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FORM 10-K
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
[X] ANNUAL REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934 AND 12CFR16.3
For the fiscal year ended December 31, 1998
Commission File Number: 000-23575
COMMUNITY WEST BANCSHARES
(Exact name of registrant as specified in its charter)
California 77-0446957
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
5638 Hollister Avenue, Goleta, California 93117
(Address of Principal Executive Offices) (Zip Code)
(Registrant's telephone number, including area code) (805)692-1862
Securities registered under Section 12(b) of the Exchange Act:
Title of each class Name of each exchange on which registered:
Common Stock, no par value National Market tier of The NASDAQ Stock
Market
Securities registered under Section 12(g) of the Exchange Act: 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 Exchange Act and 12CFR16.3 during the
past 12 months (or for such shorter period that the registrant was required to
file such reports), and (2) has been subject to such filing requirements for the
past 90 days. YES [X] NO[ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-B is not contained, and will not be contained, to the best of
the registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
There were 5,482,571 shares of common stock for the registrant issued and
outstanding as of March 3, 1999. The aggregate market value of the voting
stock, based on the closing price of the stock on the NASDAQ National Market
System on March 3, 1999, held by the nonaffiliates of the registrant was
approximately $40,000,000.
This Form 10-K contains 70 pages
COMMUNITY WEST BANCSHARES
FORM 10-K
INDEX
PART I PAGES
ITEM 1. Description of Business 3
ITEM 2. Description of Property 5
ITEM 3. Legal Proceedings 6
ITEM 4. Submission of Matters to a Vote of Security Holders 6
PART II
ITEM 5. Market for the Registrant's Common Equity and Related Stockholder Matters 7
ITEM 6. Selected Financial Data 8
ITEM 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations 9
ITEM 7A. Quantitative and Qualitative Disclosure about Market Risk 38
ITEM 8. Consolidated Financial Statements 41
PART III
ITEM 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure 68
ITEM 10. Directors, Executive Officers, Promoters and Control Persons 68
ITEM 11. Executive Compensation 68
ITEM 12. Security Ownership of Certain Beneficial Owners and Management 68
ITEM 13. Certain Relationships and Related Transactions 68
PART IV
ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 10-K 68
SIGNATURES 70
2
PART I
ITEM 1. DESCRIPTION OF BUSINESS
- -----------------------------------
General
- -------
Community West Bancshares was incorporated in the State of California on
November 26, 1996, for the purpose of forming a financial services holding
company. On December 31, 1997, Community West Bancshares ("the Company")
acquired a 100% interest in Goleta National Bank ("Goleta"). Effective that
date, shareholders of Goleta (NASDAQ:GLTB) became shareholders of the Company
(NASDAQ:CWBC) in a one-for-one exchange. On December 14, 1998, the Company
acquired a 100% interest in Palomar Savings & Loan Association ("Palomar").
As of that date, shareholders of Palomar (OTCBB:PALO) became shareholders of the
Company by receiving 2.11 shares of CWBC for each share of PALO they held. Both
acquisitions were accounted for under the pooling-of-interests method.
The Company offers a full range of commercial and retail financial services,
including the acceptance of demand, savings, and time deposits, and the
origination of commercial, U.S. Small Business Administration ("SBA"), accounts
receivable, real estate, construction, home improvement, and other installment
and term loans. It also offers cash management, remittance processing,
electronic banking, merchant credit card processing, online banking, and other
financial services to its customers.
The financial services industry as a whole offers a broad range of products. Few
companies today can effectively offer every product and service available.
Accordingly, the Company continually investigates products and services with
which it can attain a competitive advantage over others in the financial
services industry. In this way, management positions the Company to offer those
products and services requested by its customers.
The Company has been an approved lender/servicer of loans guaranteed by the SBA
since late 1990. The Company originates SBA loans, sells the guaranteed portion
into the secondary market, and services the loans. During 1995, the Company was
designated as a Preferred Lender by the SBA. As a Preferred Lender, the Company
has the ability to move loans through the approval process at the SBA much more
quickly than financial institutions which do not have such a designation. As of
December 31, 1998, the Company was the only SBA Preferred Lender headquartered
in Santa Barbara County. The Company was granted SBA Preferred Lender status
in the districts of Los Angeles, Fresno, Sacramento, San Francisco, and Santa
Ana, California, Birmingham, Alabama, Atlanta, Georgia and Miami and
Jacksonville, Florida.
During 1994, the Company established a Mortgage Loan Processing Center. Through
the Mortgage Loan Processing Center, the Company takes applications for
residential real estate loans and processes those loans for a fee for lenders
located throughout the nation. At any point in time, the Company processes loans
for 50-70 such lenders. Because it has so many lenders for which it processes,
the Company can offer many more loan programs than normally offered by any
single institution. By virtue of the large number of loan programs being
offered, the Company has developed the ability to remain ahead of its
competition.
Also in 1994, the Company began offering home improvement loans under Title I of
FHA regulations. This is the oldest government insured loan program in
existence, having begun in 1934. The Company originates Title I loans and sells
them into the secondary market and retains the servicing. In early 1995, the
Company was approved as one of a small number of financial institutions to be
able to sell Title I loans directly to the Federal National Mortgage Association
("FNMA"). This approval has given the Company a competitive advantage over
nonapproved lenders because it can price loans at lower rates to customers and
reduce or eliminate fees normally charged to customers, while at the same time
increasing the profitability to the Company.
During 1996, the Company began offering second mortgage loans ("HLTV") which
allow borrowers to receive up to 125% of their home value for debt
consolidation, home improvement, school tuition, or any worthwhile cash outlay.
There is an upper limit on these loans of $100,000. The Company relies
principally on the creditworthiness of the borrower, and to a lesser extent on
the underlying collateral, for repayment of these HLTV loans. The loan terms
under the program range from one to 25 years. In 1997 and 1998, the Company sold
these loans at a premium to third-parties. In March of 1998, the Company began
accumulating the majority of these loans for the purposes of securitization. On
December 22, 1998, the Company completed the securitization of an $81 million
pool of loans. As of December 31, 1998, the Company had accumulated $24 million
in loans to be securitized in 1999.
3
In 1996, the Company began accounts receivable financing, providing working
capital to small and mid-sized manufacturers, distributors and merchants
throughout Southern California. This division complements the Company's SBA and
commercial lending products, in addition to generating a high annual yield.
Because of the development costs involved, most small community banks have
difficulty providing electronic banking services to their customers. From its
inception, the Company has invested heavily in the hardware and software
necessary to offer today's electronic banking services. In addition to the
normal financial services, the Company offers such services as online cash
management, automated clearinghouse origination, electronic data interchange,
remittance processing, draft preparation and processing, and merchant credit
card processing. Not only do these services generate significant fee income,
they attract companies with large deposit balances. These services have helped
the Company remain at a competitive advantage over most institutions of
comprable size and many which are significantly larger than the Company.
On October 16, 1997, the Company purchased a 70% interest in Electronic
Paycheck, LLC, a California Company that has developed systems to allow
companies to pay their employees by issuing them a card or "electronic
paycheck". The systems were originally developed to pay factory workers in
Kazakhstan. The card is currently being used by companies in the agricultural
sector to pay their workers, many of whom do not have bank accounts. The Company
provides access to ATM and Point-of-Sale (POS) networks so that the cardholders
have access to their cash at thousands of locations virtually worldwide.
In September of 1998, the Company opened its second full service Branch in
Ventura, California. The Company simultaneously consolidated into that location
its Ventura SBA and mortgage loan production office and the accounts receivable
financing department.
On December 14, 1998, the Company acquired 100% of Palomar. Palomar is a
state-chartered full service savings and loan association and is subject to
supervision by the OTS, the FDIC, and the Commissioner of the California
Department of Financial Institutions. The deposits of the Association are
insured up to the applicable limits by the Savings Association Insurance Fund
("SAIF"). The Association is a member of the Federal Home Loan Bank ("FHLB")
system. Their main office is located at 355 West Grand Avenue, Escondido,
California 92025. A second branch is located at 1815 East Valley Parkway, Suite
1, Escondido, California 92027. It is the Company's intent to maintain Palomar
as a separate subsidiary of the Company.
Competition and Service Area
- -------------------------------
The financial service industry in California is highly competitive with respect
to both loans and deposits; and is dominated overall by a relatively small
number of major banks with many offices operating over wide geographic areas.
Some of the major commercial banks operating in the communities nearby the
Company's service areas offer certain services such as trust and investment
services and international banking which are not offered directly by the Company
or any of its subsidiaries, and by virtue of their greater total capitalization,
such institutions have substantially higher lending limits than the Company. To
help offset the numerous branch offices of banks, thrifts, and credit unions, as
well as competition from mortgage brokers, insurance companies, credit card
companies, and brokerage houses within the Company's service areas, the Company,
through its subsidiaries, has established loan production offices in Fresno,
Costa Mesa, San Rafael, Solvang, Santa Barbara, Anaheim, Escondido and West
Covina in California, and in Las Vegas and Reno, Nevada, Woodstock, Georgia, and
Jacksonville, Pensacola, and Panama City Beach, Florida. The Company's online
capabilities allow it to support these offices from its main computer center in
Goleta, California. Part of the Company's strategy is to establish loan
production offices in areas where there is high demand for the loan products
which it originates.
In order to compete for loans and deposits within its primary service area, the
Company uses to the fullest extent possible the flexibility which its
independent status permits. This includes an emphasis on meeting the specialized
banking needs of its customers, including personal contact by the Company's
directors, officers, and employees, newspaper publications, direct mailings and
other local advertising, and by providing experienced management and staff
trained to deal with the specific banking needs of the Company's customers.
Management has established a highly personalized banking relationship with the
Company's customers and is attuned and responsive to their financial and service
requirements. In the event there are customers whose loan demands exceed the
Company's lending limits, the Company seeks to arrange for such loans on a
participation basis with other financial institutions and intermediaries. The
Company also assists those few customers requiring highly specialized services
not offered by the Company to obtain such services from correspondent
institutions.
4
Employees
- ---------
As of December 31, 1998, the Company employed 257 persons, including 2 principal
officers. The Company's employees are not represented by a union or covered by a
collective bargaining agreement. Management of the Company believes that, in
general, its employee relations are very positive.
ITEM 2. DESCRIPTION OF PROPERTY
- -----------------------------------
The Company owns the following property:
- ---------------------------------------------
The Goleta National Bank Main office, located at 5827 Hollister Avenue, Goleta,
California. This 4,000 square foot facility houses the bank's main office, and a
separate 400 square foot building provides additional office space.
The Company leases the following properties:
- -------------------------------------------------
The Company leases, under three separate leases, four suites in an office
building at 5638 Hollister Avenue, Goleta, California, from an independent
third party. The leases are for terms expiring from May 31, 2000 to May 31,
2003, with a current monthly rent of $9,701 per month for all four suites. The
leases also provide the Company with two additional consecutive options of three
years each to extend the leases. The suites consist of approximately 7,590
square feet of office space. These suites house the company's Corporate Office,
Finance, Data Processing, Compliance, Human Resources, and Electronic Business
Services departments of the Company, as well as the offices of the Company's
subsidiary, Electronic Paycheck, LLC.
The Company leases approximately 1,500 square feet of office space located at
310 South Pine Avenue, Goleta, California, from an independent third party. The
lease is month to month, with a current monthly rent of $960 per month. This
facility houses the Special Assets and Loan Collection departments of the
Company.
The Company leases under two separate leases approximately 2,718 square feet of
office space located at 3891 State Street, Santa Barbara, California, from an
independent third party. The leases are for terms expiring November 1, 1999 and
March 31, 2001, with a current monthly rent of $7,195 per month for both leases.
The leases also provide the Company with two additional consecutive options of
three years each to extend the lease. This facility houses the Retail and
Wholesale Mortgage Lending departments of the Company.
The Company leases approximately 3,431 square feet of office space located at
1463 South Victoria Avenue, Ventura, California, from an independent third
party. The lease is for a term expiring July 20, 2002, with a current monthly
rent of $5,555 per month. The lease also provides the Company with one option of
three years to extend the lease. This facility houses the new Ventura Branch
office, as well as Mortgage, SBA Lending and the Accounts Receivable Financing
department of the Company.
The Company leases approximately 4,921 square feet of space located at 4025 East
La Palma Avenue Suite 201A, Anaheim, California, from an independent third
party. The lease is for a term expiring February 28, 2000, with a current
monthly rent of $5,905 per month. This facility houses the Anaheim Loan
Production office of the Company. In addition, the Company also leases
approximately 1,000 square feet of office space located at 100 North Citrus
Street Suite 238 in West Covina, California, from an independent third party
with a current monthly rent of $2,099. The lease is for a term expiring January
31, 2000.
The Company leases approximately 1,032 square feet of storefront space located
at 4170 South Decatur, Unit D-4, Las Vegas, Nevada, from an independent third
party. The lease is for a term expiring February 28, 2000, with a current
monthly rent of $1,858 per month. This facility houses the Las Vegas, Nevada
Loan Production office of the Company.
5
The Company leases approximately 6,380 square feet of space located at 5383
Hollister Avenue, 2nd Floor, Goleta, California, from an independent third
party. The lease is for a term expiring November 30, 2002, with a current
monthly rent of $8,613 per month. The lease also provides the Company with two
options of three years to extend the lease. This facility houses the Alternative
Mortgage lending, and SBA lending departments of the Company.
The Company also leases small executive suites on a month-to-month basis in
Bakersfield, Fresno, Modesto, San Rafael and Costa Mesa, California. The Company
also has executive suites in Woodstock, Georgia, and Jacksonville, Pensacola,
and Panama City Beach, Florida and Reno, Nevada. These offices allow the Company
to have a local presence for the production of loans while controlling the
underwriting and funding of the loans at the main office in Goleta. The Company
also leases on a month-to-month basis two storage units and a portion of a
parking lot, all, are located in Goleta.
The Company also leases approximately 7,000 square feet of office space at 355
West Grand Avenue, Escondido, California, which houses the main branch office of
Palomar. The lease is for a term expiring November 20, 2007, with a ten year
option to renew and a current monthly rent of $12,971. A second Escondido
branch office which is located at 1815 East Valley Parkway, Suite 1 has a
current monthly rent of $1,200 and a lease expiration of August 16, 2002, with
no renewal option. The third Escondido office, which is located at 283 South
Escondido Boulevard Suite E, has approximately 2,482 square feet of office
space, a current monthly rent of $2,200 and a lease that expires on August 9,
2000, with three additional one year periods as renewal options and is used for
mortgage operations. These leases are all with independent third parties.
The Company's total occupancy expense for the year ended December 31, 1998, was
$2,739,000. Management believes that its existing facilities are adequate for
its present purposes.
ITEM 3. LEGAL PROCEEDINGS
- ----------------------------
From time to time the Company is party to claims and legal proceedings arising
in the ordinary course of business. After taking into consideration information
furnished by counsel to the Company, management believes that the ultimate
aggregate liability represented thereby, if any, will not have a material
adverse effect on the Company's financial position or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
- ---------------------------------------------------------------------
A special meeting of security holders of the Company was held October 29, 1998.
The security holders voted on and approved a plan for the acquisition of
Palomar. Under this plan, Palomar becomes a wholly owned subsidiary of
Community West Bancshares. There was a total of 3,077,991, or 75.1%, proxies
voted out of 4,098,062 possible votes. The following indicates how the votes
were cast:
FOR AGAINST ABSTAIN NON-VOTES
Number of Votes Received 3,057,197 13,740 7,054 1,020,071
Percentage of Total Shares 74.6% 0.3% 0.2% 24.9%
The security holders also voted and passed a change in the bylaws to increase
the number of Board members from ten to eleven. This proposal received
3,140,626, or 76.6%, votes out of 4,098,062 possible votes. The following
indicates how the votes were cast:
FOR AGAINST ABSTAIN NON-VOTES
Number of Votes Received 3,021,988 61,064 57,574 957,436
Percentage of Total Shares 73.7% 1.5% 1.4% 23.4%
6
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
----------------------------------------------------------------------
MATTERS
-------
As of the close of business December 31, 1997, the common stock for Goleta
National Bank, symbol "GLTB", was converted to Community West Bancshares common
stock, symbol "CWBC". On January 5, 1998, NASDAQ National Market ("NASDAQ")
listed the new common stock symbol "CWBC" for trading and the old symbol "GLTB"
was removed. On December 18, 1998, the Company acquired Palomar (OTCBB:PALO),
both the table and the paragraph below relate to CWBC and its predecessor GLTB.
Prior to listing on NASDAQ, the stock was traded OTC under the symbol "GLTB".
OTC quotations reflect inter-dealer prices, without retail mark-up, mark-down or
commission and may not represent actual transactions. The common stock was
listed on NASDAQ on November 19, 1996, under the symbol "GLTB". During the
secondary stock offering which took place in the third quarter of 1996, warrants
were issued. Each warrant entitled the holder to purchase two shares of common
stock at an exercise price of $4.375 per share. The warrants expired on June 30,
1998, and were traded OTC under the new symbol "CWBCW". The following table
sets forth the high and low sales prices on a per share basis for the common
stock and a per warrant basis for the warrants, as reported by the respective
exchanges for the period indicated:
Common Stock(1) Warrants
Low High Low High
------ ------- ----- ------
1997 First Quarter 5 1/4 8 1/4 3 1/2 7 1/2
Second Quarter 6 5/8 7 5/8 7 1/2 7 1/2
Third Quarter 6 3/8 9 3/4 5 3/4 7
Fourth Quarter 8 3/8 9 1/2 6 1/2 10 1/2
1998 First Quarter 9 1/4 13 1/4 9 5/8 16 1/2
Second Quarter 11 7/8 14 5/16 9 15
Third Quarter 9 1/4 14 N/A N/A
Fourth Quarter 8 1/8 11 N/A N/A
(1) As adjusted by NASDAQ for the 1996 and 1998 2-for-1 stock splits.
On March 26, 1999, the last reported sale price per share for the Company's
stock was $8 1/2.
The Company has declared and paid cash dividends per share of $.03, $.03, and
$.04 in 1994, 1995, and 1996, respectively. The Company declared and issued a
10% stock dividend in 1995, and effected a 2-for-1 stock split in 1996 and again
in 1998. The Company has declared two quarterly dividends of $.04 per share
one which was paid on January 20, 1999 for shareholders of record as of January
5, 1999 and a second to be paid on April 26, 1999, for shareholders of record as
of April 12, 1999.
The Company had 717 shareholders of record of its common stock as of December
31, 1998.
7
ITEM 6. SELECTED FINANCIAL DATA
- -----------------------------------
SUMMARY OF EARNINGS
The following Summary of Earnings of the Company for the years ended December
31, 1998, 1997, 1996, 1995, and 1994 have been derived from the audited
financial statements included elsewhere in this document.
Year Ended December 31,(1)
-----------------------------------------------------------
(Dollars in thousands, except per share data) 1998 1997 1996 1995 1994
---------- ---------- ---------- ----------- ----------
Interest income $ 20,547 $ 13,553 $ 12,460 $ 11,970 $ 9,921
Interest expense 9,257 6,361 5,990 6,255 4,290
---------- ---------- ---------- ----------- ----------
Net interest income 11,290 7,192 6,470 5,715 5,631
Provision for loan losses 429 191 651 1,122 705
---------- ---------- ---------- ----------- ----------
Net interest income after provision for
loan losses 10,861 7,001 5,819 4,593 4,926
Other income 14,036 9,911 6,977 4,661 2,586
Other expenses 20,075 13,446 10,904 8,371 6,062
---------- ---------- ---------- ----------- ----------
Income before provision for income taxes 4,822 3,466 1,892 883 1,450
Provision for income taxes 1,941 1,316 688 (209) 631
---------- ---------- ---------- ----------- ----------
Net income $ 2,881 $ 2,150 $ 1,204 $ 1,092 $ 819
========== ========== ========== =========== ==========
Net income per share - Basic $ 0.57 $ 0.49 $ 0.32 $ .32 $ .24
Number of shares used in net income per
share calculation (2) - Basic 5,069,596 4,383,878 3,723,832 3,446,030 3,415,994
Net income per share - Diluted $ 0.55 $ 0.43 $ 0.31 $ .31 $ .24
Number of shares used in net income per
share calculation (2) - Diluted 5,243,738 4,956,148 3,878,022 3,495,882 3,434,928
Year Ended December 31,
-----------------------------------------------------------
1998 1997 1996 1995 1994
---------- ---------- ---------- ----------- ----------
Net Loans $ 165,935 $ 128,385 $ 113,807 $ 109,221 $ 105,180
Total Assets 252,034 173,920 160,937 151,586 142,570
Deposits 223,545 152,691 143,106 137,594 127,913
Total Liabilities 227,481 156,265 145,951 140,645 132,774
Total Equity 24,553 17,655 14,986 10,941 9,796
(1) See Notes to Financial Statements for a summary of significant accounting
policies and other related data.
(2) Earnings per common share information is based on the weighted average
number of common shares outstanding during each period. Earnings per share
amounts have been adjusted to reflect the 2-for-1 stock splits in 1996 and 1998
and the acquisition of Palomar.
The following table sets forth selected ratios for the periods indicated:
Year Ended December 31,
--------------------------------------
1998 1997 1996 1995 1994
------ ------ ------ ------ ------
Net earnings to average stockholder equity 13.65% 13.17% 9.29% 10.53% 8.36%
Net earnings to average total assets 1.35% 1.28% .77% .74% .57%
Total interest expense to total interest income 45.05% 46.93% 48.07% 52.26% 43.24%
Other operating income to other operating expense 69.92% 73.71% 63.99% 55.68% 42.66%
Dividend payout ratio - - 6.25% 4.69% 10.42%
Equity to assets ratio 8.18% 9.76% 8.19% 7.05% 6.87%
8
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
- --------------------------------------------------------------------------------
OF OPERATIONS
--------------
Introduction
- ------------
This discussion is designed to provide a better understanding of significant
trends related to the Company's financial condition, results of operations,
liquidity, capital resources, and interest rate sensitivity. It should be read
in conjunction with the audited financial statements and notes thereto and the
other financial information appearing elsewhere in this filing.
Results of Operations
- -----------------------
The following table sets forth for the periods indicated, the increase or
decrease of certain items in the statements of income of the Company as compared
to the prior periods:
For the Year Ended December 31,
----------------------------------------------------------------------------
1998 versus 1997 1997 versus 1996 1996 versus 1995
------------------------ ------------------------ ------------------------
Amount of Percent of Amount of Percent of Amount of Percent of
increase increase increase increase increase increase
(decrease) (decrease) (decrease) (decrease) (decrease) (decrease)
----------- ----------- ----------- ----------- ----------- -----------
INTEREST INCOME:
Loans, including fees $7,116,792 60.50% $1,132,035 10.65% $ 594,911 5.93%
Federal funds sold 56,807 9.22% 187,402 43.70% 24,723 6.12%
Time deposits in other financial institutions (106,353) -46.31% 32,844 16.69% (75,179) -27.64%
Investment securities (73,155) -7.75% (259,702) -21.57% (54,084) -4.30%
Total interest income 6,994,091 51.61% 1,092,579 8.77% 490,371 4.10%
INTEREST EXPENSE ON DEPOSITS 2,895,815 45.53% 370,633 6.19% (264,759) -4.23%
NET INTEREST INCOME 4,098,276 56.99% 721,946 11.16% 755,130 13.21%
PROVISION FOR LOAN LOSSES 238,421 125.12% (459,940) -70.71% (471,144) -42.01%
NET INTEREST INCOME AFTER PROVISION
FOR LOAN LOSSES 3,859,855 55.13% 1,181,886 20.31% 1,226,274 26.70%
OTHER INCOME:
Gains from loan sales 2,003,850 45.65% 1,744,565 65.95% 123,016 4.88%
Loan origination fees - sold or brokered loans 684,710 22.78% 909,950 43.42% 1,335,999 175.91%
Document processing fees 828,353 101.10% 309,705 60.77% 425,864 508.28%
Loan servicing fees 249,310 34.96% (54,793) -7.13% 82,032 11.96%
Service charges (74,609) -7.76% 315,544 48.83% 233,171 56.45%
Other income 433,317 2,035.02% (290,651) -93.17% 115,742 58.99%
Total other income 4,124,931 41.62% 2,934,320 42.06% 2,315,824 49.69%
(continued on next page)
9
For the Year Ended December 31,
----------------------------------------------------------------------------
1998 versus 1997 1997 versus 1996 1996 versus 1995
------------------------ ------------------------ ------------------------
Amount of Percent of Amount of Percent of Amount of Percent of
increase increase increase increase increase increase
(decrease) (decrease) (decrease) (decrease) (decrease) (decrease)
----------- ----------- ----------- ----------- ----------- -----------
OTHER EXPENSES:
Salaries and employee benefits 4,747,669 58.46% 1,932,743 31.23% 1,537,462 33.06%
Occupancy expenses 1,003,060 57.79% 337,764 24.16% 198,571 16.56%
Other operating expenses 507,908 44.19% (496,152) -30.15% 383,568 30.40%
Advertising expense 203,548 31.86% 291,175 83.76% 9,245 2.73%
Professional services 334,086 65.91% 155,918 44.43% (74,979) -17.60%
Postage & freight (379,767) -44.69% 279,220 48.94% 378,703 197.42%
Data processing/ATM processing 147,395 60.73% 23,484 10.71% 71,860 48.77%
Office supply expense 64,768 32.01% 18,102 9.83% 28,719 18.47%
Total other expenses 6,628,667 49.30% 2,542,254 23.32% 2,533,149 30.26%
INCOME BEFORE PROVISION FOR INCOME TAXES 1,356,119 39.13% 1,573,952 83.19% 1,008,949 114.25%
PROVISION FOR INCOME TAXES 625,004 47.48% 627,873 91.20% 896,978 -430.21%
NET INCOME $ 731,115 34.01% $ 946,079 78.61% $ 111,971 10.26%
=========== =========== =========== =========== =========== ===========
Net Interest Income and Net Interest Margin
- -------------------------------------------------
The Company's earnings partially depend upon the difference between the income
received from its loan portfolio and investment securities and the interest paid
on its liabilities, including interest paid on deposits. This difference is
"net interest income." The net interest income, when expressed as a percentage
of average total interest-earning assets, is referred to as the net interest
margin on interest-earning assets. The Company's net interest income is
affected by the change in the level and the mix of interest-earning assets and
interest-bearing liabilities, referred to as volume changes. The Company's net
yield on interest-earning assets is also affected by changes in the yields
earned on assets and rates paid on liabilities, referred to as rate changes.
Interest rates charged on the Company's loans are affected principally by the
demand for such loans, the supply of money available for lending purposes and
competitive factors. These factors are in turn affected by general economic
conditions and other factors beyond the Company's control, such as federal
economic policies, the general supply of money in the economy, legislative tax
policies, governmental budgetary matters and the actions of the FRB.
1998 1997 1996
------------ ------------ ------------
Interest Income $20,546,598 $13,552,507 $12,459,928
Interest Expense 9,256,700 6,360,885 5,990,252
Net Interest Income $11,289,898 $ 7,191,622 $ 6,469,676
============ ============ ============
Net Interest Margin 5.5% 4.7% 4.6%
Total interest income increased from $13,552,507 in 1997 to $20,546,598 in 1998,
representing a 51.6% increase in 1998 over 1997. This increase in 1998 over
1997 was reflected by a 35.0% increase because of an increase in
interest-earnings assets added with a 16.6% increase because of higher rates
earned on those assets. Total interest expense increased from $6,360,885 in
1997 to $9,256,700 in 1998, representing a 45.5% increase in 1998 compared to
1997. This increase was reflected by a 41.4% increase in interest-bearing
liabilities and a 4.1% increase in rates paid on deposits. The result of these
changes was net interest income increased from $7,191,622 in 1997 to $11,289,898
in 1998.
10
Total interest income increased from $12,459,928 in 1996 to $13,552,507 in 1997,
representing an 8.8% increase in 1997 over 1996. This increase in 1997 over
1996 was reflected by a 11.4% increase because of an increase in
interest-earnings assets offset with a decrease of 2.6% because of lower rates.
Total interest expense increased from $5,990,252 in 1996 to $6,360,885 in 1997,
representing a 6.2% increase in 1997 compared to 1996. This increase was
reflected by a 4.1% increase in interest-bearing liabilities and a 2.1% increase
in rates paid on deposits. The result of these changes was net interest income
increased from $6,469,676 in 1996 to $7,191,622 in 1997.
The following table sets forth the changes in interest income and expense
attributable to changes in rates and volumes:
Analysis of Changes in Net Interest Income
- ------------------------------------------
Year Ended December 31,
----------------------------------------------------------------------------------------
(Dollars in Thousands) 1998 Versus 1997 1997 Versus 1996 1996 Versus 1995
---------------------------- ---------------------------- ----------------------------
Change Change Change Change Change Change
Total Due to Due to Total Due to Due to Total Due to Due to
Change Rate Volume Change Rate Volume Change Rate Volume
-------- -------- -------- -------- -------- -------- -------- -------- --------
Time deposits in other
financial institutions $ (106) 15 (121) $ 32 10 22 $ (75) (97) 22
Federal funds sold 57 (17) 74 188 25 163 25 (37) 62
Investment securites (73) 114 (187) (259) (325) 66 (54) (143) 89
Loans, net 7,116 1,381 5,735 1,132 60 1,072 595 354 241
-------- -------- -------- -------- -------- -------- -------- -------- --------
Total interest-earning
assets 6,994 1,493 5,501 1,093 (230) 1,323 491 77 414
-------- -------- -------- -------- -------- -------- -------- -------- --------
Interest-bearing demand 71 277 (206) 16 (24) 40 (19) (19) 0
Savings 122 (130) 252 (68) (26) (42) (115) (136) 21
Time certificates of deposit 2,636 58 2,578 511 119 392 (83) (141) 58
Federal funds purchased 85 - 85 - - - - - -
Other borrowings (18) (11) (7) (88) 22 (110) (47) (11) (36)
-------- -------- -------- -------- -------- -------- -------- -------- --------
Total interest-bearing
liabilities 2,896 194 2,702 371 91 280 (264) (307) 43
-------- -------- -------- -------- -------- -------- -------- -------- --------
Net interest income $ 4,098 $ 1,299 $ 2,799 $ 722 $ (321) $ 1,043 $ 755 $ 384 $ 371
======== ======== ======== ======== ======== ======== ======== ======== ========
The change in interest income or interest expense that is attributable to both
changes in rate and changes in volume has been allocated to the change due to
rate and the change due to volume in proportion to the relationship of the
absolute amounts of changes in each.
Provision for Loan Losses
- ----------------------------
The provision for loan losses corresponds directly to the level of the allowance
that management deems sufficient to offset potential loan losses. The balance in
the loan loss allowance reflects the amount which, in management's judgment, is
adequate to provide for these potential loan losses, after weighing the mix of
the loan portfolio, current economic conditions, past loan experience and such
other factors as deserve recognition in estimating loan losses.
Each month management reviews the allowance for possible loan losses and makes
additional transfers to the allowance, as needed. Management allocated $428,969
as a provision for loan losses in 1998, $190,548 in 1997 and $650,488 in 1996.
Loans charged off, net of recoveries, in 1998 were $367,111, in 1997 were
$503,017 and in 1996 were $625,106. The ratio of the allowance for loan losses
to total gross loans was 1.3% at December 3l, 1998, 1.6% at December 31, 1997,
and 2.0% at December 31, 1996.
In management's opinion, the balance of the allowance for loan losses at
December 31, 1998, was sufficient to absorb foreseeable losses in the loan
portfolio at that time.
Other Income
- -------------
Other income increased from $6,976,637 in 1996, to $9,910,957 in 1997, and to
$14,035,888 in 1998, representing a $2,934,320 or 42.1% increase in 1997 over
1996 and $4,124,931 or a 41.6% increase in 1998 over 1997. The Company continued
to emphasize generating noninterest income. These year to year gains are a
reflection of the increases in SBA loan originations, sales, and servicing, as
well as increased growth in mortgage loan processing over the years. In
addition, fees from electronic banking services have increased dramatically over
the last three years. The Company's percentage coverage of other expenses with
other income was 64.0% in 1996, to 73.7% in 1997 and 69.9% in 1998.
11
Other Expenses
- ---------------
Other expenses include salaries and employee benefits, occupancy and equipment,
and other operating expenses. The continued growth of the Company required
additional staff and overhead expense to support the continued high level of
customer service and the increased cost of occupying the Company's offices.
Although compensation expenses have grown significantly, approximately 40% of
the Company personnel derive some or all of their compensation based on income
production. This means that a significant portion of compensation is tied to
increases in revenues instead of being a fixed expense. Other expenses increased
from $10,903,774 in 1996 to $13,446,028 in 1997 and to $20,074,695 in 1998,
representing a 23.3% in 1997 over 1996 and a 49.3% increase in 1998 over 1997.
The increases in other expenses for the periods compared were primarily because
of compensation related to loan originations and sales, the increase in the
number of loan production and processing offices, the upgrading of data
processing hardware and software, and costs related to the Palomar acquisition
in 1998.
The following table compares the various elements of other expenses as a
percentage of average assets for the three years ended December 31, (in
thousands except percentage amounts.)
Salaries
and Other
Average Total Other Employee Occupancy Operating
Assets (1) Expense Benefits Expenses Expenses
----------- ------------ --------- ---------- ----------
December 31, 1998 $ 224,419 8.94% 5.73% 1.22% 1.99%
December 31, 1997 $ 165,536 8.12% 4.90% 1.05% 2.17%
December 31, 1996 $ 152,871 7.13% 4.05% 0.91% 2.17%
(1) Based on the average of daily balances.
Income Taxes
- -------------
Income taxes were $1,941,355 in 1998, $1,316,351 in 1997, and $688,478 in 1996.
The effective income tax rate was 40.3%, 38% and 36.4% for 1998, 1997 and 1996.
Net Income
- -----------
The net income of the Company was $2,880,767 in 1998, $2,149,652 in 1997, and
$1,203,573 in 1996. Earnings per share were $.57 basic and $.55 diluted in 1998;
$.49 basic and $.43 diluted in 1997; and $.32 basic and $.31 diluted in 1996; as
adjusted to reflect the 1996 and 1998 2-for-1 stock splits and the 1995 10%
stock dividend. The increases in net income for the past three years were the
result of several factors. First, the earning assets of the Company have
increased, resulting in an increase in net interest income. Second, the
origination and sale of SBA loans has continued to grow, resulting in increased
gains on sales and increased servicing income. Third, the increased volume of
business in the Mortgage Loan Processing Center and Home Equity Lending
Department, increased fee income, income from loan sales, and servicing income.
Offsetting the income increase was an overall increase in expenses related to
the production of income.
Capital Resources
- ------------------
The Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 was
signed into law on December 19, 1991. Regulations implementing the prompt
corrective action provisions of FDICIA include significant changes to the legal
and regulatory environment for insured depository institutions, including
reductions in insurance coverage for certain kinds of deposits, increased
supervision by the federal regulatory agencies, increased reporting requirements
for insured institutions, and new regulations concerning internal controls,
accounting, and operations.
12
The prompt corrective action regulations define specific capital categories
based on institution's capital ratios. The capital categories, in defining
order, are "well capitalized," "adequately capitalized," "undercapitalized,"
"significantly undercapitalized," and "critically undercapitalized." To be
considered "well capitalized" an institution must have a core capital ratio of
at least 5% and a total risk-based capital ratio of at least 10%. Additionally,
FDICIA imposed in 1994 a new Tier I risk-based capital ratio of at least 6% to
be considered "well capitalized." Tier I risk-based capital is, primarily,
common stock and retained earnings less goodwill and other intangible assets.
Management believes, as of December 31, 1998, the Company exceeds all capital
adequacy requirements to which it is subject. As of December 31, 1998 and 1997,
the most recent notification from the FDIC categorized the Company as "well
capitalized." There are no conditions or events since that notification which
management believes have changed the Company's category.
The Company's actual capital ratios are presented below.
To Be Well
For Capital Capitalized Under
Adequacy Prompt Corrective
Actual Purposes Action Provisions
------ -------- -----------------
Amount Ratio Amount Ratio Amount Ratio
----------- ------ ----------- ------ ----------- ------
As of December 31, 1998:
Total Capital (to Risk Weighted assets)
Consolidated . . . . . . . . . . . . . . . $26,109,980 15.27% $13,674,814 8.00% $17,093,519 10.00%
Goleta National Bank . . . . . . . . . . . $16,152,794 13.88% $ 9,309,968 8.00% $11,637,460 10.00%
Palomar Savings and Loan . . . . . . . . . $ 6,492,000 12.45% $ 4,172,240 8.00% $ 5,215,300 10.00%
Tier I Capital (to Risk Weighted assets)
Consolidated . . . . . . . . . . . . . . . $23,972,867 14.02% $ 6,837,407 4.00% $10,256,111 6.00%
Goleta National Bank . . . . . . . . . . . $14,698,113 12.63% $ 4,654,984 4.00% $ 6,982,476 6.00%
Tier I Capital (to Average Assets)
Consolidated . . . . . . . . . . . . . . . $23,972,867 9.49% $10,102,001 4.00% $12,627,501 5.00%
Goleta National Bank . . . . . . . . . . . $14,698,113 8.07% $ 7,285,310 4.00% $ 9,106,638 5.00%
Core Capital (to Adjusted Tangible Assets)
Palomar Savings and Loan . . . . . . . . . $ 5,865,000 7.11% $ 3,299,000 4.00% $ 4,124,200 5.00%
Tangible Capital (to Tangible Assets)
Palomar Savings and Loan . . . . . . . . . $ 5,865,000 7.11% $ 1,237,260 1.50% N/A N/A
To Be Well
For Capital Capitalized Under
Adequacy Prompt Corrective
Actual Purposes Action Provisions
------ -------- -----------------
Amount Ratio Amount Ratio Amount Ratio
----------- ------ ---------- ------ ----------- ------
As of December 31, 1997:
Total Capital (to Risk Weighted assets)
Consolidated . . . . . . . . . . . . . . . $18,535,374 15.88% $9,336,643 8.00% $11,670,804 10.00%
Goleta National Bank . . . . . . . . . . . $12,990,366 17.36% $5,986,344 8.00% $ 7,482,930 10.00%
Palomar Savings and Loan . . . . . . . . . $ 6,055,541 13.49% $3,591,129 8.00% $ 4,488,911 10.00%
Tier I Capital (to Risk Weighted assets)
Consolidated . . . . . . . . . . . . . . . $17,071,672 14.63% $4,668,321 4.00% $ 7,002,482 6.00%
Goleta National Bank . . . . . . . . . . . $12,054,016 16.11% $2,992,928 4.00% $ 4,489,391 6.00%
Tier I Capital (to Average Assets)
Consolidated . . . . . . . . . . . . . . . $17,071,672 9.84% $6,939,541 4.00% $ 8,674,427 5.00%
Goleta National Bank . . . . . . . . . . . $12,054,016 12.63% $3,917,582 4.00% $ 4,771,978 5.00%
Core Capital (to Adjusted Tangible Assets)
Palomar Savings and Loan . . . . . . . . . $ 5,494,541 6.99% $3,144,229 4.00% $ 3,930,287 5.00%
Tangible Capital (to Tangible Assets)
Palomar Savings and Loan . . . . . . . . . $ 5,494,541 6.99% $1,179,086 1.50% N/A N/A
Schedule of Assets, Liabilities and Stockholders' Equity
- --------------------------------------------------------------
The following schedule shows the average balances of the Company's assets,
liabilities and stockholders' equity accounts as a percentage of average total
assets for the periods indicated.
13
(Dollars in Thousands) Year Ended December 31,
----------------------------------------------------------
1998 1997 1996
------------------ ------------------ ------------------
Amount Percent Amount Percent Amount Percent
--------- ------- --------- ------- --------- -------
ASSETS
- -----------------------------------------------
Cash and due from banks $ 6,196 2.8% $ 5,354 3.2% $ 4,322 2.8%
Federal funds sold 13,121 5.8% 11,675 7.1% 8,565 5.6%
Time deposits in other financial institutions 2,160 1.0% 4,006 2.4% 3,609 2.4%
FRB/FHLB Stock 791 0.3% 713 0.4% 636 0.4%
Investment securities 16,137 7.2% 16,076 9.7% 18,086 11.8%
Trading securities 44 0.0% - 0.0% - 0.0%
Loans:
Commercial 13,487 6.0% 13,637 8.2% 14,300 9.3%
Real estate 70,125 31.2% 76,642 46.3% 74,476 48.7%
Unguaranteed portions of loans insured by SBA 27,081 12.1% 21,345 12.9% 15,617 10.2%
Installment 12,267 5.5% 5,054 3.1% 6,531 4.3%
Loan participations purchased 4,016 1.8% 1,333 0.8% 746 0.5%
Less: allowance for loan loss (2,092) -0.9% (2,175) -1.3% (2,340) -1.5%
Less: net deferred loan fees and premiums (129) -0.1% (195) -0.1% (175) -0.1%
Less: discount on loan pool purchase (703) -0.3% (488) -0.3% (423) -0.3%
--------- ------- --------- ------- --------- -------
Net loans 124,052 55.3% 115,153 69.6% 108,732 71.1%
Loans held for sale 51,952 23.1% 6,351 3.8% 1,692 1.1%
Other real estate owned 181 0.1% 316 0.2% 715 0.5%
Premises and equipment, net 3,619 1.6% 2,683 1.6% 2,016 1.3%
Servicing asset 1,088 0.5% 788 0.5% 1,705 1.1%
Accrued interest receivable and other assets 5,078 2.4% 2,421 1.5% 2,793 1.9%
TOTAL ASSETS $224,419 100.0% $165,536 100.0% $152,871 100.0%
========= ======= ========= ======= ========= =======
LIABILITIES AND STOCKHOLDERS' EQUITY
- -----------------------------------------------
Deposits:
Noninterest-bearing demand 20,950 9.3% 17,307 10.5% 14,169 9.3%
Interest-bearing demand 20,511 9.1% 17,755 10.7% 16,339 10.7%
Savings 24,404 10.9% 21,906 13.2% 23,259 15.2%
Time certificates, $100,000 or more 44,216 19.7% 27,235 16.4% 22,311 14.6%
Other time certificates 91,907 41.0% 63,673 38.5% 61,601 40.3%
--------- ------- --------- ------- --------- -------
Total deposits 201,988 90.0% 147,876 89.3% 137,679 90.1%
Other Borrowings 234 0.1% 405 0.2% 2,000 1.3%
Federal funds purchased 1,479 0.7% - 0.0% - 0.0%
Accrued interest payable and other liabilities 2,358 1.0% 1,105 0.7% 672 0.4%
--------- ------- --------- ------- --------- -------
Total liabilities 206,059 91.8% 149,386 90.2% 140,351 91.8%
Stockholders' equity
Common stock 13,379 6.0% 12,595 7.6% 10,470 6.8%
Retained earnings 4,968 2.2% 3,556 2.2% 2,076 1.4%
Unrealized gain/(loss) on AFS securities 13 0.0% (1) 0.0% (26) 0.0%
Treasury stock - 0.0% - 0.0% - 0.0%
--------- ------- --------- ------- --------- -------
Total stockholders' equity 18,360 8.2% 16,150 9.8% 12,520 8.2%
TOTAL LIABILITIES AND STOCKHOLDERS'
EQUITY $224,419 100.0% $165,536 100.0% $152,871 100.0%
========= ======= ========= ======= ========= =======
14
Investment Portfolio
- ---------------------
The following table summarizes the year-end carrying value balances and
distributions of the Company's investment securities.
December 31,
------------------------------------
(Dollars rounded to thousands) 1998 1997 1996
---------- ----------- -----------
U.S. Treasury Securities $1,256,000 $ 1,751,000 $ 1,998,000
FRB Stock 264,000 251,000 156,000
FHLB Stock 546,000 512,000 482,000
GNMA Securities 4,228,000 3,874,000 4,171,000
FNMA Securities 1,893,000 7,425,000 5,732,000
FHLMC Securities 1,420,000 1,017,000 1,184,000
Mutual Fund - - 981,000
$9,607,000 $14,830,000 $14,704,000
========== =========== ===========
In addition to the above, as of December 31, 1998 and 1997 the Company holds
interest only strip assets in the amount of $10,914,900 and $2,528,587. These
interest only strips represent the present value of the right to the excess cash
flows generated by the sold loans that represent the difference between (a)
interest at the stated rate paid by borrowers and (b) the sum of (i)
pass-through interest paid to third-party investors, (ii) stipulated servicing
fees and (iii) estimated loan portfolio losses. The Company determines the
present value of this anticipated cash flow stream at the time of the loan sale
close, utilizing valuation assumptions appropriate for each particular
transaction.
The significant valuation assumptions are related to the anticipated average
lives of the loans sold, the anticipated prepayment speeds and the anticipated
credit losses related thereto. In order to determine the present value of this
excess cash flow, the Company currently applies an estimated market discount
rate of 11% for SBA and FHA Title 1 loans and 13% for HLTV loans to the expected
pro forma gross cash flows, which are calculated utilizing the weighted average
lives of the loans. The annual prepayment rate of the loans is a function of
full and partial prepayments and defaults. In the interest only strips' fair
value estimates, the Company makes assumptions of the prepayment rates of the
underlying loans, which the Company believes are reasonable. During fiscal 1998,
the Company utilized proprietary prepayment curves generated by the Company
reaching an approximate maximum annual rate of 8%, 15% and 18.25% for SBA, FHA
Title 1, and HLTV loans.
The following table summarizes the amounts, terms, distributions, and yields of
the Company's investment securities as of December 31, 1998.
After One Year
One Year or Less to Five Years Over Five Years Total
------------------ ---------------- ------------------ ------------------
Amount Yield Amount Yield Amount Yield Amount Yield
---------- ------ -------- ------ ---------- ------ ---------- ------
U.S. Treasury Securities $1,256,000 6.3% $ - N/A% $ - N/A% $1,256,000 6.9%
FRB Stock - N/A 264,000 6.4 - N/A 264,000 6.4
FHLB Stock - N/A 546,000 5.6 - N/A 546,000 5.6
GNMA Securities - N/A - N/A 4,228,000 6.6 4,228,000 6.6
FNMA Securities - N/A - N/A 1,893,000 6.7 1,893,000 6.7
FHLMC Securities - N/A - N/A 1,420,000 6.7 1,420,000 6.7
---------- ------ -------- ------ ---------- ------ ---------- ------
Totals $1,256,000 6.3% $810,000 5.9% $7,541,000 6.6% $9,607,000 6.6%
========== ====== ======== ====== ========== ====== ========== ======
15
The Investment Policy of the Company sets forth the types and maturities of
investments the Company, and its subsidiaries, may hold.
Loan Portfolio
- ---------------
The Company's largest lending categories are commercial loans, real estate
loans, unguaranteed portion of loans insured by the SBA, installment loans,
loans held for sale and real estate loan participations purchased. Loans are
carried at face amount, less payments collected, the allowance for possible loan
losses, deferred loan fees and discounts on loans purchased. Interest on all
loans is accrued daily on primarily a simple interest basis. It is generally the
Company's policy to place loans on nonaccrual status when they are 90 days past
due. Thereafter, interest income is no longer recognized. Problem loans are
maintained on accrual status only when management of the Company is confident of
full repayment within a very short period of time.
The rates of interest charged on variable rate loans are set at specified
increments in relation to the Company's published prime lending rate or other
appropriate indices and vary as those indices vary. At December 31, 1998,
approximately 63% of the Company's loan portfolio was comprised of variable
interest rate loans. At December 31, 1997, variable rate loans comprised
approximately 71% of the Company's loan portfolio. At December 31, 1996,
variable rate loans comprised approximately 74% of the Company's loan portfolio.
Distribution of Loans
- -----------------------
The distribution of the Company's total loans by type of loan as of the dates
indicated is shown in the following table (dollars in thousands):
December 31,
-----------------------------------------------------------------------
1998 1997 1996
----------------------- ---------------------- ----------------------
Percentage Percentage Percentage
to Gross to Gross to Gross
Type of loan Loan Balance Loans Loan Balance Loans Loan Balance Loans
------------- -------- ------------ -------- ------------ --------
Commercial $ 10,613,000 6.3% $ 13,195,000 10.1% $ 14,017,000 12.0%
Real estate 64,875,000 38.4 76,190,000 58.1 75,214,000 64.4
Unguaranteed portion of loans
insured by SBA 26,687,000 15.8 19,602,000 15.0 14,708,000 12.6
Installment 5,638,000 3.3 4,057,000 3.1 4,306,000 3.7
Loan participations purchased 2,287,000 1.4 2,247,000 1.7 709,000 0.6
Loans held for sale 58,836,000 34.8 15,739,000 12.0 7,767,000 6.7
------------- -------- ------------ -------- ------------ --------
GROSS LOANS 168,936,000 100.0% 131,030,000 100.0% 116,721,000 100.0%
Less:
Allowance for loan losses 2,129,000 2,067,000 2,380,000
Deferred loan fees and premiums 113,000 150,000 190,000
Discount on loan pool purchase 759,000 428,000 344,000
------------- ------------ ------------
NET LOANS $ 165,935,000 $128,385,000 $113,807,000
============= ============ ============
Commercial Loans
- -----------------
In addition to traditional commercial loans made to business customers, the
Company also extends business lines of credit. On business credit lines, the
Company specifies a maximum amount which it stands ready to lend to the customer
during a specified period, in return for which the customer agrees to maintain
its primary banking relationship with the Company. The purpose for which such
loans will be used and the security therefor, if any, are determined before the
Company's commitment is extended. Normally, the Company does not make loan
commitments in material amounts for periods in excess of one year.
16
Real Estate Loans
- -------------------
Real estate loans are primarily made for the purpose of purchasing, improving or
constructing single family residences, and commercial and industrial properties.
The majority of the Company's real estate loans are collateralized by first and
second liens on single family homes. Maturities on such loans are generally 15
to 30 years.
A large part of the Company's real estate construction loans are first and
second trust deeds on the construction of owner-occupied single family
dwellings. The Company also makes real estate construction loans on commercial
properties. These consist of first and second trust deeds collateralized by the
related real property. Construction loans are generally written with terms of
six to twelve months and usually do not exceed a loan to appraised value of 80%.
Some real estate loans are secured by nonresidential property. These loans are
often secured by office buildings or other commercial property. Loan-to-value
ratios are generally restricted to 70% of appraised value of the underlying real
property.
Unguaranteed Portion of Loans Guaranteed by the SBA
- ----------------------------------------------------------
The Company is approved as a Preferred Lender by the SBA. Loans made by the
Company under programs offered by the SBA are generally made to small businesses
for the purchase of businesses, purchase or construction of facilities, purchase
of equipment or working capital. The loans generally carry guarantees from the
SBA ranging from 75% - 90% of the balance loaned. Borrowers are required to
provide adequate collateral for these loans, similar to other commercial loans.
The SBA does allow less-collateralized loans for its "Low Doc" program, loans of
less than $100,000. When the Company originates SBA loans, it sells the
guaranteed portion of the loans into the secondary market. The Company retains
the unguaranteed portion of the loans, as well as the servicing on the loans,
for which it is paid a fee. The loans are all variable rate based upon the Wall
Street Journal Prime Rate. The servicing spread is a minimum of 1.00% on all
loans. The gains recognized by the Company on the sales of the guaranteed
portion of these loans and the ongoing servicing income received, are
significant revenue streams for the Company.
Installment Loans
- ------------------
While not a large portion of its loan portfolio, the Company does originate
installment loans, also known as, consumer loans. These loans are comprised of
automobile, small equity lines of credit and general personal loans. These loans
are primarily variable rate with terms of five years or less.
Maturity of Loans and Sensitivity of Loans to Changes in Interest Rates
- --------------------------------------------------------------------------------
The following table sets forth the amount of gross loans outstanding, as of
December 31, 1998, 1997, and 1996, which, based on the remaining scheduled
repayments of principal, have the ability to be repriced or are due in less than
one year, in one to five years, or in more than five years.
1998 1997 1996
------------------------- ------------------------ ------------------------
(Dollars rounded to thousands) Fixed Variable Fixed Variable Fixed Variable
----------- ------------ ----------- ----------- ----------- -----------
Less than One Year $ 5,431,000 $105,173,000 $ 9,307,000 $92,907,000 $ 6,752,000 $85,762,000
One Year to Five Years 10,487,000 775,000 8,166,000 24,000 9,221,000 34,000
After Five Years 47,070,000 - 20,626,000 - 14,952,000 -
----------- ------------ ----------- ----------- ----------- -----------
Total $62,988,000 $105,948,000 $38,099,000 $92,931,000 $30,925,000 $85,796,000
=========== ============ =========== =========== =========== ===========
17
The following table shows the Company's loan commitments outstanding at the
dates indicated:
December 31,
1998 1997 1996
----------- ----------- -----------
Commercial $10,693,000 $12,298,000 $ 7,412,000
Real estate 12,306,000 3,595,000 3,423,000
Loans guaranteed by the SBA 4,230,000 4,177,000 1,195,000
Installment loans 1,502,000 1,473,000 1,576,000
Standby letters of credit 35,000 30,000 2,204,000
Total commitments $28,766,000 $21,573,000 $15,810,000
=========== =========== ===========
Based upon prior experience and prevailing economic conditions, it is
anticipated that approximately 80% of the commitments at December 31, 1998, will
be exercised during 1999.
Summary of Loan Losses Experience
- -------------------------------------
As a natural corollary to the Company's lending activities, some loan losses are
experienced. The risk of loss varies with the type of loan being made and the
creditworthiness of the borrower over the term of the loan. The degree of
perceived risk is taken into account in establishing the structure of, and
interest rates and security for, specific loans and for various types of loans.
The Company attempts to minimize its credit risk exposure by use of thorough
loan application and approval procedures.
The Company maintains a program of systematic review of its existing loans.
Loans are graded for their overall quality. Those loans which the Company's
management determines require further monitoring and supervision are segregated
and reviewed on a periodic basis. Significant problem loans are reviewed on a
monthly basis by the Company's Loan Committee.
The recorded investment in loans that are considered to be impaired under SFAS
No. 114 was as follows:
December 31,
1998 1997 1996
----------- ----------- -----------
Impaired loans without specific valuation allowances $4,450,345 $2,461,168 $1,111,388
Impaired loans with specific valuation allowances 813,652 1,266,964 2,490,435
Specific valuation allowance allocated to impaired loans (464,336) (521,994) (736,853)
Impaired loans, net $4,799,661 $3,206,138 $2,864,970
=========== =========== ===========
Average investment in impaired loans $4,009,400 $3,056,054 $3,620,236
=========== =========== ===========
Interest Income recognized on impaired loans $ 288,607 $ 360,309 $ 190,559
=========== =========== ===========
It is the Company's policy to place loans on nonaccrual status when they are 90
days past due. Thereafter, interest income is no longer recognized. As such,
interest income may be recognized on impaired loans to the extent they are not
past due by 90 days or more.
Upon the adoption of SFAS No. 114, the Company classified all loans on
nonaccrual status as impaired. Accordingly, the impaired loans disclosed above
include all loans that were on nonaccrual status.
Financial difficulties encountered by certain borrowers may cause the Company to
restructure the terms of their loans to facilitate loan payments. In accordance
with the provisions of SFAS No. 114, a troubled loan that is restructured
subsequent to the adoption of SFAS No. 114 would generally be considered
impaired, while a loan restructured prior to adoption would not be considered
impaired if, at the date of measurement, it was probable that the Company would
collect all amounts due under the restructured terms. Accordingly, the balance
of impaired loans disclosed above includes all troubled debt restructured loans
that, as of December 31, 1998, 1997, and 1996 are considered impaired.
18
December 31,
1998 1997 1996
---------- ---------- ----------
Nonaccrual loans $2,971,000 $1,714,000 $ 634,000
Troubled debt restructured loans, gross $1,313,000 $3,289,000 $2,238,000
Interest foregone on nonaccrual loans and troubled debt
restructuring outstanding $ 414,000 $ 203,000 $ 226,000
Loans 30 through 90 days past due with interest accruing $ 678,000 $ 631,000 $ 838,000
The Company charges off that portion of any loan which management considers to
represent a loss. A loan is generally considered by management to represent a
loss in whole or in part when an exposure beyond any collateral value is
apparent, servicing of the unsecured portion has been discontinued or collection
is not anticipated based on the borrower's financial condition and general
economic conditions in the borrower's industry. The principal amount of any loan
which is declared a loss is charged against the Company's allowance for loan
losses.
The following table summarizes the Company's loan loss experience for the
periods indicated:
Year Ended December 31, 1998 1997 1996
------------- ------------- -------------
Balances:
Average gross loans $180,319,000 $124,603,000 $113,556,000
Gross loans at end of period 168,936,000 131,030,000 116,721,000
Loans charged off 402,000 520,000 647,000
Recoveries of loans previously charged off 35,000 17,000 22,000
------------- ------------- -------------
Net loans charged off 367,000 503,000 625,000
------------- ------------- -------------
Allowance for loan losses 2,129,000 2,067,000 2,380,000
Provisions for loan losses 429,000 191,000 650,000
Ratios:
Net loan charge-offs to average loans 0.2% 0.4% 0.5%
Net loan charge-offs to loans at end of period 0.2% 0.4% 0.5%
Allowance for loan losses to average loans 1.2% 1.7% 2.1%
Allowance for loan losses to loans held to maturity at
end of period 2.0% 1.8% 2.2%
Net loan charge-offs to allowance for loan losses at
end of period 17.2% 24.4% 26.2%
Net loan charge-offs to provision for loan losses 85.5% 263.9% 96.0%
The Company's allowance for loan losses is designed to provide for loan losses
which can be reasonably anticipated. The allowance for loan losses is
established through charges to operating expenses in the form of provisions for
loan losses. Actual loan losses or recoveries are charged or credited, directly
to the allowance for loan losses. The amount of the allowance is determined by
management of the Company. Among the factors considered in determining the
allowance for loan losses are the current financial condition of the Company's
borrowers and the value of the security, if any, for their loans. Estimates of
future economic conditions and their impact on various industries and individual
borrowers are also taken into consideration, as are the Company's historical
loan loss experience and reports of banking regulatory authorities. Because
these estimates, factors and evaluations are primarily judgmental, no assurance
can be given as to whether or not the Company will sustain loan losses
substantially higher in relation to the size of the allowance for loan losses or
that subsequent evaluation of the loan portfolio may not require substantial
changes in such allowance.
At December 31, 1998, 1997, and 1996, the allowance was 2.0%, 1.8%, and 2.2%, of
the gross held to maturity loans then outstanding, respectively. Although the
current level of the allowance is deemed adequate by management, future
provisions will be subject to continuing reevaluation of risks in the loan
portfolio.
19
Management of the Company reviews with the Board of Directors the adequacy of
the allowance for possible loan losses on a quarterly basis. The loan loss
provision is adjusted when specific items reflect a need for such an adjustment.
Management believes that there were no material loan losses during the last
fiscal year that have not been charged off. Management also believes that the
Company has adequately reserved for all individual items in its portfolio which
may result in a material loss to the Company. See "MANAGEMENT'S DISCUSSION AND
ANALYSIS OF THE SUMMARY OF EARNINGS - Provision for Loan Losses".
Interest Rates and Differentials
- -----------------------------------
Certain information concerning interest-earning assets and interest-bearing
liabilities and yields thereon is set forth in the following table. Amounts
outstanding are daily average balances:
(Dollars in thousands) Year Ended December 31,
1998 1997 1996
--------- --------- ---------
Interest-earning assets:
Time deposits in other financial institutions:
Average outstanding $ 2,160 $ 4,006 $ 3,609
Average yield 5.7% 5.7% 5.5%
Interest income $ 123 $ 230 $ 197
Federal funds sold:
Average outstanding $ 13,121 $ 11,675 $ 8,565
Average yield 5.1% 5.3% 5.0%
Interest income $ 673 $ 616 $ 429
U.S. Government investment securities:
Average outstanding $ 13,456 $ 14,234 $ 15,519
Average yield 6.1% 6.3% 6.5%
Interest income $ 824 $ 891 $ 1,014
Federal Reserve Bank/Federal Home Loan
Bank stock investment securities:
Average outstanding $ 791 $ 713 $ 636
Average yield 6.1% 6.5% 5.8%
Dividend income $ 48 $ 46 $ 37
Mutual Funds:
Average outstanding $ - $ 115 $ 2,567
Average yield 0.0% 6.1% 6.0%
Interest income $ - $ 7 $ 153
Loans:
Average outstanding (1) $176,003 $121,505 $110,425
Average yield 10.7% 9.7% 9.6%
Interest income $ 18,879 $ 11,763 $ 10,630
Total interest-earning assets:
Average outstanding $205,531 $152,248 $141,341
Average yield 10.0% 8.9% 8.8%
Interest income $ 20,547 $ 13,553 $ 12,460
(1) includes nonaccrual loans
(continued on next page)
20
(Dollars in thousands) Year Ended December 31,
1998 1997 1996
--------- --------- ---------
Interest-bearing liabilities:
Interest-bearing demand deposits:
Average outstanding $ 20,511 $ 17,755 $ 16,339
Average yield 2.8% 2.9% 3.0%
Interest expense $ 579 $ 508 $ 492
Savings deposits:
Average outstanding $ 24,404 $ 21,906 $ 23,259
Average yield 3.3% 3.2% 3.3%
Interest expense $ 817 $ 695 $ 763
Time certificates of deposit:
Average outstanding $136,123 $ 90,908 $ 83,912
Average yield 5.7% 5.6% 5.5%
Interest expense $ 7,764 $ 5,129 $ 4,619
Federal funds purchased:
Average outstanding $ 1,479 $ - $ -
Average yield 5.7% 0.0% 0.0%
Interest expense $ 85 $ - $ -
Borrowings from FHLB:
Average outstanding $ 234 $ 405 $ 2,000
Average yield 5.1% 6.9% 5.9%
Interest expense $ 12 $ 29 $ 116
Total interest-bearing liabilities:
Average outstanding $182,751 $130,974 $125,510
Average yield 5.1% 4.9% 4.8%
Interest expense $ 9,257 $ 6,361 $ 5,990
Net interest income $ 11,290 $ 7,192 $ 6,470
Average net interest margin on interest-
earning assets 5.5% 4.7% 4.6%
Liquidity Management
- ---------------------
The Company has an asset and liability management program allowing the Company
to maintain its interest margins during times of both rising and falling
interest rates and to maintain sufficient liquidity. Liquidity of the Company at
December 31, 1998, was 51.7%, at December 31, 1997, was 31.3%, based on liquid
assets (consisting of cash and due from banks, deposits in other financial
institutions, security investments, federal funds sold and loans available for
sale) divided by total assets. Management believes it maintains adequate
liquidity levels.
At times when the Company has more funds than it needs for its reserve
requirements or short term liquidity needs, the Company increases its securities
investments and sells federal funds. It is management's policy to maintain a
substantial portion of its portfolio of assets and liabilities on a short-term
or highly liquid basis in order to maintain rate flexibility and to meet loan
funding and liquidity needs. The Company has two federal funds lines of credit
with its correspondent banks totaling $6,500,000. In addition the company,
through its subsidiary Palomar Savings and Loan, has a line of credit with
Federal Home Loan Bank of 25% of its total assets which was $20,600,000 at
December 31, 1998.
21
The following table shows the Company's average deposits for each of the periods
indicated below, based upon average daily balances:
(Dollars in thousands) Year Ended December 31,
-----------------------------------------------------------
1998 1997 1996
------------------ ------------------ -------------------
Average Percent Average Percent Average Percent
Balance of Total Balance of Total Balance of Total
-------- -------- -------- -------- -------- ---------
Noninterest-bearing demand $ 20,951 10.4% $ 17,307 11.7% $ 14,160 10.3%
Interest-bearing demand 20,512 10.1 17,755 12.0 16,339 11.9
Savings 24,404 12.1 21,906 14.8 23,259 16.9
TCDs of $100,000 or more 44,216 21.9 27,235 18.4 22,311 16.2
Other TCDs 91,907 45.5 63,673 43.1 61,601 44.7
Total Deposits $201,990 100.0% $147,876 100.0% $137,670 100.0%
======== ======== ======== ======== ======== ======
Deposits
- --------
The maturities of time certificates of deposit ("TCDs") were as follows:
December 31, 1998 December 31, 1997
----------------- -----------------
TCDs over TCDs over
$100,000 Other TCDs $100,000 Other TCDs
----------- ----------- ----------- -----------
Less than three months $36,080,000 $55,362,000 $14,243,000 $21,629,000
Over three months through six months 7,016,000 12,395,000 5,599,000 10,851,000
Over six months through twelve months 15,911,000 17,558,000 10,956,000 22,120,000
Over twelve months through five years 2,735,000 10,164,000 100,000 6,546,000
Total $61,742,000 $95,479,000 $30,898,000 $61,146,000
=========== =========== =========== ===========
While the deposits of the Company may fluctuate up and down somewhat with local
and national economic conditions, management of the Company does not believe
that such deposits, or the business of the Company in general, are seasonal in
nature. Liability management is monitored by the Chief Financial Officer daily
and by the Asset/Liability Committee of the Company's Board of Directors which
meets quarterly.
Year 2000
- ----------
As the year 2000 approaches, a critical issue has emerged regarding how existing
application software programs and operating systems can accommodate this date
value. In brief, many existing application software products in the marketplace
were designed to only accommodate a two digit date position which represents the
year (for example, '98' is stored on the system and represents the year as
1998). As a result, the year 1999 could be the maximum date value these systems
will be able to accurately process. A time-sensitive software may recognize a
date using "00" as the year 1900 rather than year 2000. This could result in a
system failure or miscalculations causing disruptions of operations, including,
among other things, a temporary inability to process transactions or engage in
similar normal business activities.
The Company has adopted a plan of action to minimize the risk of the year 2000
event including the establishment of an oversight committee. This plan is fully
supported by management and the Board of Directors. The committee's goal is to
achieve a year 2000 date conversion with no effect on customers or disruption to
business operations. The plan consists of five phases; awareness, assessment,
renovation, validation, and implementation. In the awareness phase, the
committee was formed consisting of members from all departments within the
Company. This team defined the Year 2000 issue, how and where it would impact
the Company. The assessment phase determined the size of the issue and which
systems were determined as critical to the operations of the Company. During the
renovation phase, systems, hardware, and software were tested for compliance and
any non-compliant systems were replaced. Nothing determined as critical needed
replacement. During the validation phase, further testing is done on any new
equipment or systems installed. At the end of 1998, the Company re-tested all
systems in a mock exercise as if it was January 2000. In 1999, customer
awareness of the Year 2000 issue and what the Company has done to address the
issue will intensify. This will be, but is not limited to, mailings to our
customers, public announcements, and training for Company employees to address
customer concerns.
22
The Company has initiated formal communications with all of its vendors,
including the U.S. Government, to determine their Year 2000 compliance
readiness. The Company is reviewing the extent the interface systems are
vulnerable to any third parties' year 2000 issues. There can be no guarantee
that the systems of other companies on which the Company systems rely will be
timely converted and would not have an adverse effect on the Company's systems.
Many of the Company's systems include new hardware and software purchased from
vendors who have represented that these systems are already year 2000 compliant.
The Company is in the process of obtaining assurances from vendors that timely
updates will be made available to make all remaining systems compliant.
Management does not anticipate the Company will be required to purchase any
additional hardware or software to be year 2000 compliant. However, management
has incurred and will continue to incur some administrative costs relative to
the identification and testing of the Company's electronic data processing
systems. The costs and timing of the year 2000 project is based on management's
best estimates, which were derived utilizing numerous assumptions of future
events, including the continued availability of certain resources, third party
modification plans and other factors. As of December 31, 1998, the Company had
incurred $111,476 in expenses getting Year 2000 compliant and anticipates
spending $100,000 in 1999. However, there can be no guarantee that these
estimates will be achieved and actual results could differ from these plans.
SUPERVISION AND REGULATION - COMMUNITY WEST BANCSHARES
- ------------------------------------------------------------
GENERAL
- -------
Banking is a complex and highly regulated industry. The primary goals of the
regulatory scheme are to maintain a safe and sound banking system and to
facilitate the conduct of sound monetary policy. In furtherance of those goals,
congress has created several largely autonomous regulatory agencies and enacted
numerous laws that govern banks, bank holding companies and the banking
industry. The description of and the references to the status and regulations
below are brief summaries and do not purport to be complete. The descriptions
are qualified in their entirety by reference to the specific statutes and
regulations discussed.
The Company is also a bank holding company within the meaning of Section 3700 of
the California Financial Code. As such, the Company and its subsidiaries are
subject to examination by, and may be required to file reports with, the
Commissioner. Regulations have not yet been proposed or adopted or steps
otherwise taken to implement the Commissioner's powers under this statute.
Community West Bancshares (the "Company") is a bank holding company registered
under the Bank Holding Company Act of 1956, as amended (the "Act"), and is
subject to supervision by the Federal Reserve Board (the "FRB"). As a bank
holding company, the Company is required to file with the FRB an annual report
and such other additional information as the FRB may require pursuant to the
Act. The FRB may also make examinations of the Company and its subsidiaries.
The Act requires prior approval by the FRB for, among other things, the
acquisition by a bank holding company of direct or indirect ownership or control
of more than 5% of the voting shares, or substantially all the assets, of any
bank or for a merger or consolidation by a bank holding company with any other
bank holding company.
Transactions With Affiliates
- ------------------------------
The Company has two wholly-owned banking subsidiaries, Goleta National Bank, a
national banking association (the "Bank"), and Palomar Savings and Loan
Association, a California state-chartered savings bank ("Palomar")(together,
"the Subsidiaries").
23
The Company, the subsidiaries and any other subsidiaries it may acquire, either
by purchase or merger, or subsequently organize, are deemed to be affiliates
within the meaning of the Act. Pursuant thereto, loans by the Subsidiaries to
affiliates, investments by the Subsidiaries in affiliates' stock, and taking
affiliates' stock by the Subsidiaries as collateral for loans to any borrower
will be limited to 10% of an affiliate's capital, in the case of any one
affiliate, and will be limited to 20% of an affiliate's capital in the case of
all affiliates. In addition, such transactions must be on terms and conditions
that are consistent with safe and sound banking practices; in particular, a bank
and its subsidiaries generally may not purchase from an affiliate a low-quality
asset, as defined in the Act. Such restrictions also prevent a bank holding
company and its other affiliates from borrowing from a banking subsidiary of the
bank holding company unless the loans are secured by marketable collateral of
designated amounts. The Company and the Subsidiaries are also subject to certain
restrictions with respect to engaging in the underwriting, public sale and
distribution of securities.
Bank Holding Company Liquidity
- ---------------------------------
The Company is a legal entity, separate and distinct from the Subsidiaries.
Although there exists an ability to raise capital on its own behalf or borrow
from external sources, the Company's primary source of funds is through
dividends paid the Subsidiaries. However, regulatory restraints may restrict or
totally preclude the Subsidiaries from paying dividends to the Company.
The Bank may pay the Company a cash dividend, when and as declared by the Bank's
Board of Directors, out of funds legally available therefore, as specified and
limited by regulations promulgated by the Office of the Comptroller of the
Currency, (the "OCC"). Under OCC regulations, funds available for a national
bank's cash dividends are restricted to the lesser of: (i) a bank's retained
earnings or (ii) a bank's net income for the current and past two fiscal years
(less any dividends made during such period), unless approved by the OCC.
Furthermore, if the OCC determines that a dividend would cause a bank's capital
to be impaired or that payment would cause it to be undercapitalized, it can
prohibit payment of a dividend is an unsafe and unsound banking practice.
Palomar's ability to declare and pay a cash dividend is subject to the Office of
Thrift Supervision's (the "OTS") regulations which impose limitations upon all
capital distributions by savings associations, such as cash dividends, payment
to repurchase or otherwise acquire its shares, payments to shareholders of
another institution in a cash out merger and other distributions charged against
capital. In general, Palomar may not declare or pay a cash dividend on its
capital stock if the payment would cause Palomar to fail to meet one of its
regulatory capital requirements. Palomar must also provide the OTS with 30 days
advance notice of any proposed dividend declaration.
Under OTS regulations, an association that meets its capital requirements, both
before and after the proposed distribution, and has not been notified by the OTS
that it is in need of more than normal supervision (a "Tier 1 association") may,
after prior notice to, but without the approval of the OTS, make capital
distributions during a calendar year up to the higher of: (i)100% of its net
income to date during the calendar year plus the amount that would reduce by
one-half its surplus capital ratio at the beginning of the calendar year, or
(ii) 75% of its net income over the most recent four-quarter period. A Tier 1
association may make capital distributions in excess of the above amount if it
gives notice to the OTS and the OTS does not object to the distribution. At
December 31, 1998 Palomar was deemed to be a Tier 1 association.
On January 19, 1999, the OTS issued Amended Regulations (the "Amended
Regulations") regarding capital distributions, to conform its requirements to
the OTS's prompt corrective action regulation and to conform to the rules of
other banking extent possible. The Amended Regulations are effective April 1,
1999. Under the Amended Regulations, an institution that would at least remain
adequately capitalized after making a capital distribution, and was not owned by
a bank holding company, would no longer be required to provide notice to the OTS
prior to making a capital distribution. "Troubled" associations and
undercapitalized associations would also be allowed to make capital
distributions, but only after filing an application and receiving subsequent OTS
approval. Such applications would only be approved under certain limited
circumstances.
The Amended Regulations only apply to OTS regulated institutions which are not
bank holding company subsidiaries. Currently, it is not contemplated that
Palomar will cease to be the Company's subsidiary and would, therefore, continue
to be the Company's subsidiary and would, therefore, continue to be exempt from
the Amended Regulations.
24
Under the Financial Institutions Supervisory Act, the FDIC also has the
authority to prohibit an insured institution from making distributions it
considers to be unsafe and unsound. Since the Subsidiaries are FDIC insured
institutions, it is therefore possible, depending upon their financial
conditions and other relevant factors, that the FDIC could prohibit payment of
dividends to the Company.
Limitations on Business Activities
- -------------------------------------
With certain limited exceptions, a bank holding company is prohibited from
acquiring direct or indirect ownership or control of more than 5% of the voting
shares of any company which is not a bank or bank holding company and from
engaging directly or indirectly in any activity other than banking or managing
or controlling banks or furnishing services to or performing services for its
authorized subsidiaries. A bank holding company may, however, engage or acquire
an interest in a company that engages in activities which the FRB has determined
to be closely related to banking or managing or controlling banks as to be
properly incident thereto. In making such a determination, the FRB is required
to consider whether the performance of such activities can reasonably be
expected to produce benefits to the public, such as greater convenience,
increased competition, or gains in efficiency, that outweigh possible adverse
effects, such as undue concentration of resources, decreased or unfair
competition, conflicts of interests, or unsound banking practices. Although the
future scope of permitted activities is uncertain and cannot be predicted, some
of the activities that the FRB has determined by regulation to be closely
related to banking are: (i) making or acquiring loans or other extensions of
credit for its own account or for the account of others; (ii) servicing loans
and other extensions of credit for any person; (iii) operating an industrial
bank, Morris Plan bank, or industrial loan company, as authorized under state
law, so long as the institution is not a bank; (iv) operating a trust company in
the manner authorized by federal or state law, so long as the institution is not
a bank and does not make loans or investments or accept deposits, except as
permitted under the FRB's Regulation Y; (v) subject to certain limitations,
acting as an investment or financial adviser to investment companies and other
persons; (vi) leasing personal and real property or acting as agent, broker, or
adviser in leasing such property in accordance with various restrictions imposed
by Regulation Y, including a restriction that it is reasonably anticipated that
each lease will compensate the lessor for not less than the lessor's full
investment in the property; (vii) making equity and debt investments in
corporations or projects designed primarily to promote community welfare; (viii)
providing financial, banking, or economic data processing and data transmission
services, facilities, data bases, or providing access to such services,
facilities, or data bases; (ix) acting as principal, agent, or broker for
insurance directly related to extensions of credit which are limited to assuring
the repayment of debts in the event of death, disability, or involuntary
unemployment of the debtor; (x) acting as agent or broker for insurance directly
related to extensions of credit by a finance company subsidiary; (xi) owning,
controlling, or operating a savings association provided that the savings
association engages only in activities permitted for bank holding companies
under Regulation Y; (xii) providing courier services of limited character;
(xiii) providing management consulting advice to non-affiliated bank and nonbank
depository institutions, subject to the limitations imposed by Regulation Y;
(xiv) selling money orders, travelers' checks and U.S. Savings Bonds; (xv)
appraisal of real estate and personal property; (xvi) acting as an intermediary
for the financing of commercial or industrial income-producing real estate;
(xvii) providing securities brokerage services, related securities credit
activities pursuant to Regulation T, and other incidental activities; (xviii)
underwriting and dealing in obligations of the U.S., general obligations of
states and their political subdivisions, and other obligations authorized for
state member banks under federal law; and (xix) providing general information
and statistical forecasting, advisory and transactional services with respect to
foreign exchange through a separately incorporated subsidiary.
Federal law prohibits a holding company and any subsidiary banks from engaging
in certain tie-in arrangements in connection with the extension of credit.
Thus, for example, the Subsidiaries may not extend credit, lease or sell
property, or furnish any services, or fix or vary the consideration for any of
the foregoing on the condition that: (i) the customer must obtain or provide
some additional credit, property or services from or to the subsidiaries other
than a loan, discount, deposit or trust services; or (ii) the customer must
obtain or provide some additional credit, property or service from or to the
Company or any of the subsidiaries; or (iii) the customer may not obtain some
other credit, property or services from competitors, except reasonable
requirements to assure soundness of credit extended.
Capital Adequacy
- -----------------
The FRB's risk-based capital adequacy guidelines for bank holding companies and
state member banks, discussed in more detail below (see "SUPERVISION AND
REGULATION - THE SUBSIDIARIES - RECENT LEGISLATION AND REGULATORY CHANGES - 2.
Risk-Based Capital Guidelines"), assign various risk percentages to different
categories of assets, and capital is measured as a percentage of risk assets.
While in many cases total risk assets calculated in accordance with the
guidelines is less than total assets calculated absent the rating, certain
non-balance sheet assets, including loans sold with recourse, legally binding
loan commitments and standby letters of credit, are treated as risk assets, with
the assigned rate varying with the type of asset. As a result, it is possible
that total risk assets for purposes of the guidelines exceeds total assets under
generally accepted accounting principles, thereby reducing the capital-to-assets
ratio. Under the terms of the guidelines, bank holding companies are expected
to meet capital adequacy guidelines based both on total assets and on total risk
assets.
25
SUPERVISION AND REGULATION - THE SUBSIDIARIES
GENERAL
- -------
The Bank is a national banking association chartered under the laws of the
United States and is also a member of the Federal Reserve System. As such, it
is subject to regulation, supervision and regular examination by the FRB and the
OCC. Palomar is a California state-chartered full-service savings and loan
association and is therefore to regulation, supervision and regular examination
by the California Department of Financial Institutions (the "DFI") and the OTS.
Palomar is also a member of the Federal Home Loan Bank System (the "FHLB") and
is therefore subject to the FHLB's regulations, supervision and regular
examinations. The deposit of the Bank and Palomar are also insured by the
maximum applicable limits by the Bank Insurance Fund ("BIF") and by the Savings
Association Insurance Fund ("SAIF"), respectively, of the FDIC. Consequently,
both are subject to regulation, supervision and regular examination by the FDIC.
The regulations of these agencies govern most aspects of the subsidiaries'
business, including capital adequacy ratios, reserves against deposits,
restrictions on the rate of interest which may be paid on some deposit
instruments, limitations on the nature and amount of loans which may be made,
the location of branch offices, borrowings, and dividends. Supervision,
regulation and examination of the Subsidiaries by the regulatory agencies are
generally intended to protect depositors and are not intended for the protection
of the Subsidiaries' shareholder. California law also exempts all banks from
usury limitations on interest rates.
RECENT LEGISLATION AND REGULATORY CHANGES
- ---------------------------------------------
1. Introduction
------------
General. From time to time legislation is proposed or enacted which has the
- --------
effect of increasing the cost of doing business and changing the competitive
balance between banks and other financial and non-financial institutions.
Various federal laws enacted over the past several years have provided, among
other things, for the maintenance of mandatory reserves with the Federal Reserve
Bank on deposits by depository institutions (state reserve requirements have
been eliminated); the phasing-out of the restrictions on the amount of interest
which financial institutions may pay on certain of their customers' accounts;
and the authorization of various types of new deposit accounts, such as NOW
accounts, "Money Market Deposit" accounts and "Super NOW" accounts, designed to
be competitive with money market mutual funds and other types of accounts and
services offered by various financial and non-financial institutions. The
lending authority and permissible activities of certain non-bank financial
institutions such as savings and loan associations and credit unions have been
expanded, and federal regulators have been given increased authority and means
for providing financial assistance to insured depository institutions and for
effecting interstate and cross-industry mergers and acquisitions of failing
institutions. These laws have generally had the effect of altering competitive
relationships existing among financial institutions, reducing the historical
distinctions between the services offered by banks, savings and loan
associations and other financial institutions, and increasing the cost of funds
to banks and other depository institutions.
Other legislation has been proposed or is pending before the United States
Congress which would effect the financial institutions industry. Such
legislation includes wide-ranging proposals to further alter the structure,
regulation and competitive relationships of the nation's financial institutions,
to reorganize the federal regulatory structure of the financial institutions
industry, to subject banks to increased disclosure and reporting requirements,
and to expand the range of financial services which banks and bank holding
companies can provide. Other proposals which have been introduced or are being
discussed would equalize the relative powers of savings and loan holding
companies and bank holding companies, and authorize such holding companies to
engage in insurance underwriting and brokerage, real estate development and
brokerage, and certain securities activities, including underwriting and dealing
in United States Government securities and municipal securities, sponsoring and
managing investment companies and underwriting the securities thereof. It
cannot be predicted whether or in what form any of these proposals will be
adopted, or to what extent they will effect the various entities comprising the
financial institutions industry.
26
Certain of the potentially significant changes which have been enacted in the
past several years are discussed below.
Interstate Banking. The Riegle-Neal Interstate Banking and Branching Efficiency
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Act of 1994 (the "Riegle-Neal Act"), enacted on September 29, 1994, repealed the
McFadden Act of 1927, which required states to decide whether national or state
banks could enter their state, and, effective June 1, 1997, allows banks to open
branches across stat