of the Bank's business, including reserves against deposits, interest
rates payable on deposits, loans, investments, mergers and acquisitions,
borrowings, dividends and location of branch offices.
Officers:
Leon Zimmerman, age 56, is President and Chief Executive Officer of the Bank and
of the Company; David M. Philipp, age 36, is Executive Vice-President, Chief
Financial Officer and Secretary of the Bank and of the Company; Lance Gallagher,
age 53, is Senior Vice President and Operations Administrator of the Bank and
the Company: and David Redman, age 54, is Senior Vice President and Chief Credit
Officer of the Bank and of the Company.
Mr. Zimmerman joined the Company in April, 1990. He was promoted from Executive
Vice President and Chief Credit Officer of Bank of Lodi to President and CEO in
August of 1994. Mr. Zimmerman became President and CEO of the Company effective
August 1995. He lives in Lodi with his wife and has resided and worked in the
San Joaquin-Sacramento Valley since 1960, serving in various banking capacities
since 1962. Mr. Zimmerman serves on many community boards and committees,
including San Joaquin County Education Foundation, Economic Development Task
Force and LEED - Sacramento Steering Committee. He is an active member of
Rotary, Chamber of Commerce and several other community groups.
Mr. Philipp joined the Company in April, 1992. Prior to joining the Company, Mr.
Philipp was the Budget Director and Financial Analyst for Merksamer Jewelers,
Inc., at that time the eighth largest jewelry retailer in the United States,
headquartered in Sacramento, California. Prior to joining Merksamer Jewelers,
Inc., Mr. Philipp was a Supervising Senior Accountant in the Sacramento office
of KPMG, LLP. While at KPMG, LLP, Mr. Philipp specialized in providing audit and
accounting services to financial institution, agribusiness, and broadcasting
clients. Mr. Philipp is a CPA and holds a Bachelor of Science in Business
Administration, Accountancy from California State University. He lives in El
Dorado Hills with his wife and two children, having been in the Greater
Sacramento area for over 25 years. On March 1, 1999 Mr. Philipp gave notice to
the Company and the Bank of his intention to resign and pursue other business
interests.
Mr. Gallagher joined the Bank in February, 1991. He was promoted from Vice
President of Compliance to Senior Vice President and Operations Administrator in
January, 1997. As a graduate of the American Bankers Associations Graduate
School of Compliance, he is responsible for the Bank's regulatory compliance
program in addition to Bank operations and item processing. Prior to joining the
Company, Mr. Gallagher was with Wells Fargo Bank for 22 years in various
customer service, operations, and human resource capacities of increasing
responsibility. He lives in San Joaquin County with his wife and has four boys
and a grandson. Mr. Gallagher is a banking instructor for The American Institute
of Banking and Delta Community College, serves as a member of the Colleges
Banking Advisory Board, a member of the Heald College Employer Advisory
Committee, and is the Initiation Coaching Program Director with U. S. Hockey
Pacific District.
Mr. Redman joined the Company in December 1997. He has over 33 years of banking
experience in central California. He was previously President and CEO of
Citizens Bank of Paso Robles, N.A. (1990 to 1995). Mr. Redman assisted in the
start up of Commerce Bank of San Luis Obispo and served as Executive Vice
President (1985 to 1990). Most recently, he was the organizing President and CEO
for Central California Bank (in organization). His banking experience includes
several years with two major California banks. Mr. Redman's education includes
Porterville Community College and the University of Washington Graduate School
of Banking. Community involvement has included the Jaycees, Lions Club, Kiwanis
Club, Rotary, Chamber of Commerce, Downtown Merchants Association and the Elks
Lodge. He lives in Valley Springs with his wife and has three grown children.
6
Recent Legislation and Regulations Affecting Banking:
From time to time, new laws are enacted which increase the cost of doing
business, limit permissible activities, or affect the competitive balance
between banks and other financial institutions. Proposals to change the laws and
regulations governing the operations and taxation of bank holding companies,
banks and other financial institutions are frequently made in Congress, in the
California legislature and before various bank holding company and bank
regulatory agencies. The likelihood of any major changes and the impact such
changes might have are impossible to predict. Certain significant recently
proposed or enacted laws and regulations are discussed below.
Interstate Banking. Since 1986, California has permitted California banks and
bank holding companies to be acquired by banking organizations based in other
states on a "reciprocal" basis (i.e., provided the other state's laws permit
California banking organizations to acquire banking organizations in that state
on substantially the same terms and conditions applicable to local banking
organizations). Since October 2, 1995, California law implementing certain
provisions of prior federal law have (1) permitted interstate merger
transactions; (2) prohibited interstate branching through the acquisition of a
branch business unit located in California without acquisition of the whole unit
of the California bank; and (3) prohibited interstate branching through de novo
establishment of California branch offices. Initial entry into California by an
out-of-state institution must be accomplished by acquisition of or merger with
an existing whole bank which has been in existence for at least five years.
Capital Requirements. Federal regulation imposes upon all FDIC-insured financial
institutions a variable system of risk-based capital guidelines designed to make
capital requirements sensitive to differences in risk profiles among banking
organizations, to take into account off-balance sheet exposures and to aid in
making the definition of bank capital uniform internationally. Under the OCC's
risk-based capital guidelines, the Bank is required to maintain capital equal to
at least 8 percent of its assets, weighted by risk. Assets and off-balance sheet
items are categorized by the guidelines according to risk, and certain assets
considered to present less risk than others permit maintenance of capital below
the 8 percent level. The guidelines established two categories of qualifying
capital: Tier 1 capital comprising core capital elements, and Tier 2 comprising
supplementary capital requirements. At least one-half of the required capital
must be maintained in the form of Tier 1 capital. For the Bank, Tier 1 capital
includes only common stockholders' equity and retained earnings, but qualifying
perpetual preferred stock would also be included without limit if the Bank were
to issue such stock. Tier 2 capital includes, among other items, limited life
(and in the case of banks, cumulative) preferred stock, mandatory convertible
securities, subordinated debt and a limited amount of the allowance for loan and
lease losses.
The guidelines also require all insured institutions to maintain a minimum
leverage ratio of 3 percent Tier 1 capital to total assets (the "leverage
ratio"). The OCC emphasizes that the leverage ratio constitutes a minimum
requirement for the most well-run banking organizations. All other banking
organizations are required to maintain a minimum leverage ratio ranging
generally from 4 to 5 percent. The Bank's required minimum leverage ratio is 4
percent.
The federal banking agencies during 1996 issued a joint agency policy statement
regarding the management of interest-rate risk exposure (interest rate risk is
the risk that changes in market interest rates might adversely affect a bank's
financial condition) with the goal of ensuring that institutions with high
levels of interest-rate risk have sufficient capital to cover their exposures.
This policy statement reflected the agencies' decision at that time not to
promulgate a standardized measure and explicit capital charge for interest rate
risk, in the expectation that industry techniques for measurement of such risk
will evolve.
However, the Federal Financial Institutions Examination Council ("FFIEC") on
December 13, 1996, approved an updated Uniform Financial Rating System
("UFIRS"). In addition to the five components traditionally included in the
so-called "CAMEL" rating system which has been used by bank examiners for a
number of years to classify and evaluate the soundness of financial institutions
(including capital adequacy, asset quality, management, earnings and liquidity),
UFIRS includes for all bank regulatory examinations conducted on or after
January 1, 1997, a new rating for a sixth category identified as sensitivity to
market risk. Ratings in this category are intended to reflect the degree to
which changes in interest rates, foreign exchange rates, commodity prices or
equity prices may adversely affect an institution's earnings and capital. The
rating system henceforth will be identified as the "CAMELS" system.
7
As of December 31, 1998, the Bank's total risk-based capital ratio was
approximately 11.17 percent and its leverage ratio was approximately 7.35
percent. The Bank does not presently expect that compliance with the risk-based
capital guidelines or minimum leverage requirements will have a materially
adverse effect on its business in the reasonably foreseeable future. Nor does
the Bank expect that its sensitivity to market risk will adversely affect its
overall CAMELS rating as compared with its previous CAMEL ratings by bank
examiners.
Deposit Insurance Assessments. In 1995, the FDIC, pursuant to Congressional
mandate, reduced bank deposit insurance assessment rates to a range from $0 to
$.27 per $100 of deposits, dependent upon a bank's risk. The FDIC has continued
these reduced assessment rates through 1998. Based upon the above risk-based
assessment rate schedule, the Bank's current capital ratios, the Bank's current
level of deposits, and assuming no further change in the assessment rate
applicable to the Bank during 1999, the Bank estimates that its annual
noninterest expense attributed to the regular assessment schedule will not
increase during 1999.
Prompt Corrective Action. Prompt Corrective Action Regulations (the "PCA
Regulations") of the federal bank regulatory agencies established five capital
categories in descending order (well capitalized, adequately capitalized,
undercapitalized, significantly undercapitalized and critically
undercapitalized), assignment to which depends upon the institution's total
risk-based capital ratio, Tier 1 risk-based capital ratio, and leverage ratio.
Institutions classified in one of the three undercapitalized categories are
subject to certain mandatory and discretionary supervisory actions, which
include increased monitoring and review, implementation of capital restoration
plans, asset growth restrictions, limitations upon expansion and new business
activities, requirements to augment capital, restrictions upon deposit gathering
and interest rates, replacement of senior executive officers and directors, and
requiring divestiture or sale of the institution. The Bank has been classified
as a well-capitalized bank since adoption of the PCA Regulations.
Community Reinvestment Act. Community Reinvestment Act ("CRA") regulations
effective as of July 1, 1995 evaluate banks' lending to low and moderate income
individuals and businesses across a four-point scale from "outstanding" to
"substantial noncompliance," and are a factor in regulatory review of
applications to merge, establish new branches or form bank holding companies. In
addition, any bank rated in "substantial noncompliance" with the CRA regulations
may be subject to enforcement proceedings. The Bank has a current rating of
"satisfactory" CRA compliance.
Year 2000 Compliance. The Federal Financial Institutions Examination Council has
issued an interagency statement to the chief executive officers of all federally
supervised financial institutions, including the Bank, regarding Year 2000
project management awareness. Unless financial institutions address the
technology issues associated with Year 2000, the Council anticipates there could
occur major disruptions in the operations of financial institutions. The
interagency statement provides guidance to financial institutions, to providers
of data services, and all examining personnel of the federal banking agencies
regarding Year 2000 issues. The federal banking agencies intend to conduct Year
2000 compliance examinations, and the failure to implement a Year 2000 program
may constitute an unsafe and unsound banking practice. See the discussion of
this subject at the heading "Year 2000 Preparedness" under Item 7 herein,
Management's Discussion and Analysis of Financial Condition and Results of
Operations, and at footnote 23 to the Company's Consolidated Financial
Statements.
Safety and Soundness Standards. Federal bank regulatory agency safety and
soundness standards for insured financial institutions establish standards for
(1) internal controls, information systems and internal audit systems; (2) loan
documentation; (3) credit underwriting; (4) interest rate exposure; (5) asset
growth; and (6) compensation, fees and benefits. In addition, the standards
prohibit the payment of compensation which is excessive or which could lead to
material financial loss. If an agency determines that an institution fails to
meet any standard established by the guidelines, the agency may require the
financial institution to submit to the agency an acceptable plan to achieve
compliance with the standard. Agencies may elect to initiate enforcement action
in certain cases where failure to meet one or more of the standards could
threaten the safe and sound operation of the institution. The Bank has not been
and does not expect to be required to submit a safety and soundness compliance
plan because of a failure to meet any of the safety and soundness standards.
Permitted Activities. In recent years, the Federal banking agencies, especially
the OCC and the Board, have taken steps to increase the types of activities in
which national banks and bank holding companies can engage, and to make it
easier to engage in such activities. On November 20, 1996, the OCC issued final
regulations permitting national banks to engage in a wider range of activities
through subsidiaries. "Eligible institutions" (those national banks that are
well capitalized, have a
8
high overall rating and a satisfactory CRA rating, and are not subject to an
enforcement order) may engage in activities related to banking through operating
subsidiaries after going through a new expedited application process. In
addition, the new regulations include a provision whereby a national bank may
apply to the OCC to engage in an activity through a subsidiary in which the bank
itself may not engage. Although the Bank in not currently intending to enter
into any new type of business, this OCC regulation could be advantageous to the
Bank if the Bank determines to expand its operations in the future, depending on
the extent to which the OCC permits national banks to engage in new lines of
business and whether the Bank qualifies as an "eligible institution" at the time
of making application.
Monetary Policies. Banking is a business in which profitability depends on rate
differentials. In general, the differences between the interest rate received by
a bank on loans extended to its customers and securities held in that bank's
investment portfolio and the interest rate paid on its deposits and its other
borrowings constitute the major portion of the bank's earnings. To the extent
that a bank is not able to compensate for increases in the cost of deposits and
other borrowings with greater income from loans, securities and fees, the net
earnings of that bank will be reduced. The interest rates paid and received by
any bank are highly sensitive to many factors which are beyond the control of
that bank, including the influence of domestic and foreign economic conditions.
See Item 7 herein, Management's Discussion and Analysis of Financial Condition
and Results of Operations.
The earnings and growth of a bank are also affected by the monetary and fiscal
policy of the United States Government and its agencies, particularly the Board.
These agencies can and do implement national monetary policy, which is used in
part to curb inflation and combat recession. Among the instruments of monetary
policy used by these agencies are open market transactions in United States
Government securities, changes in the discount rates of member bank borrowings,
and changes in reserve requirements. The actions of the Board have had a
significant effect on banks' lending, investments and deposits, and such actions
are expected to continue to have a substantial effect in the future. However,
the nature and timing of any further changes in such policies and their impact
on banks cannot be predicted.
Proposed Legislation and Regulation. Certain legislative and regulatory
proposals that could affect the Bank and the banking business in general are
pending or may be introduced before the United States Congress, the California
State Legislature and Federal and state government agencies. The United States
Congress is considering numerous bills that could reform banking laws
substantially. For example, proposed bank modernization legislation under
consideration would, among other matters, include a repeal of the Glass-Steagall
Act restrictions on banks that now prohibit the combination of commercial and
investment banks.
It is not known whether any of these current legislative proposals will be
enacted and what effect such legislation would have on the structure, regulation
and competitive relationships of financial institutions. It is likely, however,
that many of these proposals would subject the Bank to increased regulation,
disclosure and reporting requirements and would increase competition to the Bank
and its cost of doing business.
In addition to pending legislative changes, the various banking regulatory
agencies frequently propose rules and regulations to implement and enforce
already existing legislation. It cannot be predicted whether or in what form any
such rules or regulations will be enacted or the effect that such rules and
regulations may have on the Bank's business.
The above description of the business of the Bank should be read in conjunction
with Item 7 herein, Management's Discussion and Analysis of Financial Condition
and Results of Operations.
ITEM 2. PROPERTIES
The Bank owns a 0.861 acre lot located at the corner of Ham Lane and Tokay
Street, Lodi, California. A 34,000 square foot, tri-level commercial building
for the main branch and administrative offices of the Company and the Bank was
constructed on the lot. The Company and the Bank use approximately 75% of the
leasable space in the building and the remaining area is either leased or
available for lease as office space to other tenants. The construction of this
building in 1991 has enabled the Bank to better serve its customers with more
teller windows, four drive-through lanes and expanded safe deposit box capacity.
9
The Company owns a 10,000 square foot lot located on Lower Sacramento Road in
the unincorporated San Joaquin County community of Woodbridge, California. The
entire parcel has been leased to the Bank on a long term basis at market rates.
The Bank has constructed, furnished and equipped a 1,437 square foot branch
office on the parcel and commenced operations of the Woodbridge Branch on
December 15, 1986.
The Bank assumed a long-term ground lease on 1.7 acres of land at 19000 North
Highway 88, Lockeford, California. The building previously occupying the Lodi
site at 701 South Ham Lane was moved to Lockeford, California, and has become
the permanent branch office of the Bank at that location. A temporary 1,000
square foot office had been used by the Bank at the Lockeford location. The
permanent office was opened on April 1, 1991. The temporary office, along with a
portion of the permanent building, are leased by the Bank to two tenants.
On February 22, 1997, the Bank acquired the Galt, Plymouth and San Andreas
branches of Wells Fargo Bank. The transaction included the assumption of the
6,000 square foot branch building lease in Galt with a remaining term of two
years, and the purchase of the branch building and land for the Plymouth and San
Andreas offices. The Plymouth and San Andreas offices are approximately 1,200
and 5,500 square feet, respectively. In November, 1998, upon expiration of the
Galt lease, the Galt branch was relocated to a new 3,000 square foot leased
facility one block west of the old location. The new Galt location is leased
under a five year lease with three successive five-year renewal options.
In January, 1998, the Bank opened a 1,220 square foot loan production office in
Folsom, California. The office was leased for one year with a one year renewal
option which has been exercised by the Bank. In August, 1998, the Bank opened a
4,830 square foot full service branch in Elk Grove, California. The office is
leased under a three year lease with two successive three-year renewal options.
ITEM 3. LEGAL PROCEEDINGS
Not Applicable
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not Applicable
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS
There is no established public trading market for the common stock of the
Company. The Company's common stock is traded in the over-the-counter market and
is not presently listed on a national exchange or reported by the NASDAQ Stock
Market. Trading of the stock has been limited and has been principally contained
within the Company's general service area. As of March 1, 1999, there were 1,037
shareholders of record of the Company's common stock. Set forth below is the
range of high and low bid prices for the common stock during 1997 and 1998.
1998 1997
Bid Price of Common Shares High Low High Low
First Quarter $ 13.25 13.00 $ 10.25 9.50
Second Quarter 14.50 13.63 10.25 9.63
Third Quarter 14.63 13.25 12.75 9.81
Fourth Quarter 13.38 12.00 13.00 12.13
The foregoing prices are based on trades of which Company is aware and reflect
inter-dealer prices, without retail mark-up, mark-down or commissions, and may
not necessarily represent actual transactions.
10
ITEM 6. SELECTED FINANCIAL DATA
(in thousands except per share amounts)
Consolidated Statement of Income 1998 1997 1996 1995 1994
- ------------------------------------------------------------------------------------------------------
Interest Income $ 11,508 10,592 8,045 8,089 7,462
Interest Expense 4,028 3,785 3,254 3,138 2,767
Net Interest Income 7,480 6,807 4,791 4,951 4,695
Provision for Loan Losses 250 (60) 310 115 323
Noninterest Income 1,878 1,423 1,067 940 1,050
Noninterest Expense 7,712 6,796 4,654 4,534 5,137
Net Income $ 1,052 1,015 640 843 338
Per Share Data
- ------------------------------------------------------------------------------------------------------
Basic Earnings $ .78 .77 .49 .65 .26
Diluted Earnings .74 .73 .48 .64 .26
Cash Dividends Declared $ .20 .20 .20 .15 --
Consolidated Balance Sheet Data
- ------------------------------------------------------------------------------------------------------
Federal Funds Sold $ 4,800 4,900 1,100 3,300 2,000
Investment Securities 45,647 61,917 36,913 36,945 33,100
Loans, net of loss reserve and
deferred fees 91,078 62,228 52,672 50,524 55,812
Total Assets 164,400 147,850 104,913 103,972 105,167
Total Deposits 149,544 133,891 92,207 89,216 89,979
Note Payable -- -- -- 2,585 2,618
Total Stockholders' Equity $ 13,857 12,861 11,889 11,564 10,610
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
Certain statements in this Annual Report on Form 10-K include forward-looking
information within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and
are subject to the "safe harbor" created by those sections. These
forward-looking statements involve certain risks and uncertainties that could
cause actual results to differ materially from those in the forward-looking
statements. Such risks and uncertainties include, but are not limited to, the
following factors: competitive pressure in the banking industry; changes in the
interest rate environment; general economic conditions, either nationally or
regionally becoming less favorable than expected and resulting in, among other
things, a deterioration in credit quality and an increase in the provision for
possible loan losses; changes in the regulatory environment; changes in business
conditions; volatility of rate sensitive deposits; operational risks, including
data processing system failures or fraud; asset/liability matching risks and
liquidity risks; and changes in the securities markets.
The following discussion addresses information pertaining to the financial
condition and results of operations of the Company that may not be otherwise
apparent from a review of the consolidated financial statements and related
footnotes. It should be read in conjunction with those statements and notes
found on pages 36 through 63, as well as other information presented throughout
this report.
11
Summary of Earnings Performance
- ----------------------------------------------------------------------------------------------------------------------------
For the Year Ended December 31:
----------------------------------------------------------------------
1998 1997 1996
Earnings (in thousands) $ 1,052 1,015 640
- ----------------------------------------------------- ---------------------- ----------------------- -----------------------
Basic earnings per share $ .78 .77 .49
Diluted earnings per share $ .74 .73 .48
Return on average assets 0.68% 0.75% 0.60%
Return on average equity 7.90% 8.18% 5.44%
Dividend payout ratio 25.57% 26.11% 42.55%
- ----------------------------------------------------- ---------------------- ----------------------- -----------------------
"Cash" earnings (in thousands) (1) $ 1,268 1,293 640
Diluted "cash" earnings per share $ .89 .93 .48
"Cash" return on average assets 0.82% 0.96% 0.60%
"Cash" return on average equity 9.52% 10.42% 5.44%
- ----------------------------------------------------- ---------------------- ----------------------- -----------------------
Operating "Cash" earnings (in thousands) (2) $ 1,375 1,293 640
Diluted operating "cash" earnings per share $ .97 .93 .48
Operating "Cash" return on average assets 0.89% 0.96% 0.60%
Operating "Cash" return on average equity 10.32% 10.42% 5.44%
- ----------------------------------------------------- ---------------------- ----------------------- -----------------------
Average equity to average assets 8.64% 9.12% 11.12%
- ----------------------------------------------------- ---------------------- ----------------------- -----------------------
(1) "Cash" earnings represent earnings based upon generally accepted accounting
principles plus the after-tax, non-cash effect on earnings of the
amortization of intangible assets. Following the 1997 acquisition of three
branches from Wells Fargo Bank, the "cash" earnings, return on assets, and
return on equity are the most comparable to prior year numbers. They are
also the more relevant performance measures for shareholders because they
measure the Company's ability to support growth and pay dividends.
(2) Operating "Cash" net income is computed by excluding the after-tax impact
of significant elements of revenue or costs that obscure the operating
results of core operations. Adjustments for the twelve months ended
December 31, 1998 have been made to exclude from net income the preliminary
costs of a strategic growth initiative for which the company ceased further
pursuit in May, 1998.
During 1998, the Company aggressively pursued a number of strategic growth
opportunities. One such opportunity significantly impacted expenses and the
amount of expenses related thereto has been added back to "cash" earnings to
determine operating "cash" earnings. Operating "cash" earnings per share
increased by 4% in 1998 compared to 1997. If significant loan loss recoveries
were excluded from the computation of operating "cash" earnings in 1997,
operating "cash" earnings in 1998 would be approximately 50% greater than 1997.
The increase is attributable to loan and deposit growth of 45% and 12%,
respectively, as well as record levels of mortgage loan origination and sales
volumes. As a result of the earnings in 1998, the Company continued the practice
of paying a quarterly dividend of $.05 per share that began in the first quarter
of 1995.
Diluted earnings per share for 1998 increased by 1.4% over 1997, while 1998
"cash" earnings per share declined by 4% compared to 1997. Diluted and cash
earnings per share for 1997 were 52% and 94%, respectively, above the comparable
levels for 1996. "Cash" return on equity for 1998 decreased by 9% compared to
1997, while "cash" return on equity in 1997 was 92% above 1996. Financial
leverage improved as a result of deposit growth in both 1998 and 1997. Average
equity to average assets was reduced by 48 and 200 basis points in 1998 and
1997, respectively. As a result each dollar of equity supported $12 and $11 in
assets in 1998 and 1997, respectively, compared to $11 and $9 in 1997 and 1996,
respectively. Deposits grew in connection with business development efforts in
both 1998 and 1997 as well as the acquisition of three branches from Wells Fargo
Bank on February 22, 1997. The acquisition increased deposits by $34 million as
of the closing date of the transaction.
12
Earnings per share increased in 1997 versus 1996 as a result of a 30% increase
in net interest income, a 120% reduction in the provision for loan losses and a
31% increase in noninterest income. The foregoing improvements were partially
offset by a 45% increase in noninterest expenses. While net interest income
increased in part because of significant loan loss recoveries, the growth in net
interest income was also the result of both increases in the volume of earning
assets and deposits and an increase in net interest margin. Noninterest income
in 1997 increased due in part to record volumes in both SBA and mortgage lending
of the Bank. Service charges and noninterest expenses increased principally as a
result of the acquisition of three branches from Wells Fargo Bank on February
22, 1997.
Branch Expansion and Acquisitions
In August, 1998, the Bank opened a full-service branch in the Elk Grove,
California market. The Elk Grove office is approximately 30 miles North of the
Bank's corporate headquarters in Lodi, California and it effectively expands the
Bank's trade area into South Sacramento County.
In January, 1998, the Bank opened a loan production office in the growing market
of Folsom, California. The Folsom office is approximately 45 miles Northeast of
the Bank's corporate headquarter's in Lodi, California and effectively expanded
the Bank's trade area into the greater Sacramento area.
On February 22, 1997, the Bank completed the acquisition of the Galt, Plymouth,
and San Andreas, California, branches of Wells Fargo Bank. The Bank purchased
the premises and equipment of the Plymouth and San Andreas branches and assumed
the building lease for the Galt branch. The Bank also purchased the furniture
and equipment of all three branches and paid a premium for the deposits of each
branch. The total cost of acquiring the branches, including payments to Wells
Fargo Bank as well as other direct costs associated with the purchase, was $2.86
million. The transaction was accounted for using the purchase method of
accounting. Accordingly, the purchase price was allocated first to identifiable
tangible assets based upon those assets' fair value and then to identifiable
intangible assets based upon the assets' fair value. The excess of the purchase
price over identifiable tangible and intangible assets was allocated to
goodwill. Allocations to identifiable tangible assets, identifiable intangible
assets, and goodwill were $856 thousand, $1.98 million, and $24 thousand,
respectively. Deposits totaling $34 million were acquired in the transaction.
13
Net Interest Income
The following table provides a detailed analysis of net interest spread and net
interest margin for the years ended December 31, 1998, 1997, and 1996,
respectively:
- ------------------------- ------------------------------- -------------------------------- ---------------------------------
For the Year Ended For the Year Ended For the Year Ended
December 31, 1998 December 31, 1997 December 31, 1996
(in thousands) (in thousands) (in thousands)
------------------------------- -------------------------------- ---------------------------------
Average Income/ Average Income/ Average Income/
Balance Expenses Yield Balance Expenses Yield Balance Expense Yield
Earning Assets:
Investment securities(1) $ 53,370 3,431 6.43% 53,580 3,519 6.57% 34,700 2,233 6.44%
Federal funds sold 6,780 348 5.13% 8,400 461 5.49% 3,790 199 5.25%
Loans (2) 73,720 7,729 10.48% 58,600 6,612 11.28% 54,520 5,613 10.30%
-------- ------ ------ ------- ------ ------ ------ ----- ------
133,870 11,508 8.60% 120,580 10,592 8.78% 93,010 8,045 8.65%
======== ====== ====== ======= ====== ====== ====== ===== =====
Liabilities:
Noninterest bearing $ 17,080 -- -- 13,470 -- -- 8,280 -- --
deposits
Savings, money market, 76,600 1,652 2.16% 67,520 1,660 2.46% 47,820 1,193 2.49%
& NOW deposits
Time deposits 46,800 2,376 5.08% 41,550 2,125 5.11% 34,320 1,799 5.24%
Note payable -- -- -- -- -- -- 2,440 262 10.74%
-------- ------ ----- ------- ------ ------ ------ ----- ------
Total Liabilities $140,480 4,028 2.87% 122,540 3,785 3.09% 92,860 3,254 3.50%
======== ====== ===== ======= ====== ====== ====== ===== ======
Net Spread 5.73% 5.69% 5.15%
===== ====== ======
- ------------------------- ---------- ----------- -------- ---------- ---------- ---------- ----------- ----------- ---------
Earning Income Earning Income Earning Income
Assets (Expense) Yield Assets (Expense) Yield Assets (Expense) Yield
Yield on average earining
assets 133,870 11,508 8.60% 120,580 10,592 8.78% 93,010 8,045 8.65%
-------- ------ ----- ------- ------ ------ ------ ----- ------
Cost of funds for average
earning assets 133,870 (4,028) 3.01% 120,580 (3,785) (3.13%) 93,010 (3,254) (3.50)%
-------- ------ ----- ------- ------ ------ ------ ----- ------
Net Interest Margin $ 133,870 7,480 5.59% 120,580 6,807 5.65% 93,010 4,791 5.15%
======== ====== ===== ======= ====== ====== ====== ===== =====
- ------------------------- ---------- ----------- -------- ---------- ---------- ---------- ----------- ----------- ---------
(1) Income on tax-exempt securities has not been adjusted to a tax equivalent basis.
(2) Nonaccrual loans are included in the loan totals for each year.
Net interest income increased by 10% in 1998 after increasing by 42% in 1997.
The increase in 1998 was the result of both growth in earning assets and
deposits as well as decreased deposit costs. The increase in 1997 was also the
result of both growth in earning assets and deposits as well as increased
earning asset yields and decreased deposit costs. The increase in 1997 also
included $445 thousand in interest received in connection with significant loan
loss recoveries. Excluding these recoveries from 1997, net interest income would
have increased by 18% in 1998.
Average earning assets increased by 11% in 1998 compared to 1997 and 30% in 1997
compared to 1996. The increase in average earning assets was driven by growth in
average deposits during both years. Average deposits increased by 15% in 1998
compared to 1997 and 36% in 1997 compared to 1996.
The mix of earning assets in 1998 changed as a result of year-over-year loan
growth of 45% compared to 18% in 1997. Average loans in 1998 increased 26%
compared to 1997. The increase absorbed the liquidity created by the growth in
deposits during 1998 and offset the impact of falling interest rates in all
asset categories. The loan growth also increased the average
14
loan-to-deposit ratio to 52% in 1998 compared to 48% in 1997. The
loan-to-deposit ratio declined to 48% in 1997 from 60% in 1996 as a result of
the deposits acquired in branch purchases. Average investments were nearly
unchanged in 1998 compared to 1997. The investment portfolio, into which the
proceeds from the 1997 branch acquisition were initially invested, increased on
average by 54% in 1997.
Net interest margin declined by 6 basis points in 1998 after increasing by 50
basis points in 1997. Excluding the impact of interest from the recovery of loan
losses in 1997, net interest margin would have increased by 31 basis points in
1998. This adjusted increase in 1998 was the result of several key items:
o The impact on average earning asset yields of declining interest rates
was overcome by the growth in loans that had higher yields than
investments and federal funds sold. While the yields on federal funds
and investments declined by 36 and 14 basis points, respectively,
earning asset yields decreased by 18 basis points.
o The general decline in interest rates helped to bring down the cost of
average NOW, savings and certificates of deposit by 32, 26, and 3
basis points, respectively.
o The mix of noninterest bearing deposits increased to 12% of average
deposits in 1998 from 11% in 1997.
Net interest margin increased by 50 basis points in 1997 after declining by 37
basis points in 1996. The increase in 1997 was the result of several key items:
o The general level of short-term interest rates as indicated by the
comparative yields on federal funds sold increased by approximately 24
basis points.
o Approximately $445 thousand in loan interest income was recognized
during 1997 as a result of nonaccrual loan payoffs. The recovery of
nonaccrual interest increased loan yields and net interest margin for
the year by 76 basis points and 37 basis points respectively.
o The general decline in interest rates helped to bring down the cost of
average certificates of deposit by 13 basis points, while a new tiered
rate pricing structure for savings, money market, and NOW accounts
reduced the cost of those funds by 3 basis points.
o In addition to changes in the pricing structure of deposits, the mix
of noninterest bearing and lower cost transaction accounts increased
for 1997, while the mix of higher cost certificates of deposit
declined.
o The mortgage note payable, which carried a yield of 10.45%, was paid
off during November 1996.
15
The following table presents the monetary impact of the aforementioned changes
in earning asset and deposit volumes, yields and mix for the three years ended
December 31, 1998, 1997, and 1996
- ---------------------------------------------------------------------------------------------------------------------------------
1998 compared to 1997 1997 compared to 1996 1996 compared to 1995
(in thousands) (in thousands) (in thousands)
Change due to: Change due to: Change due to:
Interest Income: Volume Rate Mix Total Volume Rate Mix Total Volume Rate Mix Total
------ ---- --- ----- ------ ---- --- ----- ------ ---- --- -----
--------------------------------------------------------------------------------------------------------
Investment securities $ 391 (79) (398) (86) 661 46 578 1,285 67 135 255 457
Federal funds sold 51 (30) (134) (113) 59 9 194 262 7 (17) 8 (2)
Loans 735 (470) 850 1,115 1,664 539 (1,203) 1,000 229 (300) (428) (499)
------- ------- ------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total interest income $ 1,177 (579) 318 916 2,384 594 (431) 2,547 303 (182) (165) (44)
======= ======= ======= ======= ======= ======= ======= ======= ======= ======= ======= =======
Interest Expense:
Noninterest-bearing
deposits -- -- -- -- -- -- -- -- -- -- -- --
Savings, money market, $ 243 (206) (45) (8) 382 (16) 103 469 56 (27) (22) 7
& NOW accounts
Time deposits 311 (15) (45) 251 573 (44) (205) 324 79 35 13 127
Note payable -- -- -- -- 84 (262) (84) (262) 13 -- (30) (17)
------- ------- ------- ------- ------- ------- ------- ------- ------- ------- ------- -------
Total interest expense $ 554 (221) (90) 243 1,039 (322) (186) 531 148 8 (39) 117
======= ======= ======= ======= ======= ======= ======= ======= ======= ======= ======= =======
Net interest income $ 623 (358) 408 673 1,345 916 (245) 2,016 155 (190) (126) (161)
======= ======= ======= ======= ======= ======= ======= ======= ======= ======= ======= =======
- ---------------------------------------------------------------------------------------------------------------------------------
The volume, rate, and mix variances for net interest income in 1998 compared to
1997 indicate that a negative rate variance driven by falling interest rates was
offset by a positive mix variance driven by a 26% increase in average loans.
That left the net increase in net interest income approximately equal to the
positive volume variance from the 11% growth in average earning assets. The net
interest income rate variance is significantly impacted by $445 thousand in 1997
interest income recognized in connection with loan loss recoveries. Excluding
the recovered interest from 1997, the rate variance would have been a positive
$87 thousand despite falling earning asset yields. The benefit from declining
deposit rates more than offsets declines in interest income that resulted from
falling earning asset yields.
The increase in net interest income for 1997 attributable to volume is
illustrative of the principal impact of acquiring the new branches. Interest
income increased by $2.4 million as a result of volume, while interest expense
increased by $1.0 million. Approximately 49% of the positive rate variance of
$916 thousand for 1997 compared to 1996 is the result of the nonaccrual interest
recoveries realized during the year. The remainder of the variance is
principally the result of paying off the mortgage note payable and yield
increases for loans and investments. The negative impact of earning asset mix
variances with respect to loans was minimized for 1997 relative to 1996 due to
favorable mix changes in the deposit base. Noninterest bearing demand deposits
increased to 11% of average deposits for 1997 compared to 9% for 1996. NOW
accounts increased to 37% of average deposits compared to 34% in 1996.
16
Allowance for Loan Losses
The following table reconciles the beginning and ending allowance for loan
losses for the previous five years. Reconciling activity is broken down into the
three principal items that impact the reserve: (1) reductions from charge-offs;
(2) increases from recoveries; and (3) increases or decreases from positive or
negative provisions for loan losses.
- --------------------------------------------------------------------------------------------
(in thousands) 1998 1997 1996 1995 1994
Balance at beginning of period $ 1,313 1,207 959 1,127 924
Charge-offs:
Commercial 67 249 237 357 98
Real estate 25 -- -- 30 --
Consumer 40 41 97 95 77
------- ------- ------- ------- -------
Total Charge-offs $ 132 290 334 482 175
Recoveries:
Commercial 112 434 260 174 37
Real estate -- -- -- -- --
Consumer 21 22 12 25 18
------- ------- ------- ------- -------
Total Recoveries 133 456 272 199 55
------- ------- ------- ------- -------
Net charge-offs $ (1) (166) 62 283 120
Additions charged to operations 250 (60) 310 115 323
------- ------- ------- ------- -------
Balance at end of period $ 1,564 1,313 1,207 959 1,127
======= ======= ======= ======= =======
Ratio of net charge-offs to average
loans outstanding (.001%) (.28%) 0.11% 0.50% 0.20%
======= ======= ======= ======= =======
- --------------------------------------------------------------------------------------------
Footnote 1(g) to the consolidated financial statement discusses the factors used
in determining the provision for loan losses and the adequacy of the allowance
for loan losses.
Charge-off activity declined by 54% in 1998 compared to 1997, while recoveries
declined by 71% for the same period. The decline in charge-offs is consistent
with the asset quality statistics discussed below in the Asset Quality section.
The Bank has not modified or significantly excepted its underwriting standards
despite growing competition within the industry. The decline in recoveries is a
function of the significant recoveries that were realized in 1997.
Charge-off activity declined by 31% and 13%, respectively, in 1996 and 1997,
while recoveries increased by 37% and 68%, respectively, for the same periods.
These trends are consistent with the improvements discussed below in the Asset
Quality section. The principal reason for the increases in recoveries was
improvement in the repayment capacity of certain credits that had previously
been charged off combined with the Bank's continued efforts subsequent to
charge-off to work diligently toward collection.
17
The loan loss provision for 1998 increased significantly relative to 1997. The
reason for the increase was twofold. With year-over-year increase in the loan
portfolio of 45%, a larger provision was necessitated by the significant growth
in lending volume and the losses inherent in that volume. In addition, the 1997
provision was negative as a result of the significant recoveries that
effectively amplified the year-to-year change in the provision with respect to
both 1998 and 1996. The declining charge-offs and larger recoveries during 1997
increased the loan loss reserve by more than management believed was necessary
to provide for loss potential in the loan portfolio. Accordingly, a negative
provision resulted from the reversal of a portion of the reserve. The loan loss
provision for 1996 exceeded the provision for 1995 by 170%. Although net
charge-offs declined from 1995 to 1996, management determined that the loan loss
provision of $310 thousand was necessary to provide for the loss potential with
respect to a specific group of loan relationships that exhibited increased
credit risk at that time.
Noninterest Income
Noninterest income increased by 32% and 33% in 1998 and 1997, respectively. SBA
revenue for 1998 was even with 1997. The increases in 1998 came from growth in
the other major components of noninterest income: service charges, mortgage
income, and other noninterest income. The following table summarizes the
significant elements of service charge, SBA, mortgage and Farmer Mac revenue for
the three years ending 1998, 1997, and 1996:
-------------------------------------------------------------------------------------------------------------
(in thousands) 1998 1997 1996
-------------------------------------------------------------------------------------------------------------
Periodic deposit account charges $ 352 307 192
Returned item charges 344 332 259
Ancillary services charges 82 70 33
Other service charges 68 57 75
-------------------------------------------------
Total service charge revenue 846 766 559
=================================================
Gain on sale of SBA loans 191 217 163
SBA loan servicing revenue 226 199 183
-------------------------------------------------
Total SBA revenue 417 416 346
Gain on sale of mortgage loans 243 77 44
Mortgage loan servicing revenue 92 53 41
-------------------------------------------------
Total mortgage revenue 335 130 85
Farmer Mac origination, sale and servicing 32 29 20
-------------------------------------------------
Total loan origination, sale and servicing revenue $ 784 575 451
-------------------------------------------------------------------------------------------------------------
Service charge revenue increased by 10% in 1998 compared to 1997 and 37% in 1997
compared to 1996. The growth in service charge income for 1998 was driven by
deposit growth. Average deposits grew 15% in 1998. The growth in service charge
revenue for 1997 resulted primarily from the acquisition of three branches as
discussed above in "Branch Acquisition." The acquisition increased deposits by
approximately 37%. In addition to deposit growth, the Bank's service charge
schedule was reviewed during 1997, and certain rates were increased in areas
where the Bank's rates were more than competitive.
Revenue from SBA loan sales was nearly comparable to the record level set in
1997, when SBA loan sales revenue increased by 33% over 1996. While SBA loan
originations increased in 1998 relative to 1997, the production cycle for many
of these loans extended relative to 1997, and fewer loans were sold. Partially
disbursed SBA loans at December 31, 1998 were $6.4 million compared to $1.1
million at December 31, 1997. The 33% increase in 1997 was the result of both
increases in the volume of loans originated and sold as well as a general
increase in the loan sale premiums realized in the secondary market for SBA loan
sales. During 1996, a new incentive compensation program was put into place. The
program was designed to provide incentives for increasing levels of production.
As production increased, the SBA servicing portfolio increased and resulted in
the 13% and 9% increases in SBA servicing revenue for 1998 and 1997,
respectively.
18
Revenue from mortgage loan sales reached a new record in 1998, surpassing the
previous record by 216%. Mortgage revenue for 1997 increased by 75% over 1996.
Mortgage operations were reorganized in 1994, and part of the annual increases
since that time are the result of the relationships that have been developed
with builders, realtors, and title companies. In addition to reorganized
operations, housing activity in the Bank's trade area continued to improve in
1998, building on the improvements in 1997. The Bank continues to package home
construction and mortgage take-out loans in a competitive manner and has
successfully marketed this product in the new trade areas that were opened as a
result of the acquisition of branches from Wells Fargo Bank in early 1997 (see
"Branch Acquisition" above). Finally, declining mortgage rates during 1998 and
1997 had a favorable impact on mortgage loan refinance volumes.
The Bank began to participate in the Federal Agricultural Mortgage Corporation
("Farmer Mac") lending program in late 1994, whereby qualifying mortgage loans
on agricultural property are originated and sold.
Noninterest Expenses
Noninterest expenses increased by 13% in 1998 compared to 1997 and 46% in 1997
compared to 1996. Growth in the Bank's branch network in 1998 and 1997 had a
significant impact on year-to-year comparability as did certain strategic
expenses incurred in 1998. Noninterest expenses for 1998 included 12 months of
expenses for the three new branches purchased in 1997 compared to ten months for
those branches in 1997. In addition, a loan production office in Folsom,
California was opened in January, 1998, and a full service branch in Elk Grove,
California was opened in August, 1998. Excluding the above factors, noninterest
expense increased by 5.5% in 1998 compared to 1997.
The single biggest factor behind the increase in 1997 compared to 1996 was the
acquisition of three branches from Wells Fargo Bank on February 22, 1997 as
discussed above in "Branch Acquisition." Excluding the expenses associated with
the three new branches in 1997 noninterest expenses increased by 17% in 1997
compared to 1996.
Noninterest expense is broken down into four primary categories each of which is
discussed in this section.
Salaries and Employee Benefits
The following table provides the detail for each major segment of salaries and
employee benefits together with relevant statistical data:
---------------------------------------------------------------------------------------------------------------
(in thousands except full time equivalents) 1998 1997 1996
----------------------------------------------------------------------------------------------------------------
Regular payroll, contract labor, and overtime $ 2,641 2,298 1,699
Incentive compensation and profit sharing 339 335 125
Payroll taxes and employment benefits 576 459 381
--------------------------------------------------
Total Salaries and Employee Benefits $ 3,556 3,092 2,205
==================================================
Number of full-time equivalent employees 95.00 82.00 62.25
--------------------------------------------------
Regular payroll per full-time equivalent employee 27.80 28.02 27.29
--------------------------------------------------
Incentive compensation to regular payroll 12.8% 14.6% 7.4%
--------------------------------------------------
Payroll taxes and benefits per full-time equivalent employee 6.06 5.60 6.12
---------------------------------------------------------------------------------------------------------------
Total salaries and benefits expense increased by 15% in 1998 and 40% in 1997.
Excluding the timing of expenses from new branches, the increases were 10% and
4% respectively. The adjusted rate of change for 1998 includes both wage
adjustments, additional positions added in the mortgage and SBA departments to
support growth and supplemental compensation accruals made pursuant to the
agreements summarized in Footnote 9 to the 1998 Consolidated Financial
Statements. The adjusted rate of change for 1997 reflects wage adjustments and
higher incentive compensation accruals related to increased profitability.
Regular payroll increased by 35% in 1997 compared to 1996 due primarily to the
increase in personnel from the three branches purchased from Wells Fargo Bank
(see "Branch Acquisition above"). At the closing date of the transaction, the
branch acquisition added 20 full-time equivalents. Regular payroll per full-time
equivalent declined by less than 1% in 1998 after increasing by 2.7% in 1997.
19
Incentive compensation includes bonus awards under the Incentive Compensation
Plan, contributions to the Employee Stock Ownership Plan and matching
contributions to the 401(k) Stock Ownership Plan. The Incentive Compensation
Plan pays bonuses to officers based upon the actual results of departmental and
Bank-wide performance in comparison to predetermined targets. Contributions to
the Employee Stock Ownership Plan are made at the discretion of the board of
directors based upon profitability. Matching contributions to the 401(k) Stock
Ownership Plan are made at the rate of 50% of the first 4% of compensation
contributed by employees. The rate of incentive compensation for 1997 was nearly
double the rate in 1996 based upon increased profitability.
Payroll taxes and employee benefits per full-time equivalent increased in 1998
compared to 1997 and declined in 1997 compared to 1996. The increase in 1998 is
related primarily to supplemental compensation accruals made pursuant to the
agreements summarized in Footnote 9 to the 1998 Consolidated Financial
Statements. The decline in 1997 was because certain benefit expenses did not
increase proportionately with the increase in full-time equivalents. Despite an
increase of 20 full-time equivalents, workers compensation insurance declined
slightly in 1997, and medical insurance per full-time equivalent declined by
$377.
Occupancy Expense
The following table provides the detail for each major segment of occupancy
expense:
-------------------------------------------------------------------------------------------------
(in thousands except square footage and cost per sq. ft.) 1998 1997 1996
-------------------------------------------------------------------------------------------------
Depreciation $289 265 251
Property taxes, insurance, and utilities 220 204 168
Property maintenance 144 154 109
Net rental expense (income) 62 (30) (45)
---------------------------
Total Occupancy $715 593 483
===========================
Square footage of occupied and unoccupied space 42,945 40,725 28,312
---------------------------
Occupancy cost per square foot $16.65 14.56 17.06
---------------------------
Locations 8 6 3
-------------------------------------------------------------------------------------------------
Occupancy expenses increased by 21% in 1998 compared to 1997 and 23% in 1997
compared to 1996.
The primary reason for the increase in 1998 is the increase in net rental
expense. The increase is related to the January opening of a loan production
office in Folsom, California and the August opening of a full service branch in
Elk Grove, California. In addition, the Galt branch was relocated in November,
1998. While the new rental expense in Galt is lower than it would have been
absent a relocation, it is higher per month than it was in 1997. With respect to
the three branches acquired from Wells Fargo Bank in 1997, 1998 includes two
additional months of occupancy expenses compared to 1997.
The increase in 1997 is attributable to the acquisition of three branches from
Wells Fargo Bank (see "Branch Acquisition"). Approximately 13,500 square feet of
space was added by the branch acquisition. Two of the locations were purchased
and the third, representing 6,000 square feet, was leased. The occupancy cost
per square foot declined by 15% as the acquired locations had a lower cost per
square foot than existing locations.
Equipment Expense
The following table provides the detail for each major segment of equipment
expense:
-------------------------------------------------------------------
(in thousands) 1998 1997 1996
-------------------------------------------------------------------
Depreciation $ 406 318 232
Maintenance 104 136 109
Rental expense 26 1 26
---------------------------------------
Total Equipment $ 536 455 367
-------------------------------------------------------------------
Equipment expense increased by 18% in 1998 compared to 1997 and increased by 24%
in 1997 compared to 1996.
20
The increase in 1998 was driven by two additional months of costs in 1998 for
the three branches acquired from Wells Fargo Bank in 1997 and the loan
production office and full service branch opened in the communities of Folsom
and Elk Grove California, respectively, in January and August of 1998,
respectively. The Galt branch was also relocated in November, 1998, and some
equipment was replaced.
The increase in 1997 was a function of the equipment acquired in, or purchased
as a result of, the acquisition of three branches from Wells Fargo Bank (see
"Branch Acquisition"). The increase in 1997 was also due in part to the
depreciation expense taken on when a new banking information system, the Phoenix
Banking System, was put into place in June of 1996. 1997 was the first full year
of depreciation and followed six months of depreciation in 1996. The old system
was no longer operationally or technologically current. As such, it was subject
to significant maintenance and repair expenses. Those costs declined by 24% in
1996 as a result of the new system. Concurrent with conversion to the Phoenix
Banking System, the bank also contracted with an outside vendor to process
customer checks and statements. These functions had previously been done
internally with rented equipment. As a result of this change, rental expenses
for equipment were nearly eliminated in 1997 compared to 1996.
Other Noninterest Expense
The following table provides the detail for each major segment of other
noninterest expense:
------------------------------------------------------------------------------------------------------
(in thousands) 1998 1997 1996
------------------------------------------------------------------------------------------------------
Third party data processing $ 719 642 371
Intangible amortization 372 479 ---
Professional fees 423 401 372
Telephone and postage 217 182 132
Director fees and retirement 223 150 124
Office supplies 176 142 113
Marketing 213 120 121
Printing 145 117 86
Other real estate owned losses and holding costs (12) 94 49
Business development 57 55 43
Regulatory assessments 51 53 40
Other 320 220 148
------------------------------------------------
Total Other Noninterest Expense $ 2,905 2,656 1,599
------------------------------------------------------------------------------------------------------
Other noninterest expenses increased by 10% in 1998 compared to 1997 and 66% in
1997 compared to 1996.
Approximately 3% out of the 10% increase in 1998 compared to 1997 is the result
of the new branches in 1998 and the inclusion of the three branches acquired in
1997 for twelve months in 1998 compared to 10 months for 1997. The remainder of
the increase is driven primarily by volume related costs. Average loans and
deposit volumes increased by 26% and 15%, respectively.
The most significant items behind the increase for 1997 were the acquisition of
three branches from Wells Fargo Bank (see Branch Acquisition), the outsourcing
of more functions to third party processors and increased losses and holding
costs on other real estate owned.
The acquisition of new branches in 1997 affected noninterest expenses in varying
degrees depending upon the fixed or variable nature of expenses. The most
definitive impact was the amortization of the core deposit and goodwill
intangible assets purchased in the acquisition. Amortization for 1997 amounted
to 24% of the purchase price of the related assets and represented 45% of the
increase in other noninterest expense for 1997 compared to 1996. The Bank is
using an accelerated method of amortization for these assets over an eight year
period. Excluding intangible amortization, the increase in other noninterest
expenses in 1997 was 36%.
21
As discussed under "Equipment Expense" above, the Bank outsourced the processing
of customer checks and statements to a third party in June of 1996. As a result
of this change in mid 1996, third party data processing costs increased in both
1996 and 1997. The acquisition of new branches approximately doubled the Bank's
customer base and added to the increase in third party data processing volumes
for 1997 compared to 1996.
Losses and holding costs for other real estate owned nearly doubled in 1997
compared to 1996. The Bank moved aggressively in 1997 to reduce other real
estate owned. In connection with that effort, carrying values and asking prices
were reduced to facilitate the sale of properties. In addition, new properties
were brought in during 1997 and increased holding costs, such as taxes and
bonds, compared to 1996.
Income Taxes
The provision for income taxes as a percentage of pretax income for 1998, 1997,
and 1996 was 25%, 32%, and 28%, respectively. The effective rate is lower than
the combined marginal rate for state and federal taxes due primarily to the
level of tax exempt income relative to total pre-tax income. Tax exempt income
increased in 1998 compared to 1997 due to an investment of $4.2 million in the
cash surrender value of life insurance as discussed below under Balance Sheet
Review. Tax exempt income declined during 1997 and 1996 in order to recoup
alternative minimum taxes paid in previous periods. As of December 31, 1998,
substantially all of these credits have been recovered, and the Company is in a
position to benefit from tax exempt income on a current basis. Footnote 12 to
the Consolidated Financial Statements contains a detailed presentation of the
income tax provision and the related current and deferred tax assets and
liabilities.
Balance Sheet Review
The following table presents average balance sheets for the years ended December
31, 1998, 1997 and 1996.
- ----------------------------------------------------------------------------------------------------------------------------
For the Year Ended For the Year Ended For the Year Ended
December 31, 1998 December 31, 1997 December 31, 1996
(in thousands) (in thousands) (in thousands)
-----------------------------------------------------------------------------
Amount Percent Amount Percent Amount Percent
------ ------- ------ ------- ------ -------
- ----------------------------------------------------------------------------------------------------------------------------
Assets:
Cash & Due from banks $ 6,701 4.32% 5,362 3.94% 4,020 3.80%
Federal funds sold 6,780 4.37% 8,400 6.17% 3,790 3.58%
Investment securities 53,370 34.42% 53,580 39.36% 34,700 32.82%
Loans (net of allowance for loan losses and 71,752 46.29% 56,744 41.68% 53,213 50.33%
deferred income)
Premises and equipment, net 7,188 4.64% 7,227 5.31% 7,044 6.66%
Other assets 9,220 5.96% 4,830 3.54% 2,966 2.81%
-------- ------ ------- ------ ------- ------
Total Assets $155,011 100.00% 136,143 100.00% 105,733 100.00%
======== ====== ======= ====== ======= ======
Liabilities & Stockholders' Equity:
Deposits $140,480 90.63% 122,540 90.00% 90,420 85.52%
Note payable -- -- -- -- 2,440 2.31%
Other liabilities 1,215 .78% 1,193 .88% 1,113 1.05%
Stockholders' equity 13,316 8.59% 12,410 9.12% 11,760 11.12%
-------- ------ ------- ------ ------- ------
Total Liabilities & Stockholders' Equity $155,011 100.00% 136,143 100.00% 105,733 100.00%
======== ====== ======= ====== ======= ======
- ----------------------------------------------------------------------------------------------------------------------------
22
Average total assets increased by 14% in 1998 compared to 1997 and 29% in 1997
compared to 1996. Year-end asset totals at December 31, 1998 reached $164.4
million and represented an increase of 11% over December 31, 1997. The increase
in 1998 is a function of deposit growth throughout the Bank's branch network, as
average deposits increased by 15% in 1998. The increase in 1997 is largely
attributable to $34 million in deposits acquired in connection with the
acquisition of three branches from Wells Fargo Bank (see "Branch Acquisition").
Deposits at December 31, 1997 increased by 45%, or $41.6 million, compared to
December 31, 1996. Average deposits for 1997 exceeded 1996 by 36%. The increase
in deposits reduced the ratio of average equity to average assets by 200 basis
points in 1997 to 9.12% and provided for a more efficient use of capital.
The liquidity generated by the growth in deposits funded growth in the loans
during 1998 and both loans and investment securities in 1997. Average loans
increased by 26% and 7% in 1998 and 1997, respectively, while loans at December
31, 1998 and 1997 were 45% and 18%, respectively, above the comparable prior
year-end totals. The average investment portfolio for 1997 was 54% larger than
in 1996.
23
Investment Securities
The following table presents the investment portfolio at December 31, 1998, 1997
and 1996 by security type, maturity, and yield:
- --------------------------------------------------------------------------------------------------------------------------------
Book Value at December 31 (in thousands):
1998 1997 1996
---- ---- ----
Amount Yield(a) Amount Yield(a) Amount Yield(a)
- -----------------------------------------------------------------------------------------------------------------------------
U.S. Treasury Securities:
Within 1 year $ 1,000 5.87% 2,995 5.94% 600 8.09%
Ater 1 year, within 5 years -- -- 1,000 5.87% 3,972 5.93%
After 5 years, within 10 years -- -- -- -- -- --
After 10 years -- -- -- -- -- --
---------------------------------------------------------------
Total U.S. Treasury $ 1,000 5.87% 3,995 5.92% 4,572 6.21%
U.S. Agency Securities:
Within 1 year 1,512 5.68% 2,101 7.06% 4,023 5.94%
After 1 year, within 5 years 13,482 6.50% 13,997 6.46% 8,537 6.71%
After 5 years, within 10 years 3,000 6.93% 9,986 7.07% 5,038 7.04%
After 10 years 1,500 6.85% 4,993 7.63% 483 8.30%
--------------------------------------------------------------
Total U.S. Agency $19,494 6.53% 31,077 6.88% 18,081 6.67%
Collateralized Mortgage Obligations:
Within 1 year -- -- -- -- -- --
After 1 year, within 5 years -- -- 225 6.08% 329 5.65%
After 5 years, within 10 years 153 5.51% 277 6.27% 376 5.84%
After 10 years 304 8.34% 534 6.57% 534 6.40%
--------------------------------------------------------------
Total Collateralized Mortgage Obligations $ 457 7.39% 1,036 6.38% 1,239 6.03%
Municipal Securities:
Within 1 year 1,196 6.20% 688 6.67% 250 6.33%
After 1 year, within 5 years 2,439 7.08% 3,118 6.94% 3,455 6.88%
After 5 years, within 10 years -- -- 530 7.60% 886 6.14%
After 10 years -- -- -- -- -- --
--------------------------------------------------------------
Total Municipals $ 3,635 6.79% 4,336 6.98% 4,591 6.71%
Other Debt Securities:
Within 1 year 93 8.50% 22 7.86% 27 8.57%
After 1 year, within 5 years 113 6.83% 2,748 7.41% 492 8.25%
After 5 years, within 10 years 2,509 7.28% 7 9.73% 1,097 7.33%
After 10 years -- -- 972 7.67% 33 8.15%
--------------------------------------------------------------
Total Other Debt Securities $ 2,813 7.36% 3,749 7.48% 1,649 7.64%
Money Market Mutual Fund 17,602 4.83% 17,200 6.12% 6,482 5.28%
Federal Agency Stock 126 6.00% 126 6.00% 83 6.00%
Unrealized Holding Gain/(Loss) 520 -- 398 -- 216 --
--------------------------------------------------------------
Total $45,647 5.93% 61,917 6.59% 36,913 6.39%
- -----------------------------------------------------------------------------------------------------------------------------
(a) The yields on tax-exempt obligations have not been computed on a tax-equivalent basis.
24
The investment portfolio at December 31, 1998 was 26% below the prior year total
after increasing by 68% in 1997 compared to 1996. The decline in the portfolio
during 1998 funded increases in loan volume. The growth in the portfolio during
1997 resulted from the investment of the deposit liquidity that was received
when the Bank purchased three branches from Wells Fargo Bank (see "Branch
Acquisition").
With the exception of the sale of money market mutual fund shares, the decline
in the portfolio during 1998 came solely from maturities and calls. The general
decline in interest rates during 1998 led to the call of several agency
securities that were purchased in 1997. Maturities and calls during 1998 were
approximately $20.9 million. At December 31, 1998, the portfolio included $9.0
million in callable agency securities with an average maturity, months-to-call,
and yield of 8.33%, 7.0%, and 6.9%, respectively.
The growth in the portfolio during 1997 was focused primarily in the U.S. Agency
segment and more specifically callable U.S. Agency bonds. The callable bonds
provide attractive yields relative to noncallable securities for the same
contractual maturity. In a rising rate scenario, the call option to the issuer
loses economic advantage. As a result, the securities estimated life extends but
the yield in excess of non-callable yields at the purchase date provides some
compensation for the extended life. In a falling rate scenario, the call option
to the issuer gains economic advantage. As a result, the likelihood of the bond
being called increases. While the proceeds from the call would need to be
reinvested at lower rates, the higher coupon on the callable bond compensates
for the risk of the bond being called. The callable U.S Agency securities
purchases were diversified. Final maturities ranged from three to fifteen years
with call protection from three months to two years. At December 31, 1997, the
Bank's callable U.S. Agency portfolio totaled $21 million and had an average
final maturity of nine years with average call protection of ten months.
A portion of the investment portfolio contains structured notes. Structured
notes generally carry terms that reference some index or predefined schedule as
a means of determining the coupon rate of interest to be paid on the security,
and there may also be interest rate caps or floors that limit the extent to
which the coupon rate can adjust in any given period and/or for the life of the
security. Depending upon the referenced index or predefined schedule as well as
the interest rate cap or floor, the coupon rate of a structured note can lead,
lag, move in tandem with, or move in the opposite direction of market interest
rates. As a result, the market value of the note can be favorably or adversely
impacted depending upon the direction and magnitude of change in market interest
rates. Structured notes may also contain provisions that give the issuer the
right to call the security away from the owner at a predetermined price;
therefore, the contractual, expected, and actual final maturity of the notes may
differ. Both the collateralized mortgage obligations and the structured agency
bonds are considered to be derivative securities under the broadest definitions
of derivatives, however, derivative investments in the Bank's portfolio are
structured such that they fall on the conservative end of the derivative risk
spectrum.
The amortized cost of the Bank's structured note portfolio at December 31, 1998
and 1997 was $.50 million and $1.0 million, respectively, and represented
approximately 1.1% and 1.6%, respectively, of the investment portfolio. The
market value of the structured note portfolio at December 31, 1998 and 1997 was
$.50 million and $1.0 million, respectively. All of the structured notes were
issued by Federal Agencies and therefore carry the implied AAA credit rating of
the Federal Government. The structured note portfolio at December 31, 1998 and
1997 carries only floating rate coupons that generally lag overall movements in
market interest rates.
25
Loans
The following table summarizes gross loans and the components thereof as of
December 31 for each of the last five years:
- ----------------------------------------------------------------------------------------------------------------------------
Outstanding at December 31 (in thousands):
-----------------------------------------------------------------------------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
- ----------------------------------------------------------------------------------------------------------------------------
Commercial $77,956 53,684 45,322 41,538 44,847
Real estate construction 11,743 6,900 5,802 7,549 9,809
Installment and other 3,463 3,525 3,155 2,757 2,656
------- ------ ------ ------ ------
$93,162 64,109 54,279 51,844 57,312
======= ====== ====== ====== ======
- ----------------------------------------------------------------------------------------------------------------------------
Gross loans outstanding as of December 31, 1998 and 1997 exceeded the comparable
prior year-end totals by 45% and 18%, respectively. Improving economic
conditions and business development efforts were the foundation for the growth
in both years. A significant amount of effort was put forth by management during
1994 to improve the credit quality of the loan portfolio and alter the labor
intensiveness of certain segments of the portfolio. The portfolio dollars
declined in 1995 as a result of these efforts. During 1995 and thereafter,
management's focus expanded to business development and the approach to business
development was refined. The growth in 1996 through 1998 is attributable to
diligent application of those business development disciplines.
The most significant segment of the loan portfolio is commercial loans, which
represented 84% of the total portfolio at December 31, 1998 and 1997. Commercial
loans include agricultural loans, working capital loans to businesses in a
number of industries, and loans to finance commercial real estate. Agricultural
loans represented approximately 14% and 21% of the commercial loan portfolio at
December 31, 1998 and 1997, respectively. Agricultural loans are diversified
throughout a number of agricultural business segments, including dairy,
orchards, row crops, vineyards, cattle and contract harvesting. Agricultural
lending risks are generally related to the potential for volatility of
agricultural commodity prices. Commodity prices are affected by government
programs to subsidize certain commodities, weather, and overall supply and
demand in wholesale and consumer markets. Excluding agricultural loans, the
remaining portfolio is principally dependent upon the health of the local
economy and related to the real estate market.
The maturity and repricing characteristics of the loan portfolio at December 31,
1998 are as follows:
- ---------------------------------------------------------------------------------------------------------------
Due: (1) Fixed Rate Floating Rate Total
---------- ------------- -----
In 1 year or less $ 13,039 18,294 31,333
After 1 year through 5 years 20,867 15,916 36,783
After 5 years 9,705 15,341 25,046
-------- ------ ------
Total Loans $ 43,611 49,551 93,162
========