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UNITED STATES
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, 2004
Commission File Number: 000-31929
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SONOMA VALLEY BANCORP
(Name of registrant at as specific in its charter)
CALIFORNIA 68-0454068
(State of incorporation) (I.R.S. Employer Identification No.)
202 West Napa Street
Sonoma, California 95476
(707) 935-3200
(Address, including zip code, and telephone number,
including area code, of principal executive offices)
------------------------
Securities to be registered under section 12(b) of the Exchange Act: None
Securities to be registered under section 12(g) of the Exchange Act:
Name of each exchange
Title of each class on which registered
------------------- ---------------------
Common Stock, No Par Value None
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 (229.405 of this chapter) is contained herein, and will not be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment of this Form 10-K. |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act) [ ] Yes [ X ] No
Aggregate market value of Common Stock held by non-affiliates of Sonoma Valley
Bancorp as of March 4, 2005 based on the current market price of the stock: $
34,415,942
The number of shares of registrant's common stock outstanding as of March 4,
2005 was 2,151,370.
DOCUMENTS INCORPORATE BY REFERENCE
The information required by Items 10,11,12,13 and 14 of Part III are
incorporated by reference to the registrant's proxy statement, which will be
filed within 120 days of the registrant's year end.
With the exception of historical facts stated herein, the matters discussed
in this Form 10-K are "forward looking" statements that involve risks and
uncertainties that could cause actual results to differ materially from
projected results. Such "forward looking" statements include, but are not
necessarily limited to statements regarding anticipated levels of future
revenues and earnings from the operation of Sonoma Valley Bancorp's wholly owned
subsidiary, Sonoma Valley Bank, projected costs and expenses related to
operations of the bank's liquidity, capital resources, and the availability of
future equity capital on commercially reasonable terms. Factors that could cause
actual results to differ materially include, in addition to the other factors
identified in this Form 10-K, the following: (i) increased competition from
other banks, savings and loan associations, thrift and loan associations,
finance companies, credit unions, offerors of money market funds, and other
financial institutions; (ii) the risks and uncertainties relating to general
economic and political conditions, both domestically and internationally,
including, but not limited to, inflation, or natural disasters affecting the
primary service area of the Bank or its major industries; or (iii) changes in
the laws and regulations governing the Bank's activities at either the state or
federal level. Readers of this Form 10-K are cautioned not to put undue reliance
on "forward looking" statements which, by their nature, are uncertain as
reliable indicators of future performance. Sonoma Valley Bancorp disclaims any
obligation to publicly update these "forward looking" statements, whether as a
result of new information, future events, or otherwise.
PART I
ITEM 1. BUSINESS
General
Sonoma Valley Bancorp ("Company") was incorporated under California law on
March 9, 2000 at the direction of Sonoma Valley Bank for the purpose of forming
a single-bank holding company structure pursuant to a plan of reorganization.
The reorganization became effective November 1, 2000, after obtaining all
required regulatory approvals and permits, shares of the Company's common stock
were issued to shareholders of Sonoma Valley Bank in exchange for their Sonoma
Valley Bank stock. Previously, Sonoma Valley Bank filed its periodic reports and
current reports under the Securities Exchange Act of 1934 with the Federal
Deposit Insurance Corporation. Following the reorganization, periodic and
current reports are now filed with the Securities and Exchange Commission.
The business operations of the Company continue to be conducted through its
wholly-owned subsidiary, Sonoma Valley Bank ("Bank"), which began commercial
lending operations on June 3, 1988. In addition to its main branch located in
Sonoma, California, the Bank also operates two additional branch offices, one
branch office is located in Glen Ellen, California. In March 2004, the Bank
opened another branch office, Banco de Sonoma, located in Boyes Hot Springs,
California. The following discussion, therefore, although presented on a
consolidated basis, analyzes the financial condition and results of operations
of the Bank for the twelve month period ended December 31, 2004.
Primary Services
The Bank emphasizes the banking needs of small to medium-sized commercial
businesses, professionals and upper middle to high income individuals and
families in its primary service area of Sonoma, California and the immediate
surrounding area. In recognition of CRA compliance, the Company offers products
to accommodate special needs of individuals regardless of their economic status
and more recently the Company has focused on the needs of the Latino community.
The Bank offers depository and lending services keyed to the needs of its
business and professional clientele. These services include a variety of demand
deposit, savings and time deposit account
Page 2
alternatives, all insured by the FDIC up to its applicable limits. Special
merchant and business services, such as coin, night depository, courier, on line
cash management and merchant teller services are available. The Bank offers
Internet Banking for both commercial and consumer customers, bank by mail
service, drive-up ATM service, extended hours including Saturday banking,
drive-up windows and telephone voice response. The Bank's lending activities are
directed primarily towards granting short and medium-term commercial loans,
augmented by customized lines of credit, for such purposes as operating capital,
business and professional start-ups, inventory, equipment, accounts receivable,
credit cards, and interim construction financing, personal loans and loans
secured by residential real estate.
With the opening of our third Branch office, Banco de Sonoma Office in
March, 2004, the bank is offering additional services to the Latino community in
our market place. The Banco de Sonoma office is staffed by bilingual officers,
customer service employees and tellers. The Bank offers special money transfer
services to facilitate the transfer of funds to Mexico.
The business of the Bank is not seasonal. The Bank intends to continue with
the same basic commercial banking activities it has operated with since
beginning operations June 3, 1988. Retail deposit gathering activities at the
branches comprise the bulk of sources for lending. The Bank has approved
borrowing levels at the Federal Home Bank for temporary funding needs.
Competition
In general, the banking business in California and in the market areas,
which the Bank serves, is highly competitive with respect to both loans and
deposits, and is dominated by a relatively small number of major banks, which
have many offices operating over a wide geographic area. The Bank competes for
loans and deposits with these and other regional banks, including several which
are much larger than the Bank, as well as savings and loan associations, thrift
and loan associations, finance companies, credit unions, offerors of money
market funds and other financial institutions.
The Bank's primary service area is currently served by branches of eight
other banks (including three major banks: Citigroup, Bank of America and Wells
Fargo Bank). In order to compete with the major financial institutions in its
primary service area, the Bank uses its flexibility as an independent bank. This
includes emphasis on specialized services and personalized attention.
In the event there are customers whose loan demands exceed the Bank's
lending limit, the Bank seeks to arrange for such loans on a participation basis
with other financial institutions and intermediaries. The Bank also is able to
assist those customers requiring other services not offered by the Bank by
obtaining those services through its correspondent banks.
Concentration of Credit Risk
The majority of the Bank's loan activity is with customers located within
the county of Sonoma. While the Bank has a diversified loan portfolio,
approximately 87% of these loans are secured by real estate in its service area.
This concentration for the year ending December 31, 2004 is presented below:
(in thousands of dollars)
Secured by real estate:
Construction/land development $ 24,152
Farmland 4,187
1-4 family residences 25,184
Commercial/multi-family 79,037
Page 3
Employees
As of December 31, 2004, the Company employed 55 full-time equivalent
employees.
Supervision and Regulation
The Company is a registered bank holding company under the Bank Holding
Company Act, regulated, supervised and examined by the Federal Reserve Bank. As
such, it must file with the Federal Reserve Bank an annual report and additional
reports as the Federal Reserve Board may require. The Company is also subject to
periodic examination by the Federal Reserve Board.
In addition, both the Company and the Bank are extensively regulated under
both federal and state laws and regulations. These laws and regulations are
primarily intended to protect depositors, not shareholders. To the extent that
the following information describes statutory or regulatory provisions, it is
qualified in its entirety by reference to the particular statutory and
regulatory provisions at issue.
As a California state-licensed bank, the Bank is subject to regulation,
supervision and periodic examination by the California Department of Financial
Institutions. The Bank is also subject to regulation, supervision, and periodic
examination by the Federal Deposit Insurance Corporation (the "FDIC"). The Bank
is not a member of the Federal Reserve System, but is nevertheless subject to
certain regulations of the Board of Governors of the Federal Reserve System. As
a state bank, the Bank's deposits are insured by the FDIC to the maximum amount
permitted by law, which is currently $100,000 per depositor in most cases. For
this protection, the Bank pays a semi-annual assessment.
The regulations of these state and federal bank regulatory agencies govern
most aspects of the Company's and the Bank's business and operations, including
but not limited to, requiring the maintenance of non-interest-bearing reserves
on deposits, limiting the nature and amount of investments and loans which may
be made, regulating the issuance of securities, restricting the payment of
dividends, regulating bank expansion and bank activities, including real estate
development activities. The Federal Reserve Board, the Federal Deposit Insurance
Corporation, and the California Department of Financial Institutions have broad
enforcement powers over depository institutions, including the power to prohibit
a bank from engaging in business practices which are considered to be unsafe or
unsound, to impose substantial fines and other civil and criminal penalties, to
terminate deposit insurance, and to appoint a conservator or receiver under a
variety of circumstances. The Federal Reserve Board also has broad enforcement
powers over bank holding companies, including the power to impose substantial
fines and other civil and criminal penalties.
Regulation of Bank Holding Companies
As a bank holding company, the Company's activities are subject to extensive
regulation by the Federal Reserve Board. The Bank Holding Company Act requires
us to obtain the prior approval of the Federal Reserve Board before (i) directly
or indirectly acquiring ownership or control of any voting shares of another
bank or bank holding company if, after such acquisition, we would own or control
more than 5% of the shares of the other bank or bank holding company (unless the
acquiring company already owns or controls a majority of such shares); (ii)
acquiring all or substantially all of the assets of another bank or bank holding
company; or (iii) merging or consolidating with another bank holding company.
The Federal Reserve Board will not approve any acquisition, merger or
consolidation that would have a substantially anticompetitive result, unless the
anticompetitive effects of the proposed transaction are clearly outweighed by a
greater public interest in meeting the convenience and needs of the community to
be served. The Federal Reserve Board also considers capital adequacy and other
financial and managerial factors in its review of acquisitions and mergers.
Page 4
With certain exceptions, the Bank Holding Company Act also prohibits us
from acquiring or retaining 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, or from engaging directly or indirectly in activities other than those
of banking, managing or controlling banks, or providing services for its
subsidiaries. The principal exceptions to these prohibitions involve certain
non-bank activities that, by statute or by Federal Reserve Board regulation or
order, have been determined to be activities closely related to the business of
banking or of managing or controlling banks.
Federal Deposit Insurance
The FDIC may terminate the deposit insurance of any insured depository
institution if the FDIC determines that the institution has engaged or is
engaging in unsafe or unsound practices, is in an unsafe or unsound condition to
continue operations or has violated any applicable law, regulation, order or any
condition imposed in writing by, or pursuant to written agreement with, the
FDIC. The FDIC may also suspend deposit insurance temporarily during the hearing
process for a permanent termination of insurance if the institution has no
tangible capital.
Impact of Economic Conditions and Monetary Policies
The earnings and growth of the Bank are and will be affected by general
economic conditions, both domestic and international, and by the monetary and
fiscal policies of the United States Government and its agencies, particularly
the Federal Reserve Bank (FRB). One function of the FRB is to regulate the money
supply and the national supply of bank credit in order to mitigate recessionary
and inflationary pressures. Among the instruments of monetary policy used to
implement these objects are open market transactions in United States Government
securities, changes in the discount rate on member bank borrowings, and changes
in reserve requirement held by depository institutions. The monetary policies of
the FRB have had a significant effect on the operating results of commercial
banks in the past and are expected to continue to do so in the future. However,
the effect of such policies on the future business and earnings of the Bank
cannot be accurately predicted.
Recent and Proposed Legislation
From time to time, legislation is enacted which has the effect of
increasing the cost of doing business, limiting or expanding permissible
activities, or affecting the competitive balance between banks and other
financial institutions. Proposals to change the laws and regulations governing
the operations and taxation of banks and other financial institutions are
frequently made in Congress, in the California legislature, and by various bank
regulatory agencies. No prediction can be made as to the likelihood of any major
changes or the impact such changes might have on the Bank. Certain changes of
potential significance to the Bank which have been enacted recently or others
which are currently under consideration by Congress or various regulatory or
professional agencies are discussed below.
The Financial Services Modernization Act of 1999 (also known as the
"Gramm-Leach-Bliley Act" after its Congressional sponsors) substantially
eliminates most of the separations between banks, brokerage firms, and insurers
enacted by the Glass-Steagall Act of 1933. The reform legislation permits
securities firms and insurers to buy banks, and banks to underwrite insurance
and securities. States retain regulatory authority over insurers. The Treasury
Department's Office of the Comptroller of the Currency has authority to regulate
bank subsidiaries that underwrite securities and the Federal Reserve has
authority over bank affiliates for activities such as insurance underwriting and
real-estate development.
Page 5
The U.S. federal bank regulatory agencies' risk-based capital guidelines
are based upon the 1988 capital accord of the Basel Committee on Banking
Supervision (the "Basel Committee"). The Basel Committee is a committee of
central banks and bank supervisors from the major industrialized countries that
develops broad policy guidelines that each country's supervisors can use to
determine the supervisory policies they apply. In January 2001, the Basel
Committee on Banking Supervision issued a proposal for a "New Capital Accord".
The New Capital Accord incorporates a three-part framework of minimum capital
requirements, supervisory review of an institution's capital adequacy and
internal assessment process, and market discipline through effective disclosure
to encourage safe and sound banking practices. To remain a financial holding
company, a company must remain "well capitalized" and "well managed". "Well
managed" means that at their most recent examination the bank received a
satisfactory composite rating and at least a satisfactory rating for management.
The federal banking agencies are required to take "prompt corrective action" in
respect of depository institutions and their bank holding companies that do not
meet minimum capital requirements. FDIC established five capital tiers: "well
capitalized", "adequately capitalized", "undercapitalized", "significantly
undercapitalized" and "critically undercapitalized". A depository institution's
capital tier, or that of its bank holding company, depends upon where its
capital levels are in relation to various relevant capital measures, including a
risk-based capital measure and a leverage ratio capital measure, and certain
other factors. As of December 31, 2004, the Company and Bank are "well
capitalized" and "well managed".
Under the regulations adopted by the federal banking agencies, a bank
holding company is "well capitalized" if it has (i) a total risk-based capital
ratio of 10% or greater, (ii) a Tier 1 risk-based capital ratio of 6% or
greater, (iii) a leverage ratio of 5% or greater and (iv) is not subject to any
written agreement, order or directive to meet and maintain a specific capital
level for any capital measure. An "adequately capitalized" depository
institution is defined as one that has (i) a total risk-based capital ratio of
8% or greater, (ii) a Tier 1 risk-based capital ratio of 4% or greater and (iii)
a leverage ratio of 4% or greater (or 3% or greater in the case of a bank rated
a composite 1 under the Uniform Financial Institution Rating System, "CAMELS
rating", established by the Federal Financial Institution Examinations Council).
A company is considered (i) "undercapitalized" if it has (A) a total risk-based
capital ratio of less than 8%, (B) a Tier 1 risk-based capital ratio of less
than 4% or (C) a leverage ratio of less than 4% (or 3% in the case of an
institution with a CAMELS rating of 1), (ii) "significantly undercapitalized" if
it has (A) a total risk-based capital ratio of less than 6%, or (B) a Tier 1
risk-based capital ratio of less than 3% or (C) a leverage ratio of less than 3%
and (iii)"critically undercapitalized" if it has a ratio of tangible equity to
total assets equal to or less than 2%. An institution may be deemed by the
regulators to be in a capitalization category that is lower than is indicated by
its actual capital position if, among other things, it receives an
unsatisfactory examination rating.
The USA Patriot Act of 2001 ("USA Patriot Act") imposes additional
obligations on U.S. financial institutions, including banks and broker dealer
subsidiaries, to implement policies, procedures and controls which are
reasonably designed to detect and report instances of money laundering and the
financing of terrorism. In addition, provisions of the USA Patriot Act require
the federal financial institution regulatory agencies to consider the
effectiveness of a financial institution's anti-money laundering activities when
reviewing bank mergers and bank holding company acquisitions.
The Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley") intended to address
corporate and accounting fraud. Sarbanes-Oxley applies to publicly reporting
companies. In addition to the establishment of a new accounting oversight board,
which will enforce auditing, quality control and independence standards and will
be funded by fees from all publicly traded companies, the bill restricts
provision of both auditing and consulting services by accounting firms. To
maintain auditor independence, any non-audit services being provided to an audit
client requires pre-approval by the Company's audit committee members. In
addition, the audit partners must be rotated.
Page 6
Sarbanes-Oxley also requires the chief executive officer and the chief
financial officer to certify to the accuracy of periodic reports filed with the
Securities Exchange Commission (the "SEC"), subject to civil and criminal
penalties if they knowingly or willfully violate this certification requirement.
In addition, under Sarbanes-Oxley, legal counsel will be required to report
evidence of a material violation of the securities laws or a breach of fiduciary
duty by a company to its chief executive officer or its chief legal officer,
and, if such officer does not appropriately respond, to report such evidence to
the audit committee or other similar committee of the board of directors or the
board itself. Companies are required to adopt a Code of Ethics for their
Financial Managers and any violators are subject to disciplinary action.
Longer prison terms and increased penalties will also be applied to
corporate executives who violate federal securities laws, the period during
which certain types of suits can be brought against a company or its officers
has been extended, and bonuses issued to top executives prior to restatement of
a company's financial statements are now subject to disgorgement if such
restatement was due to corporate misconduct. Executives are also prohibited from
insider trading during retirement plan "blackout" periods, and loans to company
executives are restricted. Sarbanes-Oxley accelerates the time frame for
disclosures by public companies, as they must immediately disclose any material
changes in their financial condition or operations. Directors and executive
officers must also provide information for most changes in ownership in a
company's securities within two business days of the change.
Sarbanes-Oxley also prohibits any officer or director of a company or any
other person acting under their direction from taking any action to fraudulently
influence, coerce, manipulate or mislead any independent public or certified
accountant engaged in the audit of the company's financial statements for the
purpose of rendering the financial statements materially misleading. In
addition, Sarbanes-Oxley requires that each financial report required to be
prepared in accordance with (or reconciled to) accounting principles generally
accepted in the United States of America and filed with the SEC reflect all
material correcting adjustments that are identified by a "registered public
accounting firm" in accordance with accounting principles generally accepted in
the United States of America and the rules and regulations of the SEC.
Section 404 of the Sarbanes-Oxley Act of 2002 requires the SEC to prescribe
rules requiring the inclusion of an internal control report in each annual
report. Accordingly, in the annual report for December 31, 2006, management will
be required to include a report on the effectiveness of the Company's internal
controls. The Company's independent auditors are required to attest to and
report on management's assessment of internal control. The Company's management
and staff are working diligently toward evaluating and documenting the internal
control systems in order to allow management to report on, and the Company's
independent auditors to attest to, the Company's internal control over financial
reporting. The Company has retained the services of a consulting firm to assist
management and staff with this process. Even so, there can be no assurances that
the evaluation required by Sarbanes-Oxley will not result in the identification
of significant control deficiencies or that the Company's auditors will be able
to attest to the effectiveness of our internal controls over financial
reporting.
Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board issued a
revision of Statement of Financial Accounting Standards (SFAS) No. 123,
Accounting for Stock-Based Compensation establishing revised standards for the
accounting for transactions in which an entity exchanges its equity instruments
for goods or services. This statement no longer allows, as an alternative, the
use of Accounting Principles Board (APB) Opinion No. 25's intrinsic value method
of accounting for stock options, as had been provided under the original SFAS
No. 123. Under APB No. 25, issuing stock options generally resulted in no
recognition of compensation expense. Under revised SFAS No. 123, entities are
required to recognize the cost of services received in exchange for awards of
equity instruments based on the grant-date fair value. This revised SFAS
Page 7
is effective for the Company beginning in the third quarter of 2005. All options
issued after the effective date of this SFAS, as well as options granted in the
past for which the requisite services have not been provided as of the effective
date of this SFAS, are required to be recorded as compensation expense. The
implementation of this SFAS will have no impact on the Company since the Company
recorded compensation expense for stock options granted after January 1, 2003
and there are no remaining requisite services for stock options granted prior to
January 1, 2003.
Page 8
Statistical Data
The following information is required by the Industry Guide 3, "Statistical
Disclosure by Bank Holding Companies". The averages shown have been calculated
using the average daily balance.
Sequential Page
Number
I. Distribution of Assets, Liabilities and Share-
holders' Equity; Interest Rates and Differential
A. Average balance sheets 20
B. Analysis of net interest earnings 20
C. Rate/volume analysis 21
II. Investment Portfolio
A. Book value (Amortized Cost) of investments 45
B. Weighted average yield and maturity 20, 24, 30 and 46
C. Securities of issuer exceeding
ten percent of equity: None
III. Loan Portfolio
A. Types of loans 20 and 47
B. Maturities and sensitivities of loans
to change in interest rates 30 and 48
C. Risk elements
1. Non-accrual, past due,
and restructured loans 25 and 47
2. Potential problem loans: None
3. Foreign outstandings: None
4. Loan concentrations 24 and 47
D. Other Interest-Bearing Assets: None
IV. Summary of Loan Loss Experience 26 and 48
V. Deposits
A. Average balances and average rates paid 20
B. Other categories of deposits None
C. Foreign outstandings None
D. Maturity of time deposits greater than $100,000 30
E. Maturity of foreign time deposits greater than 100,000 None
VI. Return on Equity and Assets 17
VII. Short-term Borrowings: None
Page 9
ITEM 2. PROPERTIES
The Company is headquartered in Sonoma, California. At the present time the
Company's Bank has three branch offices. In 1995, the Bank leased additional
office space adjacent to the Sonoma Branch and in September 1997 the Bank
purchased property across the street from the Sonoma Branch. The Sonoma Branch
is located at 202 W. Napa Street, Sonoma. The building contains approximately
6800 square feet and has been subleased on a long-term basis (the initial term
expires in 2009, with option to extend for two additional five-year terms). The
office is considered by management to be well maintained and adequate for the
purpose intended. Lease payments made in 2004 totaled $233,978 compared to the
$224,979 paid in 2003. The lease provides for future annual rents to be adjusted
for changes in the Consumer Price Index ("CPI"), with a minimum annual increase
of 4%, effective each March 1st.
In July 1995, the Bank leased a building at 463 Second Street West. The
building contains approximately 2400 square feet and has been leased on a long
term basis to coincide with the Sonoma Branch lease. The initial term expired in
2000, with the first option to expire in 2005, with an option to extend for two
additional five year terms and one additional four year term. Lease payments
made in 2004 totaled $38,016 compared with the $37,006 paid in 2003. The lease
provides for future annual rents to be adjusted for changes in the Consumer
Price Index ("CPI") effective each July 1st.
In September 1997, the Bank purchased the building and land at 472 Second
St. West. The building contains approximately 1013 square feet. The Bank paid
$246,943 for the property. At present the Bank is utilizing the parking area for
additional parking for Bank employees and until February 2005, the Bank has been
renting out the building premises. At the present time, the Bank is evaluating
how to utilize the additional space to accommodate additional growth. Rental
income in 2004 was $18,051 compared to $17,406 in 2003.
The Glen Ellen Branch Office is located at 13751 Arnold Drive, Glen Ellen.
The facility is 525 square feet. The facility is leased for a five year term
expiring in 2008 with the option to extend for two additional five year terms.
Lease payments made in 2004 totaled $13,596 compared to $11,789 in 2003. The
lease provides for future annual rents to be adjusted for changes in the CPI,
with a minimum annual increase of 4% effective April 1st of each year.
The Banco de Sonoma Branch, which opened in March 2004, is located at 18615
Sonoma Hwy, Suite 108, Boyes Hot Springs, California. The facility is 1200
square feet. The facility is leased for a five year term expiring in 2009 with
options to extend for two additional five year terms. Lease payments in 2004
totaled $18,630. The lease provides for future annual rents to be adjusted for
changes in the CPI effective February 1st of each year.
ITEM 3. LEGAL PROCEEDINGS
In the normal course of operations, the Company and /or its Bank may have
disagreements or disputes with vendors, borrowers, or employees, which may or
may not result in litigation. These disputes are seen by the Company's
management as a normal part of business. There are no pending actions reported
and no threatened actions that management believes would have a significant
material impact on the Company's financial position, results of operations or
cash flows.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
The Company did not submit any matters to security holders during the
fourth quarter of its last fiscal year ended December 31, 2004.
Page 10
PART II
ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED SECURITY HOLDER
MATTERS
The Company is trading on the Over the Counter Bulletin Board ("OTC BB")
under the symbol "SBNK". The Company is not listed on any exchange or on the
National Association of Securities Dealers Automated Quotation System
("NASDAQ").
Several brokers act as facilitators in the trades of Sonoma Valley Bancorp
stock. They are:
A.G.Edwards Monroe Securities
703 2nd Street Suite 100 343 W. Erie Street Suite 410
Santa Rosa, CA 95409 Chicago, IL 60610
Denise Gilseth Russ Feltes
(800) 972-4800 (312) 327-2535
Fax (707) 528-1117 Fax (312) 327-2540
Baird, Patrick & Company UBS Financial Services
20 Exchange Place 6570 Oakmont Drive
R. J. Dragani Santa Rosa, CA 95409
New York, New York 10005 John Rector
(800) 421-0123 (707) 539-1500
Fax (212) 493-6643 Fax (707) 537-3553
Edward Jones Hoefer & Arnett
515 First Street East 555 Market Street 18th Floor
Sonoma, CA 95476 San Francisco, CA 94105
Gary Scott Cherie Stokes (415) 538-5727
(707) 935-1856 Dave Bonaccorso (415) 538-5723
Fax (707) 935-1894 Switchboard (800) 346-5544
Fax (415)398-4875
Wedbush Morgan Securities Seidler Companies
1300 S.W. Fifth Avenue Suite 2000 P.O.Box 1688
Joey Warmenhoven X254 42605 Moonridge Road
Portland, Oregon 97201-5667 Troy Norlander
(503) 224-0480 Big Bear, CA 92315
Fax (503) 224-7097 (800) 288-2811
Fax (909) 585-7220
Tnorlander@seidlercos.com
Page 11
The table below summarizes those trades of the common stock as reported by OTC
BB, setting forth the high and low prices for the periods shown. The stock
prices have been adjusted for stock dividends and stock splits.
Quarter Ended: High Low
--------------- ---------------
December 31, 2004 $ 30.00 $ 22.00
September 30, 2004 25.00 20.67
June 30, 2004 24.00 22.33
March 31, 2004 24.67 20.00
December 31, 2003 $ 20.67 $ 18.83
September 30, 2003 20.00 18.40
June 30, 2003 19.33 17.78
March 31, 2003 19.68 17.40
As of March 4, 2005, there were 1,048 registered holders of the Company's common
stock, in addition to an unknown number of holders whose shares of common stock
are held in street name.
Payment of Dividends
Under state law, the Board of Directors of a California state-licensed bank
may declare a cash dividend, subject to the restriction that the amount
available for the payment of cash dividends shall be the lesser of retained
earnings of the bank or the bank's net income for its last three fiscal years
(less the amount of any distributions to shareholders made during such period).
However, under the Financial Institutions Supervisory Act, the FDIC has
broad authority to prohibit a bank from engaging in banking practices which it
considers to be unsafe or unsound. It is possible, depending upon the financial
condition of the bank in question and other factors, that the FDIC may assert
that the payment of dividends or other payments by a bank is considered an
unsafe and unsound banking practice and therefore, implement corrective action
to address such a practice.
The Bank paid cash dividends of $300,000 on December 29, 2000, $500,000 on
April 18, 2001, $500,000 on February 26, 2003, $1,000,000 on June 18, 2003,
$4,000,000 on May 24, 2004 and $500,000 on February 24, 2005 to the Company.
Future dividend payments from the Bank to the Company will depend on the Bank's
future earnings, the Bank's ability to meet certain capital requirements and the
Bank having an adequate allowance for loan losses.
The Company paid cash dividends of $0.25 per share to shareholders of
record as of March 1, 2004 with payment made on March 15, 2004, $.25 per share
to shareholders of record as of August 6, 2004 with payment made on August 26,
2004, and $.25 per share to shareholders of record as of March 1, 2005 with
payment made on March 15, 2005. The Board of Directors of the Company is
currently reviewing our strategic plan to utilize our capital assets in order to
enhance shareholder value. One of the initiatives includes review of the
declaration of future cash dividends. No plan has yet been finalized.
Page 12
Historically, the Company and the Bank have declared ten stock dividends of
5% each, two stock dividends of 10% in May 1996 and June 1997, a 2 for 1 stock
split in March 1998, a 3 for 2 stock split in July 2004 and three cash dividends
in February 2004, July 2004 and February 2005 as detailed below:
Dividends Paid by the Bank
Date Declared Record Date Date Paid
----------------- ------------------ ---------------------
May 13, 1992 May 31, 1992 June 15, 1992
June 26, 1993 July 15, 1993 July 31, 1993
July 20, 1994 August 1, 1994 August 15, 1994
January 18, 1995 February 5, 1995 February 20, 1995
August 16, 1995 September 11, 1995 September 29, 1995
May 22, 1996 June 14, 1996 June 28, 1996
June 18, 1997 July 15, 1997 August 1, 1997
March 18, 1998 April 15, 1998 April 30, 1998
July 21, 1999 August 16, 1999 August 31, 1999
August 16, 2000 September 8, 2000 September 25, 2000
Dividends Paid by the Company
Date Declared Record Date Date Paid
----------------- -------------- ---------------------
July 18, 2001 August 3, 2001 August 17, 2001
June 17, 2002 July 2, 2002 July 16, 2002
June 18, 2003 July 2, 2003 July 16, 2003
February 18, 2004 March 1, 2004 March 15, 2004
July 21, 2004 August 6, 2004 August 26, 2004
February 16, 2005 March 1, 2005 March 15, 2005
Page 13
The following chart summarizes the Company repurchases of the Company's common
shares as part of the Company's tender offer expiring May 21, 2004 and the
Company's publicly announced repurchase plan.
------------------------- --------------------- ---------------------- ----------------------- -------------------------
(a) (b) (c) (d)
Maximum Number
(or Approximate
Dollar Value of
Total Number of Shares (or units)
Shares (or Units) that May Yet be
Purchased as Part Purchased Under
Total Number of of Publicly the Plans or
Shares (or Units) Average Price paid Announced Plans or Programs
Period Purchased per Share (or Unit) Programs
---------------- --------------------- ---------------------- ----------------------- -----------------
Month #1: 189 $29.375 81,489 $540,067
1/1/04 - 1/31/04
Month #2: 383 $30.00 81,872 $534,515
2/1/04 - 2/29/04
Month #3: 0 0 81,872 $534,515
3/1/04 - 3/31/04
Month #4: 0 0 81,872 $534,515
4/1/04 - 4/30/04
Month #5: 126,208(1) $35.00 126,208 0
5/1/04 - 5/31/04
Month #6: 29 $35.00 81,901 $533,500
6/1/04 - 6/30/04
Month #7: 0 0 81,901 $533,500
7/1/04 - 7/31/04
Month #8: 0 0 81,901 $533,500
8/1/04 - 8/31/04
Month #9: 0 0 81,901 $533,500
9/1/04 - 9/30/04
Month #10: 0 0 81,901 $533,500
10/1/04 - 10/31/04
0 0 81,901 $533,500
Month #11:
11/1/04 - 11/30/04
0 0 81,901 $533,500
Month #12:
12/1/04 - 12/31/04
126,809 $34.977 208,109 $533,500
Total
(1)The Company purchased 126,208 shares of common stock at $35 per share
through a tender offer, which expired on May 21, 2004.
Page 14
ITEM 6. SELECTED FINANCIAL DATA
SONOMA VALLEY BANCORP
Selected Consolidated Financial Data
dollars in thousands, except share
and per share data
For the years ended:
2004 2003 2002 2001 2000 1999
--------- --------- --------- --------- ---------- ----------
RESULTS OF OPERATIONS:
Net interest income $ 10,004 $ 8,906 $ 8,633 $ 8,236 $ 7,870 $ 6,699
Provision for loan losses 130 20 393 342 335 240
Non-interest income 1,710 1,715 1,641 1,309 893 941
Non-interest expense 7,225 6,244 5,862 5,224 5,061 4,614
Provision for income tax 1,451 1,446 1,275 1,379 1,160 976
---------- --------- --------- ---------- ---------- ----------
Net Income $ 2,908 $ 2,911 $ 2,744 $ 2,600 $ 2,207 $ 1,810
========== ========= ========= ========== ========== ==========
SELECTED AVERAGE BALANCES:
Assets $ 210,883 $195,177 $ 164,200 $ 147,807 $ 135,924 $ 123,202
Loans, net of unearned 139,395 123,044 116,867 100,605 86,547 73,222
Deposits 186,496 171,620 143,228 129,534 120,135 109,801
Shareholders' equity 20,799 20,232 17,964 15,121 12,984 11,490
PER SHARE DATA:
Basic net income $ 1.35 $ 1.34 $ 1.26 $ 1.18 $ 1.00 $ .81
Fully diluted net income $ 1.25 $ 1.23 $ 1.16 $ 1.10 $ .96 $ .79
Period end book value $ 9.65 $ 9.89 $ 8.81 $ 7.64 $ 6.52 $ 5.47
Weighted average shares
outstanding 2,148,558 2,165,066 2,176,386 2,209,727 2,220,605 2,293,407
FINANCIAL RATIOS:
Return on average assets 1.38% 1.49% 1.67% 1.76% 1.62% 1.47%
Return on average
shareholders' equity 13.98% 14.39% 15.27% 17.19% 17.00% 15.75%
Net yield on earning
assets 5.48% 5.24% 6.06% 6.25% 6.49% 6.04%
Cost control ratio 59.52% 56.95% 55.07% 52.72% 55.06% 58.52%
Average shareholders'
equity to average assets 9.86% 10.37% 10.94% 10.23% 9.55% 9.33%
CAPITAL RATIOS:
Risk-based capital:
Tier I 10.77% 12.81% 12.31% 11.81% 12.78% 12.36%
Total 12.02% 14.07% 13.57% 13.07% 14.04% 13.62%
Leverage ratio 9.51% 10.50% 10.62% 10.38% 10.11% 9.54%
CREDIT QUALITY:
Net charge-offs to
average loans 0.24% 0.14% 0.02% 0.05% -0.04% 0.04%
Allowance for possible
loan losses to period
end loans 1.59% 2.15% 2.17% 2.25% 2.29% 2.19%
Page 15
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The Year Ended December 31, 2004 versus December 31, 2003
The business operations of the Company continue to be conducted
through its wholly-owned subsidiary, Sonoma Valley Bank ("Bank"), which
began commercial lending operations on June 3, 1988. Accordingly, the
following discussion and analysis of the financial condition and the
results of operations should be read in conjunction with the financial
statements and notes included elsewhere in this annual report. Per share
amounts for prior years have been adjusted for the Company's 3 for 2 stock
split declared July 2004 and 5% stock dividends declared in June 2003, June
2002, July 2001, August 2000 and July 1999. The continued growth and
success of the company is dependent upon a stable economy, an increasing
deposit base in the Valley and economically viable technology to enhance
customer service. Expansion of services in the Valley such as the opening
of a new branch, the placement of a remote ATM in the local hospital, and
the deployment of wire transfer services through an international network
are some of the strategies contributing to successful performance. It is
management's opinion that community banking will continue to prosper, by
providing useful services in niche markets, in spite of the consolidation
taking place in the industry.
Critical Accounting Policies
The accounting and reporting policies of the Company conform to
accounting principles generally accepted in the United States and general
practices within the financial services industry. The preparation of
financial statements in conformity with generally accepted accounting
principles requires management to make estimates and assumptions that
affect the amounts reported in the financial statements and accompanying
notes. Actual results could differ from those estimates. A summary of the
Company's most significant accounting policies is contained in Note A to
the consolidated financial statements. The Company considers its most
critical accounting policies to consist of the allowance for loan and lease
losses and the estimation of fair value, which are separately discussed
below.
Allowance for Loan and Lease Losses. The allowance for loan and lease
losses represents management's best estimate of inherent losses in the
existing loan portfolio. The allowance for loan and lease losses is
increased by the provision for losses on loans and leases charged to
expense and reduced by loans and leases charged off, net of recoveries. The
provision for loan and lease losses is determined based on management's
assessment of several factors: reviews and evaluations of specific loans
and leases, changes in the nature and volume of the loan portfolio, current
economic conditions and the related impact on specific borrowers and
industry groups, historical loan and lease loss experience, the level of
classified and nonperforming loans and the results of regulatory
examinations.
The Company's Audit Committee engages experienced independent loan
portfolio review professionals many of whom are former bank examiners. The
Audit Committee determines the scope of such reviews and provides the
report of findings to the Board's Loan Committee after it has reviewed and
accepted the report. These reviews are supplemented with periodic reviews
internally by the Company's credit review function, as well as the periodic
examination of both selected credits and the credit review process by the
applicable regulatory agencies. The information from these reviews assists
management in the timely identification of problems and potential problems
and provides a basis for deciding whether the credit represents a probable
loss or risk that should be recognized.
Changes in the financial condition of individual borrowers, in
economic conditions, in historical loss experience and in the conditions of
the various markets in which collateral may be sold may all affect the
required level of the allowance for loan and lease losses and the
associated provision for loan and lease losses.
Page 16
Estimation of Fair Value. Accounting principles generally accepted in
the United States require that certain assets and liabilities be carried on
the Consolidated Balance Sheet at fair value or at the lower of cost or
fair value. Furthermore, the fair value of financial instruments is
required to be disclosed as a part of the notes to the consolidated
financial statements for other assets and liabilities (see Note R, page
64). Fair values are volatile and may be influenced by a number of factors,
including market interest rates, prepayment speeds, discount rates, the
shape of yield curves and the credit worthiness of counterparties.
Fair values for the majority of the Company's available for sale
investment securities are based on quoted market prices. In instances where
quoted market prices are not available, fair values are based on the quoted
prices of similar instruments with adjustment for relevant distinctions.
For trading account assets, fair value is estimated giving consideration to
the contractual interest rates, weighted average maturities and anticipated
prepayment speeds of the underlying instruments and market interest rates.
Overview
The Company continues to be profitable, however, net income declined
by $3,387 from $2,911,007 for the year ending December 31, 2003 to
$2,907,621 for the year ending December 31, 2004. The decline in net income
is a result of the expenses associated with the opening of the new branch,
Banco de Sonoma, during the first quarter of 2004 and the recognition of
expense for stock options granted during January 2004. Additionally the
Company has experienced a decrease in income associated with loan referral
fees. The refinancing boom has slowed considerably, a trend that could
continue in the next few years, and the Bank now originates many of the
mortgage loans previously outsourced to a vendor. The net effects of these
items combined to lower net income. On a per share basis, basic net income
per share equaled $1.35 in 2004 compared to $1.34 in 2003.
Return on average total assets for 2004, 2003 and 2002 was 1.38%,
1.49% and 1.67%, respectively. Return on average shareholders' equity
declined to 13.98% in 2004 compared to 14.39% in 2003. The decline in the
return on average assets in 2004 is the result of the increase in average
assets from $195.2 million in 2003 to $210.9 million in 2004, growth of
8.1% and the lower amount of income generated during the period. The lower
return on equity is the result of the decline in income during 2004 and the
$567,000 increase in average equity from $20.2 million in 2003 to $20.8
million in 2004.
While the bank has continued to enjoy strong earnings over the last
three years, the banks growth in assets has exceeded the earnings growth.
Earnings growth has been impacted by the decline in the net interest
margin, which is a combination of increased rate competition for loans and
the lower market rates for investment securities. Income at year end 2004
is lower than 2003 due to the 53 basis point decline in the yield on loans
(see the table-Average Balances, Yields and Rates Paid on page 20), the
decline in loan referral income, the increase in operating expense due to
the new Banco de Sonoma Branch Office and the expensing of stock options.
The Company has experienced pressure to refinance loans for customers that
were priced at higher yields and now have been negotiated at lower rates.
The most significant event affecting the Company's growth is the
opening of the Banco de Sonoma Branch in Boyes Hot Springs. Initially, this
has had a negative effect on the Income Statement by generating a loss of
$282,000. The branch office is offering services to the Latino community in
our market place. Management identified this is as a niche which was
under-served and an opportunity for future growth and profitability. All
employees at the branch are bilingual and able to offer full service
banking. An additional product which has been added is the ability for the
customer to effect an immediate transfer of funds to Mexico. Management
anticipates that the growth in the branch will be slow and steady and
profitable within three or four years.
Page 17
Total shareholders' equity declined by $790,000 or 3.68% at year end
2004. On May 21, 2004, the Company closed the tender offer purchasing
126,208 shares of stock at $35.00 per share for a total of $4,488,126
including expenses associated with this offer, lowering equity. In addition
to the tender offer, the Company repurchased and retired 601 shares of
stock for $18,057. In 2004, stock options were granted to senior employees,
which increased equity by $103,680. At December 31, 2004 the Company
reported net income of $2,907,621 which included an expense for the stock
options of $103,680, therefore the net effect of the stock option
transaction relative to equity was zero. In March and August 2004 the
company paid out cash dividends for a combined amount of $906,732. An
additional $7,498 was paid for fractional shares in August 2004 as a result
of the three for two split of the Company's common stock. The directors and
officers exercised 97,494 options which added $1,168,805 to the capital
accounts. The tax benefit on these options exercised was $617,260, which
also increased equity. The net effect of this activity in the capital
accounts was capital of $20,681,160 as of December 31, 2004, compared to
capital of $21,471,279 as of December 31, 2003.
At December 31, 2004, total assets were $218.2 million, a 6.4%
increase over the $205.1 million at December 31, 2003. The Company showed
loans of $153.2 million in 2004, compared with $122.5 million at year-end
2003, an increase of 25.1%. Deposits increased, growing 7.5%, from $180.1
million at year-end 2003 to $193.7 million at year-end 2004. The
loan-to-deposit ratio increased to 79.1% in 2004 from 68.0% in 2003. In
2005, management anticipates similar growth in assets and deposits, but as
interest rates increase we anticipate that loan growth will slow.
The Company has acquired additional software to accommodate
maintaining a portfolio of adjustable rate residential loans, which was not
an option in prior years. Additionally, the bank has enhanced its ability
to engage in mortgage origination for the secondary market, and will be
using the increased liquidity for warehousing product available for sale.
This activity is expected to enhance earnings for the Company.
RESULTS OF OPERATIONS
Net Interest Income
Net interest income is the difference between total interest income
and total interest expense. Net interest income, adjusted to a fully
taxable equivalent basis, increased $1.2 million to $10.4 million, up 12.7%
from 2003 net interest income of $9.3 million. Net interest income on a
fully taxable equivalent basis, as shown on the table - Average Balances,
Yields and Rates Paid (page 20), is higher than net interest income on the
statements of operations because it reflects adjustments applicable to
tax-exempt income from certain securities and loans ($424,000 in 2004 and
$343,000 in 2003, based on a 34% federal income tax rate).
The increase in net interest income (stated on a fully taxable
equivalent basis) was the net effect of an increase of $1.0 million in
interest income and a $170,000 decrease in interest expense, which is a
result of loans growing at a faster rate than deposits and a loan to
deposit ratio of 79.1% in 2004 compared to 68.0% in 2003. Declining rates
influenced net interest income in spite of the growth in earning assets.
The decline in interest expense is expected to plateau as the effective
interest cost for the bank is not expected to decline further and with the
increase in market interest rates could have a dramatic effect on the cost
of deposits. This increased rate competition for loans and investments
combined with the inability to keep rates down will likely result in a flat
to declining earnings environment.
Net interest income (stated on a fully taxable equivalent basis)
expressed as a percentage of average earning assets, is referred to as net
interest margin. The Company's net interest margin increased 24 basis
points to 5.48% in 2004 from 5.24% in 2003. The increase in the net
interest margin is the result of the 100 basis point increase in the prime
lending rate, growth in loan volume and the transition of assets from Fed
Funds Sold to loan products.
Page 18
Interest Income
As previously stated, interest income (stated on a fully taxable
equivalent basis) increased by $1.0 million to $12.0 million in 2004, a
9.2% increase over the $11.0 million realized in 2003.
The $1.0 million increase was the result of a 7.8% increase in average
earning assets to $190.4 million combined with an 8 basis point increase in
average yield for the year. The yield on earning assets was 6.29% as of
December 31, 2004 compared to 6.21% for the year end 2003. The small
increase in yield is a result of loans coming off floors. The 8 basis point
increase is small, because higher yielding maturing loans are being
replaced by lower yielding fixed rate loans and existing loans are
refinancing at lower rates.
Interest Expense
Total interest expense declined by $170,000 to $1.6 million. The
average rate paid on all interest-bearing liabilities was 1.09% in 2004,
compared to 1.28% in 2003. Average balances increased from $134.1 million
to $142.4 million, a 6.2% gain.
The gain in volume of average balances was responsible for a $52,000
increase in interest expense offset by a $222,000 decrease related to lower
interest rates paid for a net decrease of $170,000. The lower rates paid on
interest-bearing liabilities is a result of management's ability to keep
interest rates down, in a rising rate environment.
Individual components of interest income and interest expense are
provided in the table - Average Balances, Yields and Rates Paid on page 20.
Provision for Loan Losses
The provision for loan losses charged to operations is based on the
Company's monthly evaluation of the loan portfolio and the adequacy of the
allowance for loan losses in relation to total loans outstanding. The
provisions to the allowance for loan losses amounted to $130,000 in 2004
and $20,000 in 2003. The increase in the provision is the result of
management's evaluation and assessment of the loan portfolio, the higher
charge offs in 2004 and the increase in the loan growth. Management
anticipates loan growth will continue in 2005, which would necessitate a
further increase in the provision to the reserve for loan losses.
The economic climate continues to improve and the non-performing
assets ratio at December 31, 2004 was .72% compared to 1.26% as of year end
2003. Non accrual loans were $1.0 million as of December 31, 2004 compared
to $1.2 million as of December 31, 2003, a decline of 17.7%. Loans
charged-off, net of recoveries, resulted in losses totaling $336,000 in
2004 (one loan represented 80.3% of this figure) and $167,000 in 2003.
Refer to page 47 Note D for an analysis of the changes in the allowance for
loan and lease losses.
Page 19
SONOMA VALLEY BANCORP
AVERAGE BALANCES/YIELDS AND RATES PAID
Rate/Volume
2004 2003 2002
------ ------ ------
ASSETS AVERAGE INCOME/ YIELD/ AVERAGE INCOME/ YIELD/ AVERAGE INCOME/ Yield/
BALANCE EXPENSE RATE BALANCE EXPENSE RATE BALANCE EXPENSE Rate
-------- --------- ------- -------- -------- ------- -------- -------- -------
Interst-earning
assets:
Loans(2):
Commercial $ 98,243 $ 6,999 7.12% $ 85,965 $ 6,493 7.55% $ 75,696 $ 5,978 7.90%
Consumer 14,224 963 6.77% 11,632 889 7.64% 13,186 1,098 8.33%
Real Estate
Construction 19,134 1,471 7.69% 18,781 1,530 8.15% 19,040 1,689 8.87%
Real Estate
Mortgage 5,178 372 7.18% 3,820 333 8.72% 5,732 481 8.39%
Tax Exempt
loans (1) 3,033 254 8.37% 3,147 263 8.36% 3,367 285 8.46%
Leases 36 8 22.22% 67 22 32.84% 164 27 16.46%
Tax Exempt
leases (1) 1 0 0.00% 47 10 21.28% 106 15 14.15%
Unearned loan
fees (454) (416) (424)
-------- -------- --------
Total loans 139,395 10,067 7.22% 123,043 9,540 7.75% 116,867 9,573 8.19%
Investment
securities
Available for
Sale:
Taxable 23,265 781 3.36% 11,093 352 3.17% 6,029 365 6.05%
Tax
exempt(1) 0 0 0.00% 0 0 0.00% 0 0 0.00%
Hold to maturity
Taxable 390 10 2.56% 392 13 3.32% 201 13 6.47%
Tax
exempt(1) 17,187 993 5.78% 11,270 736 6.53% 10,904 777 7.13%
-------- -------- -------- --------- -------- --------
Total investment
securities 40,842 1,784 4.37% 22,755 1,101 4.84% 17,134 1,155 6.74%
Federal funds
sold 9,447 106 1.12% 30,318 318 1.05% 14,053 216 1.54%
FHLB stock 600 20 3.33% 288 13 4.51% 275 15 5.45%
Total due from
banks/interest
bearing 154 5 3.25% 202 1 0.50% 73 1 1.37%
-------- -------- -------- -------- -------- --------
Total interest
earning assets 190,438 11,982 6.29% 176,606 10,973 6.21% 148,402 10,960 7.39%
======== ======== ========
Noninterest-bearing
assets:
Reserve for loan
losses (2,436) (2,772) (2,547)
Cash and due from
banks 9,319 9,090 7,600
Premises and
equipment 1,370 1,120 705
Other assets 12,192 11,133 10,040
-------- -------- --------
Total assets $210,883 $195,177 $164,200
======== ======== ========
LIABILITIES AND
SHAREHOLDERS' EQUITY
Interest-bearing
liabilities:
Interest-bearing
deposits
Interest-bearing
transaction 30,888 $ 52 0.17% 29,819 $ 51 0.17% 23,794 $ 84 0.35%
Savings deposits 67,114 434 0.65% 59,266 466 0.79% 48,052 656 1.37%
Time deposits over
100,000 18,740 400 2.13% 19,794 477 2.41% 18,362 547 2.98%
Other Time deposits 25,666 668 2.60% 25,209 730 2.90% 20,155 674 3.34%
-------- -------- -------- -------- -------- --------
Total interest-
bearing deposits 142,408 1,554 1.09% 134,088 1,724 1.28% 110,363 1,961 1.78%
Federal Funds purhcased 0 0 0.00% 0 0 0.00% 0 0 0.00%
Other short term
borrowings 0 0 0.00% 3 0 0.00% 0 0 0.00%
-------- ------- -------- -------- -------- --------
Total interest
bearing
liabilites 142,408 1,554 1.09% 134,091 1,724 1.28% 110,363 $ 1,961 1.78%
======== ======== ========
Non interest-bearing
liabilities
Non interest-bearing
demand deposits 44,088 37,531 32,865
Other liabilities 3,588 3,323 3,008
Shareholders' equity 20,799 20,232 17,964
-------- -------- -------
Total liabilities
and shareholders'
equity $210,833 $195,177 $164,200
======== ======== ========
Interest rate spread 5.20% 4.93% 5.61%
Interest income $ 11,982 6.29% $ 10,973 6.21% $ 10,960 7.39%
Interest expense 1,554 0.81% 1,724 0.98% 1,961 1.32%
--------- ---- -------- ---- -------- ----
Net interest income/
margin $ 10,428 5.48% $ 9,249 5.24% $ 8,999 6.06%
========= ======== ========
(1) Fully tax equivalent adjustments are based on a federal income tax rate of
34% in 2004, 2003 and 2002.
(2) Non accrual loans have been included in loans for the purposes of the above
presentation. Loan fees of approximately $299,000, $405,000 and $343,000
for the twelve months ended December 31, 2004, 2003 and 2002, respectively,
were amortized to the appropriate interest income categories.
Page 20
SONOMA VALLEY BANCORP
Rate/Volume Analysis
2004 over 2003 2003 over 2002
Volume Rate Vol/Rate Total Volume Rate Vol/Rate Total
ASSETS
Interest-earning assets:
Loans:
Commercial 928 (369) (53) 506 811 (261) (35) 515
Consumer 198 (101) (23) 74 (129) (90) 11 (209)
Real estate construction 29 (86) (2) (59) (23) (138) 2 (159)
Real estate mortgage 118 (59) (20) 39 (160) 19 (6) (148)
Tax exempt loans (10) 1 0 (9) (19) (4) 0 (22)
Leases (10) (7) 3 (14) (16) 27 (16) (5)
Tax exemt leases (10) (10) 10 (10) (8) 8 (4) (5)
Unearned fee income 0 0 0 0 0 0 0 0
-------- ------ ------ ------- ------- ------- ------- -------
Total loans 1,243 (631) (85) 527 456 (439) (48) (33)
Investment securities:
Available for sale:
Taxable 386 20 23 429 307 (174) (146) (13)
Tax-exempt 0 0 0 0 0 0 0 0
Held to maturity:
Taxable 0 (3) 0 (3) 12 (6) (6) 0
Tax-exempt 386 (84) (45) 257 26 (65) (2) (41)
-------- ------ ------ ------- ------- ------- ------- -------
Total investment
securities 772 (67) (22) 683 345 (245) (154) (54)
Federal funds sold (219) 22 (15) (212) 250 (69) (79) 102
FHLB Stock 14 (3) (4) 7 1 (3) (0) (2)
Due from bank-int bearing (1) 6 (1) 4 2 (1) (1) 0
-------- ------ ------ ------- ------- ------- ------- -------
Total interest-earning assets 1,809 (673) (127) 1,009 1,054 (757) (282) 13
======== ====== ====== ======= ======= ======= ======= =======
LIABILITIES
Interest-bearing liabilities:
Interest-bearing deposits:
Savings deposits 2 0 0 2 21 (44) (11) (34)
Interest-bearing demand deposits 62 (83) (11) (32) 153 (277) (65) (189)
Time less than $100,000 (25) (55) 3 (77) 43 (105) (8) (70)
Time $100,000 and over 13 (74) (1) (62) 169 (90) (23) 56
-------- ------ ------ ------- ------- ------- ------- -------
Total interest-bearing
deposits 52 (213) (9) (170) 386 (516) (107) (237)
Federal funds purchased 0 0 0 0 0 0 0 0
Other borrowings 0 0 0 0 0 0 0 0
Total interest-bearing
Liabilities 52 (213) (9) (170) 386 (516) (107) (237)
Interest differential 1,758 (462) (118) 1,178 668 (241) (175) 250
======== ====== ====== ======= ======= ======= ======= =======
Page 21
Volume/Rate variances were allocated in the following manner:
a. Changes affected by volume (change in volume times old rate)
b. Changes affected by rates (change in rates times old volume)
c. Changes affected by rate/volume (change in volume times change in rates)
The total for each category was arrived at by totaling the individual items in
their respective categories.
Non-interest Income
Non-interest income of $1.710 million decreased .29% or $5,000 in
comparison with the $1.715 million recorded in 2003. In 2004 income from service
charges on deposit accounts increased 5.3% or $55,000 from $1.0 million in 2003
to $1.1 million in 2004. This increase was a result of both an increase in
service charges and growth in deposit accounts.
Other fee income showed a small decline in 2004 of 5.6% or $18,000 from
$324,000 in 2003 to $306,000 in 2004. The lower income is a result of the
decline in loan referral income from $122,000 in 2003 to $35,000 in 2004 a
decrease of $87,000. Other categories of other fee income showed strong growth.
Credit card merchant income was $71,000 in 2003 and grew to $129,000 in 2004, an
increase of $58,000. The remaining categories of other fee income include
miscellaneous fees for Bank services which showed growth in 2004 over 2003.
Other non-interest income showed an 11.8% decline or $42,000 from $357,000
in 2003 to $315,000 in 2004. This is largely a result of a decline in the income
generated by bank owned life insurance policies in 2004. Income on the policies
was $343,000 in 2003 compared to $298,000 in 2004 or a yield of 7.56% and 6.47%,
respectively. As market rates increase, the income produced by these policies
should increase.
Non-interest Expense
Total non-interest expense increased 15.7% to $7.2 million in 2004 from
$6.2 million in 2003. Non-interest expense represented 3.4% of average total
assets in 2004 and 3.2% in 2003. The expense/asset ratio is a standard industry
measurement of a bank's ability to control its overhead or non-interest costs.
During 2005, the Company will continue to emphasize cost controls, though
certain costs, such as professional fees associated with the implementation and
compliance with the Sarbanes-Oxley Act, costs of company insurance and salary
and benefit expense including workers compensation insurance and medical
benefits are not controllable by management. Refer to Note I, page 52, for a
detailed description of Non-Interest Income and Other Non-Interest Expense.
Salaries and Benefits
The most significant increase was in the salaries and benefits category.
Salary and benefits increased 18.2% from $3.5 million in 2003 to $4.1 million in
2004 of which $267,000 reflects the salary and benefits expenses associated with
the new Banco de Sonoma Office. The remainder of the increase reflects
additional staffing in Sonoma, normal merit increases and employee incentives
paid as a result of the Company's earnings in 2004. Additionally, there
continues to be significant increases in workers compensation and employee
medical benefits. At December 31, 2004 and 2003 total full-time equivalent
employees were 55 and 49, respectively, an increase of 6 full time equivalent
employees. Year-end assets per employee were $3.97 million in 2004 compared with
$4.2 million in 2003.
Premises and Equipment
Expenses related to premises and equipment increased by 17.2% or $132,000
to $901,000 in 2004 from $769,000 in 2003. Of that increase, $67,000 resulted
from additional costs associated with the opening of the Banco de Sonoma Office.
Bank lease expense increased $29,000 from $289,000 in 2003 to $318,000 in 2004.
Banco de Sonoma was responsible for $19,000 of that increase and the remaining
$10,000 represented the increase in lease expenses at the other three locations
and rental storage. Lease income in 2004 was $18,000 compared to $17,000 in
2003.
Page 22
Expenses on fixed assets were $322,000 in 2003 compared to $395,000 in
2004, with $30,000 of the $73,000 increase attributable to the opening of the
new office. The remaining increase is the result of equipment upgrades, as well
as the amortization of expenses from the remodel of the Sonoma and Glen Ellen
offices.
Other Non-interest Expense
Other non-interest expense increased by 10.8% to $2.2 million in 2004 from
$2.0 million in 2003. The increase in other non-interest expense was due to
increases in professional fees, advertising and marketing, stationery and office
supplies and FDIC and other insurance. Professional fees were $680,000 in 2003
and increased to $751,000 in 2004, an increase of $71,000 or 10.5%. The
categories of professional fees which showed the most significant increases were
in the areas of accounting and taxes, other exam fees, and accruals for Director
Retirement and legal fees. The increases in accounting and taxes, other exam
fees and legal fees are a result of complying with the Sarbanes-Oxley Act and
examinations to audit compliance with many of the new consumer regulations, such
as Customer Privacy, U. S. Patriot Act and Bank Secrecy Act. Additionally, with
the growth in the Company, time spent by outside professionals increased,
therefore, the costs increased. The Director Retirement costs increased as a
result of a lower crediting rate when determining benefit expense.
Advertising and marketing and stationery and office supplies increased due
to the costs associated with setting up a new office. An initial outlay to stock
the facility is necessary and then ongoing costs will level out. Again, as the
Company grows these costs will show some year over year increase.
In 2005, the Company anticipates professional fees will increase
dramatically due to the costs associated with compliance with Sarbanes Oxley
Rule 404, governing internal control provisions. To assist with compliance, the
Company has retained the services of a consulting firm.
Provision for Income Taxes
The provision for income taxes increased to an effective tax rate of 33.3%
in 2004 compared with 33.2% in 2003.
BALANCE SHEET ANALYSIS
Investment Securities
Investment securities were $37.6 million at December 31, 2004, a 2.7%
increase from the $36.7 million at December 31, 2003. At year end 2004, the
overall portfolio had a market value of $38.1 million compared with an amortized
cost of $37.9 million. The Company purchases securities rated A or higher by
Standard and Poor's and/or Moody's Investors Service. In the event a security is
downgraded, the Company will monitor the investment more closely or sell if
appropriate. Local tax-exempt bonds are occasionally purchased without an A
rating.
Securities are classified as held to maturity (HTM) if the Company has both
the intent and the ability to hold these securities to maturity. As of December
31, 2004, the Company had securities totaling $17.4 million with a market value
of $17.8 million categorized as held to maturity. Decisions to acquire municipal
securities, which are generally placed in this category, are based on tax
planning needs and pledge requirements.
Securities are classified as available for sale (AFS) if the Company
intends to hold these debt securities for an indefinite period of time, but not
necessarily to maturity. Investment securities which are
Page 23
categorized as available for sale are acquired as part of the overall asset and
liability management function and serve as a primary source of liquidity.
Decisions to acquire or dispose of different investments are based on an
assessment of various economic and financial factors, including, but not limited
to, interest rate risk, liquidity and capital adequacy. Securities held in the
available for sale category are recorded at market value, which is $20.3 million
compared to an amortized cost of $20.5 million as of December 31, 2004.
There were twenty Federal Farm Credit Bank, Federal Home Loan Bank, Federal
Home Loan Mortgage Corporation or Federal National Mortgage Association
securities of $19.8 million and one U.S. Treasury security of $496,000 in the
AFS portfolio and nineteen municipal securities of $6.7 million in the HTM
portfolio that are temporarily impaired as of December 31, 2004. Of the above,
there were three Federal Home Loan Mortgage Agency and Federal Home Loan Bank
securities of $2.3 million in the AFS portfolio and three municipal securities
of $867,000 in the HTM portfolio that have been in a continuous loss position
for 12 months or more as of December 31, 2004. The primary cause of the
impairment of these securities is interest rate volatility inherent in a rising
rate environment which causes the market value of the security to decline.
Management understood the potential market risks at the time of acquisition and
determined the benefit to the Company of the higher interest rates received more
than offset the potential deterioration in value. It is the Company's intent to
carry the securities to maturity date, at which time the Company will receive
face value for the securities at no loss.
Although the quoted market values fluctuate, investment securities are
generally held to maturity, and accordingly, gains and losses to the income
statement are recognized upon sale, or at such time as management determines
that a permanent decline in value exists. In the opinion of management, there
was no investment in securities at December 31, 2004 that constituted a material
credit risk to the Company. The lower market value to amortized costs was a
result of the increase in market interest rates and not an indication of lower
credit quality.
The table below shows the components of the investment portfolio and
average yields. For further information concerning the Company's total
securities portfolio, including market values and unrealized gains and losses,
refer to Note C of the Notes to Consolidated Financial Statements on page 45.
Twelve months ended 12/31/04 Twelve months ended 12/31/03
Average Average Average Average
Balance Yield Balance Yield
U.S. Treasury securities $ 516 2.3% $ 780 1.8%
U.S. federal agency issues 22,198 3.3% 9,263 2.9%
State, county and municipal issues 17,578 5.7% 11,662 6.4%
Corporate securities 550 6.4% 1,050 6.4%
-------- --------
Total investment securities $ 40,842 4.4% $ 22,755 4.8%
======== ========
Loans
A comparative schedule of average loan balances is presented in the table
on page 20; year-end balances are presented in Note D to the Consolidated
Financial Statements page 47.
Loan balances, net of deferred loan fees at December 31, 2004, were $153.2
million, an increase of 25.1% over 2003. Commercial loans, comprising 71.2% of
the portfolio, increased $17.1 million, or 18.6% over 2003 showing the greatest
change in volume of all categories. Included in commercial loans are loans made
for commercial purposes and secured by real estate.
Page 24
Real Estate Mortgage loans were the category which showed the greatest
growth rate, growing $5.5 million from $2.2 million at December 31, 2003 to $7.7
million as of December 31, 2004, a growth rate of 246.6%. During 2004 the
Company expanded their conventional Real Estate Loan portfolio. It is
anticipated that the growth rate will be more modest in 2005 due to the increase
in interest rates.
Consumer loans and Real Estate Construction loans grew $4.5 million and
$3.6 million, a growth rate of 38.3% and 21.9%, respectively. Only lease
financing receivables showed a decline of $32,000 from $80,000 to $48,000.
Customer interest in lease financing receivables has declined in our market,
therefore, the bank has not been active in generating these loans. Management
does not see this lack of interest in lease financing receivables changing in
the foreseeable future.
Risk Elements
The majority of the Company's loan activity is with customers located
within Sonoma County. Approximately 87% of the total loan portfolio is secured
by real estate located in the Company's service area. Significant concentrations
of credit risk may exist if a number of loan customers are engaged in similar
activities and have similar economic characteristics. The Company believes it
has policies in place to identify problem loans and to monitor concentrations of
credit (see Note O, on page 60 of the Consolidated Financial Statements,
Concentration of Credit Risk).
Based on its risk management review and a review of its loan portfolio,
management believes that its allowance for loan losses for the quarter ending
December 31, 2004, is sufficient to absorb losses inherent in the loan
portfolio. This assessment is based upon the best available information and does
involve uncertainty and matters of judgment. Accordingly, the adequacy of the
loan loss reserve cannot be determined with precision, but is subject to
periodic review, and could be susceptible to significant change in future
periods.
Loan Commitments and Letters of Credit
Loan commitments are written agreements to lend to customers at agreed upon
terms, provided there are no violations of any condition established in the
contract. Commitments generally have fixed expiration dates or other termination
clauses. Loan commitments may have variable interest rates and terms that
reflect current market conditions at the date of commitment. Because many of the
commitments are expected to expire without being drawn upon, the amount of total
commitments does not necessarily represent the Company's anticipated future
funding requirements. Unfunded loan commitments were $34.6 million at December
31, 2004 and $35.3 million at December 31, 2003.
Standby letters of credit commit the Company to make payments on behalf of
customers when certain specified events occur. Standby letters of credit are
primarily issued to support customers' financing requirements of twelve months
or less and must meet the Company's normal policies and collateral requirements.
Standby letters of credit outstanding were $360,000 at December 31, 2004 and
$725,000 at December 31, 2003.
Nonperforming Assets
Management classifies all loans as non-accrual loans when they become more
than 90 days past due as to principal or interest, or when the timely collection
of interest or principal becomes uncertain, if earlier, unless they are
adequately secured and in the process of collection.
A loan remains in a non-accrual status until both principal and interest
have been current for six months and meets cash flow or collateral criteria, or
when the loan is determined to be uncollectible and is
Page 25
charged off against the allowance for loan losses, or in the case of real estate
loans, is transferred to other real estate owned. A loan is classified as a
restructured loan when the interest rate is reduced, when the term is extended
beyond the original maturity date, or other concessions are made by the Company,
because of the inability of the borrower to repay the loan under the original
terms.
The Company had loans of $1.0 million in non-accrual status at December 31,
2004 and $1.2 million at December 31, 2003. There were $1.0 million in loans 90
days or more past due at December 31, 2004 and $1.2 million in loans 90 days or
more past due at December 31, 2003. Occasionally, the Company will have more
loans in non-accrual status than are 90 days past due, if they determine the
collection of principal or interest is unlikely.
Allowance for Loan Losses
The allowance for loan losses is maintained at a level considered adequate
to provide for losses that can be reasonably anticipated. The allowance is
increased by provisions charged to operating expense and reduced by charge-offs,
net of recoveries. The allowance is based on estimates, and ultimate losses may
vary from the current estimates. These estimates are reviewed monthly and, as
adjustments become necessary, they are reported in earnings in the periods in
which they become known.
The review process is intended to identify loan customers who may be
experiencing financial difficulties. In these circumstances, a specific reserve
allocation or charge-off may be recommended. Other factors considered by
management in evaluating the adequacy of the allowance include: loan volume,
historical net loan loss experience, the condition of industries and geographic
areas experiencing or expected to experience economic adversities, credit
evaluations, and current economic conditions. The allowance for loan losses is
not a precise amount, but based on the factors above, represents management's
best estimate of losses that may be ultimately realized from the current loan
portfolio.
Worsening conditions in certain economic sectors and geographic areas could
adversely affect the loan portfolio, necessitating larger provisions for loan
losses than currently estimated. However, as of December 31, 2004, the Company
believes its overall allowance for loan losses is adequate based on its analysis
of conditions at that time.
At December 31, 2004, the allowance for loan losses was $2.4 million, or
1.6% of year end loans, compared with $2.6 million or 2.2% of year end loans at
December 31, 2003. This reduction in the allowance is consistent with the
improved quality of the loan portfolio.
Net charge-offs to average loans increased when compared with the prior
year. The Company recorded net losses of $336,000 or .24% of average loans in
2004 compared to $167,000 or .14% of average loans in 2003. The increased,
although still low, level of charge-offs in 2004 reflects the Company's
attention and effort in managing and collecting past due loans by encouraging
the customer to bring them to a current status or to pay them off and
management's desire to quickly charge off a loan when it is determined to be
uncollectible. The prompt charge-off of loans increases the quality of the loan
portfolio.
Deposits
A comparative schedule of average deposit balances is presented in the
table on page 20; year-end deposit balances are presented in the table below.
Total deposits increased $13.5 million (7.5%) in 2004, to $193.7 million.
Demand deposits increased $6.6 million, or 17.4% in 2004. Savings deposits
increased by $6.6 million, or 10.3%, and interest-
Page 26
bearing checking increased$2.4 million, or 7.5% during 2004. Other time deposits
of less than $100,000 decreased $822,000, or 4.2%, and time deposits over
$100,000 decreased $1.3 million, for a decline of 4.7% over 2003 balances.
The composition of deposits for the years ending December 31, 2004 and 2003 are
as follows:
December 31, Percentage December 31, Percentage
2004 of Total 2003 of Total
------------ ---------- ------------ ---------
Interest-bearing transaction deposits $ 34,912,205 18.0% $ 32,467,678 18.0%
Savings deposits 70,254,926 36.3% 63,680,697 35.4%
Time deposits, $100,000 and over 25,307,661 13.1% 26,565,347 14.7%
Other time deposits 18,630,846 9.6% 19,453,317 10.8%
------------ ------------
Total interest-bearing deposits 149,105,638 77.0% 142,167,039 78.9%
Non-interest-bearing deposits 44,557,377 23.0% 37,947,577 21.1%
------------ ------------
Total deposits
$193,663,015 100.0% $180,114,616 100.0%
============ ============
Capital
The Bank is subject to FDIC regulations governing capital adequacy. The
FDIC has adopted risk-based capital guidelines which establish a risk-adjusted
ratio relating capital to different categories of assets and off-balance sheet
exposures. Under the current guidelines, as of December 31, 2004, the Bank was
required to have minimum Tier I and total risk-based capital ratios of 4% and
8%, respectively. To be well capitalized under Prompt Corrective Action
Provisions requires minimum Tier I and total risk-based capital ratios to be 6%
and 10%, respectively.
The FDIC has also adopted minimum leverage ratio guidelines for compliance
by banking organizations. The guidelines require a minimum leverage ratio of 4%
of Tier 1 capital to total average assets. Banks experiencing high growth rates
are expected to maintain capital positions well above the minimum levels. The
leverage ratio, in conjunction with the risk-based capital ratio, constitutes
the basis for determining the capital adequacy of banking organizations.
Based on the FDIC's guidelines, the Bank's total risk-based capital ratio
at December 31, 2004 was 11.34% and its Tier 1 risk-based capital ratio was
10.09%. The Bank's leverage ratio was 8.94%. All the ratios exceed the minimum
guidelines of 8.00%, 4.00% and 4.00%, respectively. The ratios for the Company
at December 31, 2003, were 14.07%, 12.81% and 10.49%, respectively. The capital
ratios for the Company at December 31, 2004, were 12.02%, 10.77% and 9.51%,
respectively.
In February 2001, the Company approved a program to repurchase Sonoma
Valley Bancorp stock up to $1.0 million and in August 2002 the Company approved
the repurchase of an additional $1.0 million of Sonoma Valley Bancorp stock. As
of December 31, 2004, $1,466,494 had been repurchased and retired, net of
options which were exercised and then subsequently repurchased and retired.
Refer to page 18, for a discussion of the changes in capital and page 37 for the
table of "Changes in Shareholders' Equity."
Management believes that the Bank's current capital position, which exceeds
guidelines established by industry regulators, is adequate to support its
business.
Page 27
Off Balance Sheet Commitments
The Company's off balance sheet commitments consist of commitments to
extend credit and standby letters of credit. These commitments are extended to
customers in the normal course of business and are described on page 25, Loan
Commitments and Letters of Credit and in Note N to the Consolidated Financial
Statements on page 59. The Company also has contractual obligations consisting
of operating leases for various facilities and payments to participants under
the Company's supplemental executive retirement plan and deferred compensation
plan, which are described in Note H on page 49.
The following table summarizes the Company's contractual obligations as of
December 31, 2004.
Payments due by period
---------- ----------- --------- --------- -----------
Less than 1 More than 5
Contractual Obligations Total year 1-3 years 3-5 Years years
- ----------------------- ---------- ----------- --------- --------- -----------
Operating Lease Obligations 1,321,431 296,229 585,143 143,037 297,022
Executive Officer Supplemental Retirement 1,891,236 13,590 29,750 102,027 1,745,869
Deferred Compensation 1,129,333 13,540 28,425 39,033 1,048,335
Liquidity Management
The Company's liquidity is determined by the level of assets (such as cash,
federal funds sold and available-for-sale securities) that are readily
convertible to cash to meet customer withdrawal and borrowing needs. Deposit
growth also contributes to the Company's liquidity. The Company's liquidity
position is reviewed by management on a regular basis to verify that it is
adequate to meet projected loan funding and potential withdrawal of deposits.
The Company has a comprehensive Asset and Liability Policy which it uses to
monitor and determine adequate levels of liquidity. At year end 2004, the
Company's liquidity ratio (adjusted liquid assets to deposits and short term
liabilities) was 18.47% compared to 29.03% and 20.39% at year end 2003 and 2002,
respectively. Management expects that liquidity will remain adequate throughout
2005, as loans are not expected to grow significantly more than deposits, and
excess funds will continue to be invested in quality liquid assets, such as U.S.
Treasury and Agency securities.
Market Risk Management
Overview. Market risk is the risk of loss from adverse changes in market
prices and rates. The Company's market risk arises primarily from interest rate
risk inherent in its loan and deposit functions. The goal for managing the
assets and liabilities of the Company is to maximize shareholder value and
earnings, while maintaining a high quality balance sheet without exposing the
Company to undue interest rate risk. The Board of Directors has overall
responsibility for the interest rate risk management policies. Sonoma Valley
Bank has an Asset and Liability Management Committee (ALCO) that establishes and
monitors guidelines to control the sensitivity of earnings to changes in
interest rates.
Asset/Liability Management. Activities involved in asset/liability
management include but are not limited to lending, accepting and placing
deposits and investing in securities. Interest rate risk is the primary market
risk associated with asset/liability management. Sensitivity of earnings to
interest rate changes arises when yields on assets change in a different time
period or in a different amount from that of interest costs on liabilities. To
mitigate interest rate risk, the structure of the balance sheet is managed
Page 28
with the goal that movements of interest rates on assets and liabilities are
correlated and contribute to earnings even in periods of volatile interest
rates. The asset/liability management policy sets limits on the acceptable
amount of variance in net interest margin and market value of equity under
changing interest environments. The Company uses simulation models to forecast
earnings, net interest margin and market value of equity.
Simulation of earnings is the primary tool used to measure the sensitivity
of earnings to interest rate changes. Using computer-modeling techniques, the
Company is able to estimate the potential impact of changing interest rates on
earnings. A balance sheet forecast is prepared quarterly using inputs of actual
loans, securities and interest-bearing liabilities (i.e. deposits/borrowings)
positions as the beginning base. The forecast balance sheet is processed against
four interest rate scenarios. The scenarios include 100 and 200 basis point
rising rate forecasts, a flat rate forecast, and 100 and 200 basis point falling
rate forecasts which take place within a one year time frame. The net interest
income is measured during the year assuming a gradual change in rates over the
twelve-month horizon. The Company's 2005 net interest income, as forecast below,
was modeled utilizing a forecast balance sheet projected from year-end 2004
balances. The following table summarizes the effect on net interest income (NII)
of a +/-100 and a +/-200 basis point change in interest rates as measured
against a constant rate (no change) scenario.
Interest Rate Risk Simulation of Net Interest Income as of December 31, 2004
(In thousands)
Variation from a constant rate scenario Change in NII
+200bp ($255)
+100bp ($133)
-100bp ($401)
-200bp ($805)
The simulations of earnings do not incorporate any management actions,
which might moderate the negative consequences of interest rate deviations.
Therefore, they do not reflect likely actual results, but serve as conservative
estimates of interest rate risk.
Interest Rate Sensitivity Analysis. Interest rate sensitivity is a function
of the repricing characteristics of the portfolio of assets and liabilities.
These repricing characteristics are the time frames within which the
interest-bearing assets and liabilities are subject to change in interest rates
either at replacement, repricing or maturity. Interest rate sensitivity
management focuses on the maturity of assets and liabilities and their repricing
during periods of changes in market interest rates. Interest rate sensitivity is
measured as the difference between the volumes of assets and liabilities in the
current portfolio that are subject to repricing at various time horizons. The
differences are known as interest sensitivity gaps.
A positive cumulative gap may be equated to an asset sensitive position. An
asset sensitive position in a rising interest rate environment will cause a
bank's interest rate margin to expand. This results as floating or variable rate
loans reprice more rapidly than fixed rate certificates of deposit that reprice
as they mature over time. Conversely, a declining interest rate environment will
cause the opposite effect. A negative cumulative gap may be equated to a
liability sensitive position. A liability sensitive position in a rising
interest rate environment will cause a bank's interest rate margin to contract,
while a declining interest rate environment will have the opposite effect.
The following table sets forth the dollar amounts of maturing and/or
repricing assets and liabilities for various periods. This does not include the
impact of prepayments or other forms of convexity caused by changing interest
rates. Historically, this has been immaterial and estimates for them are not
included.
Page 29
The Company has more liabilities than assets repricing during the next
year. In evaluating the repricing pressures for liabilities, management is
taking a conservative perspective and has already repriced deposits
(liabilities) more quickly than loans (assets). There is significant market
pressure to keep lending rates low and increase rates on deposit accounts. In
2004, the Company was able to maintain lower deposit rates, even in the rising
rate environment. Now there is considerable market pressure to catch up with the
prior interest rate increases. The table below indicates that the Company is
liability sensitive throughout the next year. At the end of the twelve month
cycle, the rate sensitive gap shows $59.3 million more in liabilities than
assets repricing.
The Company controls its long term interest rate risk by keeping long term
fixed rate assets (longer than 5 years) less than its long term fixed rate
funding, primarily demand deposit accounts and capital. The following table sets
forth cumulative maturity distributions as of December 31, 2004 for the
Company's interest-bearing assets and interest-bearing liabilities, and the
Company's interest rate sensitivity gap as a percentage of total
interest-earning assets. Of the $120.4 million in fixed rate assets over 12
months, shown in the table below, $47.3 million are long term assets over five
years. This $47.3 million compares favorably to the $63.9 million in demand and
core deposits and equity. With the 125 basis point increase in the Fed Funds
rate in 2004, the loans which were at floors were classified from the fixed rate
category to floating rate and are now repricing with greater frequency.
(dollars in thousands)
Immediate Up to 3 4 to 6 7 to 12 Over
December 31, 2004 Reprice Months Months Months 12 Months Total
-------- ------- -------- -------- ---------- --------
ASSETS:
Securities + Other $ 0 $ 340 $ 477 $ 953 $ 35,902 $ 37,672
Interest-Bearing Balances
Loans 43,866 6,825 5,410 10,185 84,446 150,732
Fed Funds Sold + Overnight
Interest-Bearing Balances 9,875 9,875
-------- -------- -------- ------- -------- --------
Total Rate Sensitive Assets $ 53,741 $ 7,165 $ 5,887 $11,138 $120,348 $198,279
======== ======== ======== ======= ======== ========
LIABILITIES:
MMDA/NOW/SAV $105,167 $ 0 $ 0 $ 0 $ 0 $105,167
CD's<$100 0 4,719 4,451 4,451 5,011 18,632
CD's>$100 0 5,821 10,099 2,525 6,863 25,308
Borrowings 0 0
-------- -------- -------- ------- ------- --------
Total Rate Sensitive Liabilities $105,167 $ 10,540 $ 14,550 $ 6,976 $ 11,874 $149,107
======== ======== ======== ======= ======== ========
Rate Sensitivity Gap $ (51,426) $ (3,375) $ (8,663) $ 4,162 $108,474 $ 49,172
Cumulative Rate Sensitivity Gap $ (51,426) $(54,801) $(63,464) $(59,302) $ 49,172
Cumulative Position to Total
Assets (23.6%) (25.1%) (29.1%) (27.2%) 22.5%
Inflation
Assets and liabilities of a financial institution are principally monetary
in nature. Accordingly, interest rates, which generally move with the rate of
inflation, have potentially the most significant effect on the Company's net
interest income. The Company attempts to limit inflation's impact on rates and
net income margins by minimizing its effect on these margins through continuing
asset/liability management programs.
Page 30
Management's Discussion and Analysis
The Year Ended December 31, 2003 versus December 31, 2002
Summary
Net income for 2003 was $2.9 million compared with $2.7 million in 2002.
Basic earnings per share for 2003 were $1.34 compared with $1.26 in 2002. Return
on average assets was 1.49% in 2003 compared with 1.67% the previous year, while
return on average equity was 14.39% in 2002 and 15.27% for the previous year.
Total assets reached $205.1 million in 2003, a 12.3% increase over the
$182.6 million at December 31, 2002. Loans decreased 4.4% to $122.5 million,
compared with $128.1 million at year-end 2002. Deposits increased, growing 12.6%
from $160.0 million at year-end 2002 to $180.1 million at year-end 2003. The
loan-to-deposit ratio declined from 80.0% to 68.0%.
Net Interest Income
Net interest income on a fully tax equivalent basis increased by $250,000
to $9.2 million in 2003, up 2.8% from 2002 net interest income of $9.0 million.
The net interest margin for 2003 decreased to 5.24% from 6.06% for the previous
year. Individual components of interest income and interest expense are provided
in the table - Average Balances, Yields and Rates Paid on page 20.
Interest Income
Interest income increased by $13,000, or .12%, to $10.97 million over the
$10.96 million realized in 2002. The volume of earning assets increased by 19.0%
to $176.6 million from $148.4 million in 2002, while the yield on average
earning assets declined 117 basis points.
Interest Expense
Interest expense decreased by $237,000 to $1.7 million in 2003 from $2.0
milli