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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2003
or
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _______________ to _________________
Commission File Number : 0-12499
First Financial Bancorp
(Exact name of registrant as specified in its charter)
California 94-28222858
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
701 South Ham Lane, Lodi, California 95242
(Address of principal executive offices) (Zip Code)
(209) 367-2000
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, no par value
(Title of Class)
Preferred Share Purchase Rights
(Title of Class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. [ X ] Yes [ ] No
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ X ]
Indicate by check mark whether the Registrant is an accelerated filer
(as defined in Rule 12b-2 of the Act). Yes [ ] No [ X ]
The aggregate market value of the Common Stock held by non-affiliates of the
registrant was approximately $27,705,000 (based on the $17.00 average of bid and
ask prices per share on June 30, 2003).
As of March 5, 2004, there were 1,783,420 shares of Common Stock
(adjusted for the 10% stock dividend declared March 25, 2004) no par value,
outstanding.
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1
FIRST FINANCIAL BANCORP
2003 FORM 10-K
TABLE OF CONTENTS
PART 1
ITEM 1. BUSINESS ......................................................... 4
General ........................................................ 4
The Bank ....................................................... 4
Bank Services .................................................. 4
Sources of Business ............................................ 5
Competition .................................................... 5
Officers ....................................................... 6
Employees ...................................................... 6
Supervision and Regulation ..................................... 7
The Company ............................................. 7
The Bank ................................................ 7
Recent Legislation and Regulations Affecting Banking .... 8
ITEM 2. PROPERTIES ....................................................... 14
ITEM 3. LEGAL PROCEEDINGS ................................................ 14
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS .............. 14
Part II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS ............................................ 15
ITEM 6. SELECTED FINANCIAL DATA .......................................... 16
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS ...................................... 17
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ....... 40
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ..................... 40
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE ............................ 40
ITEM 9A. CONTROLS AND PROCEDURES .......................................... 40
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ............... 41
ITEM 11. EXECUTIVE COMPENSATION ........................................... 44
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.... 49
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ................... 52
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES............................ 52
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K .. 53
Signatures ................................................................ 83
Index to Exhibits.......................................................... 84
2
PART I
Certain statements in this Annual Report on Form 10-K include forward-looking
information within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and
are subject to the "safe harbor" created by those sections. These
forward-looking statements involve certain risks and uncertainties that could
cause actual results to differ materially from those in the forward-looking
statements. Forward-looking statements, which are based on certain assumptions
and describe future plans, strategies, and expectations, are generally
identifiable by the use of words such as "believe", "expect", "intend",
"anticipate", "estimate", "project", "assume," "plan," "predict," "forecast" or
similar expressions. These forward-looking statements relate to, among other
things, expectations of the business environment in which the Company operates,
projections of future performance, potential future performance, potential
future credit experience, perceived opportunities in the market, and statements
regarding the Company's mission and vision.
The Company's actual results, performance, and achievements may differ
materially from the results, performance, and achievements expressed or implied
in such forward-looking statements due to a wide range of risks and
uncertainties. Such risks and uncertainties include, but are not limited to, the
following factors: competitive pressure in the banking industry; changes in the
interest rate environment; general economic conditions, either nationally or
regionally becoming less favorable than expected and resulting in, among other
things, a deterioration in credit quality and an increase in the provision for
possible loan losses; changes in the regulatory environment; monetary and fiscal
policies of the U.S. Government; changes in real estate valuations; changes in
business conditions; volatility of rate sensitive deposits; operational risks,
including data processing system failures or fraud; asset/liability matching
risks and liquidity risks; impact of litigation; the ability of management and
directors to work together cooperatively and efficiently; civil disturbances or
terrorist threats or acts; or apprehension about the possible future occurrences
of acts of this type; the outbreak or escalation of hostilities involving the
United States; and changes in the securities markets. Also, all of the Company's
operations and most of its customers are located in California. During recent
times, the availability of a sufficient supply of electrical power in California
has been unreliable at times. In addition, other events, including those of
September 11, 2001, have increased the uncertainty related to the national and
California economic outlook and could have an effect on the future operations of
the Company or its customers, including borrowers.
The Company does not undertake, and specifically disclaims any obligation, to
update any forward-looking statements to reflect occurrences or unanticipated
events or circumstances after the date of such statements.
3
ITEM 1. BUSINESS
General:
First Financial Bancorp (the "Company") was incorporated under the laws of the
State of California on May 13, 1982, and operates principally as a bank holding
company for its wholly owned subsidiary, Bank of Lodi, N.A. (the "Bank"). The
Company is registered under the Bank Holding Company Act of 1956, as amended.
The Bank is the principal source of income for the Company. The Company also
holds all of the capital stock of its other subsidiaries, Western Auxiliary
Corporation and First Financial (CA) Statutory Trust I. Western Auxiliary
Corporation (WAC), a California Corporation, functions as trustee on deeds of
trust securing mortgage loans originated by the Bank. At December 31, 2003 the
Company had a wholly-owned trust, First Financial (CA) Statutory Trust I, a
Delaware business trust formed in 2001 for the exclusive purpose of issuing
Company obligated manditorily redeemable cumulative trust preferred securities
of Subsidiary Grantor Trust holding solely junior subordinated debentures. As a
result of the adoption of FIN 46R, the Company deconsolidated the Trust as of
and for years ended December 31, 2003 and 2002. Prior to December 31, 2003, the
Trust was a consolidated subsidiary and was included in liabilities in the
consolidated balance sheet, as "Obligated mandatorily redeemable capital
securities of subsidiary trust." The common securities and debentures, along
with the related income effects were eliminated in the consolidated financial
statements. All references herein to the "Company" include the Bank and all
other subsidiaries, unless the context otherwise requires.
Information on the Company's financial results and its products and services is
available on the Internet at http://www.bankoflodi.com. Copies of the Company's
Annual Report on Form 10-K, Quarterly Reports on 10-Q and Current Reports on
Form 8-K filed with the Securities and Exchange Commission will be furnished to
any shareholder, free of charge, upon request. These reports also are available
over the Internet at http://www.sec.gov.
The Bank:
The Bank was organized on May 13, 1982 as a national banking association. The
application to organize the Bank was accepted for filing by the Comptroller of
the Currency (the "OCC") on September 8, 1981, and preliminary approval to
organize was granted on March 27, 1982. On July 18, 1983 the Bank received from
the OCC a Certificate of Authority to Commence the Business of Banking.
Subsequently, the Bank opened branch offices in Woodbridge and Lockeford,
California. Effective February 22, 1997, the Bank acquired the Galt, Plymouth
and San Andreas offices of Wells Fargo Bank. A loan production office in Folsom,
California was opened in January 1998, and was approved to operate as a
full-service branch in July 1999. In July 2001 the Bank relocated the Folsom
branch. A full-service branch was opened in Elk Grove, California in August
1998. In March 2001, the Bank established a Small Business Administration loan
production office in Folsom, California. A full-service branch was opened in
Sacramento, California in September 2003.
The Bank's headquarters is located at 701 South Ham Lane, Lodi, California. This
area is estimated to have a population approaching 60,000 persons. The area
includes residential developments, neighborhood shopping centers, business and
professional offices and manufacturing and agricultural concerns.
Bank Services:
The Bank offers a wide range of commercial banking services to individuals and
business concerns located in and around its primary service area. These services
include personal and business checking and savings accounts (including
interest-bearing negotiable order of withdrawal ("NOW") accounts and/or accounts
combining checking and savings accounts with automatic transfers), and time
certificates of deposit. The Bank also offers extended banking hours at its
drive-through window, night depository and bank-by-mail services, and travelers'
checks (issued by an independent entity). Each branch location has a 24-hour ATM
machine, and the Bank has 24 hour telephone banking and bill paying services.
The Bank issues debit cards, MasterCard credit cards and acts as a merchant
depository for cardholder drafts under both VISA and MasterCard. In addition, it
provides direct deposit of social security and other government checks. The Bank
also offers Internet banking and bill payment services, which are located at
http://www.bankoflodi.com.
During 1998, the Bank entered into an agreement with Investment Centers of
America to offer stocks, bonds, mutual funds, annuities and insurance products
through offices located on-site at Bank branches. The first Investment Centers
of America office was established at the Lodi branch location. This agreement
was terminated during 2003.
4
The Bank engages in a full complement of lending activities, including
commercial, Small Business Administration (SBA), residential mortgage,
consumer/installment, and short-term real estate loans, with particular emphasis
on short and medium-term obligations. Commercial lending activities are directed
principally toward businesses whose demand for funds falls within the Bank's
lending limit, such as small to medium-sized professional firms, retail and
wholesale outlets and manufacturing and agricultural concerns. Consumer lending
is oriented primarily to the needs of the Bank's customers, with an emphasis on
automobile financing and leasing. Consumer loans also include loans for boats,
home improvements, debt consolidation, and other personal needs. Real estate
loans include short-term "swing" loans and construction loans. Residential
mortgages are generally sold into the secondary market for these loans. SBA
loans are made available to small to medium-sized businesses. The Bank generates
noninterest income through premiums received on the sale of the guaranteed
portions of SBA loans and the resulting on-going servicing income on its SBA
portfolio.
Sources of Business:
Management seeks to obtain sufficient market penetration through the full range
of services described above and through the personal solicitation of the Bank's
officers, directors and shareholders. All officers are responsible for making
regular calls on potential customers to solicit business and on existing
customers to obtain referrals. Promotional efforts are directed toward
individuals and small to medium-sized businesses. The Bank's customers are able
in their dealings with the Bank to be served by bankers who have commercial loan
experience, lending authority, and the time to serve their banking needs quickly
and competently. Bankers are assigned to customers and not transferred from
office to office as in many major chain or regional banks. In order to expedite
decisions on lending transactions, the Bank's loan committee meets on a regular
basis and is available where immediate authorization is important to the
customer.
The risk of non-payment (or deferred payment) of loans is inherent in commercial
banking. Furthermore, the Bank's marketing focus on small to medium-sized
businesses may involve certain lending risks not inherent in loans to larger
companies. Smaller companies generally have shorter operating histories, less
sophisticated internal record keeping and financial planning capabilities, and
greater debt-to-equity ratios. Management of the Bank carefully evaluates all
loan applicants and attempts to minimize its credit risk through the use of
thorough loan application and approval procedures.
Consistent with the need to maintain liquidity, management of the Bank seeks to
invest the largest portion of the Bank's assets in loans of the types described
above. Loans are generally limited to less than 80% of deposits and capital
funds. The Bank's surplus funds are invested in the investment portfolio, made
up of both taxable and non-taxable debt securities of the U.S. government, U.S.
government agencies, states, and municipalities. On a day-to-day basis, surplus
funds are invested in federal funds sold, securities purchased under resale
agreements and other short-term money market instruments.
Competition:
The banking business in California generally, and in the northern portion of
central California where the Bank is located, is highly competitive with respect
to both loans and deposits and is dominated by a relatively small number of
major banks with branch office networks and other operating affiliations
throughout the State. The Bank competes for deposits and loans with these banks,
as well as with savings and loan associations, thrift and loan associations,
credit unions, mortgage companies, insurance companies and other lending
institutions. Among the advantages certain of these institutions have over the
Bank are their ability (i) to finance extensive advertising campaigns, (ii) to
allocate a substantial portion of their investment assets in securities with
higher yields (not available to the Bank if its investments are to be
diversified) and (iii) to make funds available for loans in geographic regions
with the greatest demand. In competing for deposits, the Bank is subject to the
same regulations with respect to interest rate limitations on time deposits as
other depository institutions. See "Supervision and Regulation" below.
Many of the major commercial banks operating in the Bank's service area offer
certain services, such as international banking and trust services, which are
not offered directly by the Bank, and such banks, by virtue of their greater
capitalization, have substantially higher lending limits than the Bank. In
addition, other entities, both public and private, seeking to raise capital
through the issuance and sale of debt and equity securities compete with the
Bank for the acquisition of funds for deposit.
In order to compete with other financial institutions in its primary service
area, the Bank relies principally on local promotional activities, personal
contacts by its officers, directors, employees and shareholders, extended hours
and specialized services. The Bank's promotional activities emphasize the
advantages of dealing with a locally-owned and headquartered institution
sensitive to the particular needs of the community. The Bank also assists
customers in obtaining loans in excess of the Bank's lending limit or services
not offered by the Bank by arranging such loans or services in participation
with or through its correspondent banks.
The State Bank Parity Act, effective January 1, 1996, eliminated certain
existing disparities between California state chartered banks and national
banking associations, such as the Bank, by authorizing the California
Commissioner of Financial Institutions (the "Commissioner") to address such
disparities through a streamlined rule-making process.
5
Officers:
Leon Zimmerman, age 61, is President and Chief Executive Officer of the Bank and
of the Company; Robert H. Daneke, age 50 is Executive Vice President and Chief
Credit Officer of the Bank and of the Company, and; Allen R. Christenson, age 46
is Senior Vice-President, Chief Financial Officer and Secretary of the Bank and
of the Company.
Mr. Zimmerman joined the Company in April 1990. He was promoted from Executive
Vice President and Chief Credit Officer of Bank of Lodi to President and CEO in
August of 1994. Mr. Zimmerman became President and CEO of the Company effective
August 1995. He lives in Lodi with his wife and has resided and worked in the
San Joaquin-Sacramento Valley since 1960, serving in various banking capacities
since 1962. Mr. Zimmerman serves on many community boards and committees,
including the Lodi Police Chaplaincy Association, San Joaquin County Education
Foundation, Chamber of Commerce - Agribusiness Committee, and LEED - Sacramento
Steering Committee. He is a member of Lodi Rotary Club, Sutter Club -
Sacramento, World Trade Club - San Francisco, Independent Order of Odd Fellows,
Lodi Grape Festival and Harvest Fair and several other community groups.
Mr. Daneke joined the Company in December 1999 bringing on board 23 years of
banking experience. Prior to joining the Company, Mr. Daneke was employed at
Clovis Community Bank for eight years and was promoted to Senior Vice
President/Senior Credit Officer in 1997. In addition, his career has included:
seven years with the Correspondent Bank Division of Community Bank in Redwood
City and seven years with Bank of America Corporate Banking Group. Mr. Daneke
holds a B.B.A. Degree in Finance from the University of Iowa. He is also a
graduate of Pacific Coast Banking School at the University of Washington, the
California Intermediate Banking School at the University of San Diego and the
Lodi Chamber of Commerce Leadership Lodi Program. He currently is a member of
the Lodi Chapter of Independent Order of Odd Fellows and serves on Lodi Unified
School District's Budget Advisory Committee. Mr. Daneke resides in Lodi with his
wife and two children.
Mr. Christenson joined the Company in August 1999. Prior to joining the Company,
Mr. Christenson was Senior Vice President and Chief Financial Officer of River
City Bank, located in Sacramento, California (1994-1999). Prior to joining River
City Bank, Mr. Christenson was Senior Vice President and Chief Financial Officer
of CapitolBank Sacramento, which was acquired by another bank (1993-1994). Prior
to joining CapitolBank Sacramento, Mr. Christenson was in public accounting for
over eight years, specializing in financial audits and consulting within the
financial services industry. Mr. Christenson has a Bachelors degree from
California State University, Sacramento. Mr. Christenson and his wife are the
parents of five children. He is a life-long resident of the greater Sacramento
area and continues to serve in various community and civic organizations.
Employees:
As of December 31, 2003, the Company employed 130 full-time equivalent
employees, including three executive officers. Management believes that the
Company's relationship with its employees is good.
6
Supervision and Regulation
The Company:
The common stock of the Company is subject to the registration requirements of
the Securities Act of 1933, as amended, and the qualification requirements of
the California Corporate Securities Law of 1968, as amended. The Company is also
subject to the periodic reporting requirements of Section 13(a) of the
Securities Exchange Act of 1934, as amended, which include, but are not limited
to, annual, quarterly and other current reports with the Securities and Exchange
Commission.
The Company is a bank holding company registered under the Bank Holding Company
Act of 1956 (the "Act") and is subject to supervision by the Board of Governors
of the Federal Reserve System (the "Board"). As a bank holding company, the
Company must file with the Board quarterly reports, annual reports, and such
other additional information as the Board may require pursuant to the Act. The
Board also examines the Company and its subsidiaries on a regular basis.
The Act requires prior approval of the Board for, among other things, the
acquisition by a bank holding company of direct or indirect ownership or control
of more than 5% of the voting shares, or substantially all the assets, of any
bank, or for a merger or consolidation by a bank holding company with any other
bank holding company. The Act also prohibits the acquisition by a bank holding
company or any of its subsidiaries of voting shares, or substantially all the
assets, of any bank located in a state other than the state in which the
operations of the bank holding company's banking subsidiaries are principally
conducted, unless the statutes of the state in which the bank to be acquired is
located expressly authorize the acquisition.
With certain limited exceptions, a bank holding company is prohibited from
acquiring direct or indirect ownership or control of more than 5% of the voting
shares of any company that is not a bank or bank holding company and from
engaging directly or indirectly in any activity other than banking or managing
or controlling banks or furnishing services to, or performing services for, its
authorized subsidiaries. A bank holding company may, however, engage in or
acquire an interest in a company that engages in activities that the Board has
determined to be so closely related to banking or to managing or controlling
banks as to be properly incident thereto. In making this determination, the
Board is required to consider whether the performance of an activity reasonably
can be expected to produce benefits to the public, such as greater convenience,
increased competition, or gains in efficiency, which outweigh possible adverse
effects, such as undue concentration of resources, decreased or unfair
competition, conflicts of interest or unsound banking practices. The Board is
also empowered to differentiate between activities commenced de novo and
activities commenced by the acquisition, in whole or in part, of a going
concern.
Additional statutory provisions prohibit a bank holding company and any
subsidiary banks from engaging in certain tie-in arrangements in connection with
the extension of credit, sale or lease of property or furnishing of services.
Thus, a subsidiary bank may not extend credit, lease or sell property, or
furnish any services, or fix or vary the consideration for any of the foregoing
on the condition that: (i) a customer obtain or provide some additional credit,
property or service from or to the bank other than a loan, discount, deposit or
trust service; or (ii) the customer obtain or provide some additional credit,
property or service from or to the company or any other subsidiary of the
company; or (iii) the customer not obtain some other credit, property or service
from competitors, except reasonable requirements to assure soundness of the
credit extended. These anti-tying restrictions also apply to bank holding
companies and their non-bank subsidiaries as if they were banks.
The Company's ability to pay cash dividends is subject to restrictions set forth
in the California General Corporation Law. The Bank is a legal entity separate
and distinct from the Company, and is subject to various statutory and
regulatory restrictions on its ability to pay dividends to the Company. See Note
15(c) to the consolidated financial statements for further information regarding
the payment of cash dividends by the Company and the Bank.
The Company is a bank holding company within the meaning of Section 3700 of the
California Financial Code. As such, the Company and its subsidiaries are subject
to examination by, and may be required to file reports with, the Commissioner.
Regulations have not yet been proposed or adopted to implement the
Commissioner's powers under this statute.
The Bank:
The Bank, is a national banking association whose deposit accounts are insured
by the Federal Deposit Insurance Corporation (the "FDIC") up to the maximum
legal limits. The Bank is subject to regulation, supervision, and regular
examination by the OCC. The Bank is a member of the Federal Reserve System, and,
as such, is subject to certain provisions of the Federal Reserve Act and
regulations issued by the Board. The Bank is also subject to applicable
provisions of California law, insofar as they are not in conflict with, or
preempted by, federal law. The regulations of these various agencies govern most
aspects of the Bank's business, including reserves against deposits, interest
rates payable on deposits, loans, investments, mergers and acquisitions,
borrowings, dividends and location of branch offices.
7
Changes in Legislation and Regulations Affecting Banking:
From time to time, new laws are enacted which increase the cost of doing
business, limit permissible activities, or affect the competitive balance
between banks and other financial institutions. Proposals to change the laws and
regulations governing the operations and taxation of bank holding companies,
banks and other financial institutions are frequently made in Congress, in the
California legislature and before various bank holding company and bank
regulatory agencies. The likelihood of any major changes and the impact such
changes might have are impossible to predict. Certain significant recently
proposed or enacted laws and regulations are discussed below.
Interstate Banking. California permits California banks and bank holding
companies to be acquired by banking organizations based in other states on a
"reciprocal" basis (i.e., provided the other state's laws permit California
banking organizations to acquire banking organizations in that state on
substantially the same terms and conditions applicable to local banking
organizations). California law (1) permits interstate merger transactions; (2)
prohibits interstate branching through the acquisition of a branch business unit
located in California without acquisition of the whole unit of the California
bank; and (3) prohibits interstate branching through de novo establishment of
California branch offices. Initial entry into California by an out-of-state
institution must be accomplished by acquisition of or merger with an existing
whole bank which has been in existence for at least five years.
Capital Requirements. Federal regulation imposes upon all FDIC-insured financial
institutions a variable system of risk-based capital guidelines designed to make
financial institution capital requirements sensitive to differences in risk
profiles among banking organizations, to take into account off-balance sheet
exposures and to aid in making the definition of bank capital uniform
internationally. Under the risk-based capital guidelines, the Bank is required
to maintain capital equal to at least 8 percent of its assets, weighted by risk.
Assets and off-balance sheet items are categorized by the guidelines according
to risk, and certain assets considered to present less risk than others permit
maintenance of capital below the 8 percent level. The guidelines established two
categories of qualifying capital: Tier 1 capital comprising core capital
elements, and Tier 2 comprising supplementary capital requirements. At least
one-half of the required capital must be maintained in the form of Tier 1
capital. For the Bank, Tier 1 capital includes only common stockholders' equity
and retained earnings, but qualifying perpetual preferred stock would also be
included without limit if the Bank were to issue such stock. Tier 2 capital
includes, among other items, limited life and cumulative preferred stock,
mandatory convertible securities, subordinated debt, and a limited amount of the
institution's allowance for loan and lease losses.
The risk-based capital guidelines also require insured institutions to maintain
a minimum leverage ratio of 3 percent Tier 1 capital to total assets (the
"leverage ratio"). The OCC emphasizes that the leverage ratio constitutes a
minimum requirement for the most well run banking organizations. All other
banking organizations are required to maintain a minimum leverage ratio ranging
generally from 4 to 5 percent. The Bank's required minimum leverage ratio is 4
percent.
The federal banking agencies also monitor the ability of banks to manage
interest-rate risk exposure. Interest rate risk is the risk that changes in
market interest rates might adversely affect a bank's financial condition. The
goal of the agencies is to ensure that institutions with high levels of
interest-rate risk have sufficient capital to cover their exposures to risk.
The Federal Financial Institutions Examination Council ("FFIEC") has adopted an
updated Uniform Financial Rating System ("UFIRS"). The UFIRS utilizes the
"CAMELS" rating system, which classifies and evaluates the soundness of
financial institutions based upon an evaluation of capital adequacy, asset
quality, management, earnings, liquidity and sensitivity to market risk, which
is intended to reflect the degree to which changes in interest rates, foreign
exchange rates, commodity prices or equity prices may adversely affect an
institution's earnings and capital.
As of December 31, 2003, the Bank's total risk-based capital ratio was
approximately 10.68 percent and its leverage ratio was approximately 7.96
percent. The Bank does not presently expect that compliance with the risk-based
capital guidelines, minimum leverage sensitivity to market risk requirements
will have a materially adverse effect on its business in the reasonably
foreseeable future.
During 2002 the Holding Company contributed $2 million into the bank as
contributed capital which is included in Tier 1 capital for regulatory capital
adequacy determination purposes. The funds were made available as a result of a
$5 million trust preferred securities offering. The securities offering is
discussed in Note 8 to the consolidated financial statements.
8
Insurance Premiums and Assessments. The FDIC has authority to impose a special
assessment on members of the Bank Insurance Fund (the "BIF") to insure that
there will be sufficient assessment income for repayment of BIF obligations and
for any other purpose which it deems necessary. The FDIC is authorized to set
semi-annual assessment rates for BIF members at levels sufficient to maintain
the BIF's reserve ratio to a designated level of 1.25% of insured deposits.
Congress has considered various proposals to merge the BIF with the Savings
Association Insurance Fund or otherwise to require banks to contribute to the
insurance funds for savings associations. Adoption of any of these proposals
might increase the cost of deposit insurance for all banks, including the Bank.
Under FDICIA, the FDIC has developed a risk-based assessment system, which
provides that the assessment rate for an insured depository institution will
vary according to the level of risk incurred in its activities. An institution's
risk category is based upon whether the institution is well capitalized,
adequately capitalized or less than adequately capitalized. Each insured
depository institution is also to be assigned to one of three "supervisory
subgroups": Subgroup A institutions are financially sound institutions with a
few minor weaknesses; Subgroup B institutions are institutions that demonstrate
weaknesses which, if not corrected, could result in significant deterioration;
and Subgroup C institutions are institutions for which there is a substantial
probability that the FDIC will suffer a loss in connection with the institution
unless effective action is taken to correct the areas of weakness. The FDIC
assigns each BIF member institution an annual FDIC assessment rate on BIF
insured deposits which, as of the date of this Offering Circular, varies between
$0.00 per $100 of insured deposits with a $2,000 annual minimum (for well
capitalized Subgroup A institutions) and $0.27 per $100 of insured deposits (for
undercapitalized Subgroup C institutions). In addition, banks must pay an amount
which fluctuates (but is currently 1.54 cents per $100 of insured deposits)
towards the retirement of the Financing Corporation bonds issued in the 1980s to
assist in the recovery of the savings and loan industry.
Prompt Corrective Action. The Prompt Corrective Action Regulations (the "PCA
Regulations") of the federal bank regulatory agencies establish the following
five capital categories in descending order: well capitalized, adequately
capitalized, undercapitalized, significantly undercapitalized and critically
undercapitalized. Assignment to a capital category depends upon an institution's
total risk-based capital ratio, Tier 1 risk-based capital ratio, and leverage
ratio. Institutions classified in one of the three undercapitalized categories
are subject to certain mandatory and discretionary supervisory actions, which
include increased monitoring and review, implementation of capital restoration
plans, asset growth restrictions, limitations upon expansion and new business
activities, requirements to augment capital, restrictions upon deposit gathering
and interest rates, replacement of senior executive officers and directors, and
requiring divestiture or sale of the institution. The Bank has been classified
as a well-capitalized bank since adoption of the PCA Regulations.
Community Reinvestment Act. Community Reinvestment Act ("CRA") regulations
evaluate banks' lending to low and moderate income individuals and businesses
across a four-point scale from "outstanding" to "substantial noncompliance," and
are a factor in regulatory review of applications to merge, establish new
branches or form bank holding companies. In addition, any bank rated in
"substantial noncompliance" with the CRA regulations may be subject to
enforcement proceedings. The Bank has a current rating of "satisfactory" CRA
compliance.
Safety and Soundness Standards. Federal bank regulatory agency safety and
soundness standards for insured financial institutions establish standards for
(1) internal controls, information systems and internal audit systems; (2) loan
documentation; (3) credit underwriting; (4) interest rate exposure; (5) asset
growth; and (6) compensation, fees and benefits. In addition, the standards
prohibit the payment of compensation which is excessive or which could lead to
material financial loss. If an agency determines that an institution fails to
meet any standard established by the guidelines, the agency may require the
financial institution to submit to the agency an acceptable plan to achieve
compliance with the standard. Agencies may elect to initiate enforcement action
in certain cases where failure to meet one or more of the standards could
threaten the safe and sound operation of the institution. The Bank has not been
and does not expect to be required to submit a safety and soundness compliance
plan because of a failure to meet any of the safety and soundness standards.
Permitted Activities. In recent years, the Federal banking agencies, especially
the OCC and the Board, have taken steps to increase the types of activities in
which national banks and bank holding companies can engage, and to make it
easier to engage in such activities. In particular, the OCC has issued
regulations permitting national banks to engage in a wide range of activities
through subsidiaries. "Eligible institutions" (national banks that are well
capitalized, have a high overall rating and a satisfactory CRA rating, and are
not subject to an enforcement order) may engage in activities related to banking
through operating subsidiaries after going through an expedited application
process. In addition, the regulations include a provision whereby a national
bank may apply to the OCC to engage in an activity through a subsidiary in which
the bank itself may not engage.
9
Monetary Policies. Banking is a business in which profitability depends on rate
differentials. In general, the differences between the interest rate received by
a bank on loans extended to its customers and securities held in that bank's
investment portfolio and the interest rate paid on its deposits and its other
borrowings constitute the major portion of the bank's earnings. To the extent
that a bank is not able to compensate for increases in the cost of deposits and
other borrowings with greater income from loans, securities and fees, the net
earnings of that bank will be reduced. The interest rates paid and received by
any bank are highly sensitive to many factors that are beyond the control of
that bank, including the influence of domestic and foreign economic conditions.
See Item 7 herein, Management's Discussion and Analysis of Financial Condition
and Results of Operations.
The earnings and growth of a bank are also affected by the monetary and fiscal
policy of the United States Government and its agencies, particularly the Board.
These agencies can and do implement national monetary policy, which is used in
part to curb inflation and combat recession. Among the instruments of monetary
policy used by these agencies are open market transactions in United States
Government securities, changes in the discount rates of member bank borrowings,
and changes in reserve requirements. The actions of the Board have had a
significant effect on banks' lending, investments and deposits, and such actions
are expected to continue to have a substantial effect in the future. However,
the nature and timing of any further changes in such policies and their impact
on banks cannot be predicted.
Financial Services Modernization Legislation. The Gramm-Leach-Bliley Act of 1999
(the "Modernization Act") repealed two affiliation provisions of the
Glass-Steagall Act: Section 20, which restricted the affiliation of Federal
Reserve member banks with firms "engaged principally" in specified securities
activities; and Section 32, which restricted officer, director, or employee
interlocks between a member bank and any company or person "primarily engaged"
in specified securities activities. In addition, the Modernization Act also
expressly preempts any state law restricting the establishment of financial
affiliations, primarily related to insurance. The law establishes a
comprehensive framework to permit affiliations among commercial banks, insurance
companies, securities firms, and other financial service providers by revising
and expanding the BHC Act framework to permit a holding company system to engage
in a full range of financial activities through a new entity known as a
Financial Holding Company. "Financial activities" is broadly defined to include
not only banking, insurance, and securities activities, but also merchant
banking and additional financial activities or complementary activities that do
not pose a substantial risk to the safety and soundness of depository
institutions or the financial system generally.
In order for the Company to take advantage of the ability provided by the
Modernization Act to affiliate with other financial service providers, it must
become a "Financial Holding Company." To do so, the Company would file a
declaration with the Federal Reserve electing to engage in activities
permissible for Financial Holding companies and certifying that it is eligible
to do so because its insured depository institution subsidiary (the Bank) is
well-capitalized and well-managed. In addition, the Federal Reserve must also
determine that an insured depository institution subsidiary has at least a
"satisfactory" rating under the Community Reinvestment Act. The Company
currently meets the requirements for Financial Holding Company status. The
Company will continue to monitor its strategic business plan to determine
whether, based on market conditions and other factors, the Company wishes to
utilize any of its expanded powers provided in the Modernization Act.
Under the Modernization Act, securities firms and insurance companies that elect
to become Financial Holding Companies may acquire banks and other financial
institutions. The Company does not believe that the Modernization Act will have
a material adverse effect on its operations in the near-term. However, to the
extent that it permits banks, securities firms, and insurance companies to
affiliate, the financial services industry may experience further consolidation.
The Modernization Act is intended to grant to community banks certain powers as
a matter of right that larger institutions have accumulated on an ad hoc basis.
Nevertheless, the Act may have the result of increasing the amount of
competition that the Company and the Bank face from larger institutions and
other types of companies offering financial products, many of which may have
substantially more financial resources than the Company and the Bank.
Privacy Provisions of the Modernization Act. The Modernization Act required
federal banking regulators to adopt rules limiting the ability of banks and
other financial institutions to disclose nonpublic information about consumers
to nonaffiliated third parties. The rules require disclosure of privacy policies
to consumers and, in some circumstances, allow consumers to prevent disclosure
of certain personal information to nonaffiliated third parties. The privacy
provisions of the Modernization Act also affect how consumer information may be
transmitted through diversified financial services companies and conveyed to
outside vendors.
10
Regulation W. The Federal Reserve has adopted Regulation W to implement sections
23A and 23B of the Federal Reserve Act.
Sections 23A and 23B and Regulation W limit the risks to a bank from
transactions between the bank and its affiliates and limit the ability of a bank
to transfer to its affiliates the benefits arising from the bank's access to
insured deposits, the payment system and the discount window and other benefits
of the Federal Reserve system. The statute and rule impose quantitative and
qualitative limits on the ability of a bank to extend credit to, or engage in
certain other transactions with, an affiliate (and a nonaffiliate if an
affiliate benefits from the transaction). However, certain transactions that
generally do not expose a bank to undue risk or abuse the safety net are
exempted from coverage under Regulation W.
Historically, a subsidiary of a bank was not considered an affiliate for
purposes of Sections 23A and 23B, since their activities were limited to
activities permissible for the bank itself. The GLB Act authorized "financial
subsidiaries" that may engage in activities not permissible for a bank. These
financial subsidiaries are now considered affiliates. Certain transactions
between a financial subsidiary and another affiliate of a bank are also covered
by sections 23A and 23B under Regulation W.
Regulation W has certain exemptions, including:
-- For state-chartered banks, an exemption for subsidiaries lawfully
conducting nonbank activities before issuance of the final rule.
-- An exemption for extensions of credit by a bank under a general
purpose credit card where the borrower uses the credit to purchase
goods or services from an affiliate of the bank, so long as less than
25 percent of the aggregate amount of purchases with the card are
purchases from an affiliate of the bank (a bank that does not have
nonfinancial affiliates is exempt from the 25 percent test).
-- An exemption for loans by a bank to a third party secured by
securities issued by a mutual fund affiliate of the bank (subject to a
number of conditions).
-- An exemption that would permit a banking organization to engage more
expeditiously in internal reorganization transactions involving a
bank's purchase of assets from an affiliate (subject to a number of
conditions.
The regulation contains new valuation rules for a bank's investments in, and
acquisitions of, affiliates.
The Federal Reserve expects examiners and other supervisory staff to review
intercompany transactions closely for compliance with the statutes and
Regulation W and to resolve any violations or potential violations quickly.
Sarbanes-Oxley Act. The Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley")
implemented legislative reforms intended to address corporate and accounting
fraud. In addition to the establishment of a new accounting oversight board that
will enforce auditing, quality control and independence standards and will be
funded by fees from all publicly traded companies, Sarbanes-Oxley places certain
restrictions on the scope of services that may be provided by accounting firms
to their public company audit clients. Any non-audit services being provided to
a public company audit client will require preapproval by the company's audit
committee. In addition, Sarbanes-Oxley makes certain changes to the requirements
for accounting firm partner rotation after a period of time. Sarbanes-Oxley
requires chief executive officers and chief financial officers, or their
equivalent, to certify to the accuracy of periodic reports filed with the SEC,
subject to civil and criminal penalties if they knowingly or willingly violate
the certification requirement. In addition, under Sarbanes-Oxley, counsel are
required to report evidence of a material violation of the securities laws or a
breach of fiduciary duty by a company to its chief executive officer or its
chief legal officer, and, if such officer does not appropriately respond, to
report such evidence to the audit committee or other similar committee of the
board of directors or to the board itself.
Under Sarbanes-Oxley, longer prison terms will apply to corporate executives who
violate federal securities laws; the period during which certain types of suits
can be brought against a company or its officers is extended; and bonuses issued
to top executives prior to restatement of a company's financial statements are
subject to disgorgement if the restatement was due to corporate misconduct.
Executives are also prohibited from insider trading during retirement plan
"blackout" periods, and loans to company executives (other than loans by
financial institutions permitted by federal rules and regulations) are
restricted. In addition, a provision directs that civil penalties levied by the
SEC as a result of any judicial or administrative action under Sarbanes-Oxley be
deposited to a fund for the benefit of harmed investors. The legislation
accelerates the time frame for disclosures by public companies, as they must
immediately disclose any material changes in their financial condition or
operations. Directors and executive officers must also provide information for
most changes in ownership in a company's securities generally within two
business days of the change.
11
Sarbanes-Oxley also increases responsibilities and codifies certain requirements
relating to audit committees of public companies and how they interact with the
company's "registered public accounting firm." Audit Committee members must be
independent and are absolutely barred from accepting consulting, advisory or
other compensatory fees from the issuer. In addition, companies must disclose
whether at least one member of the committee is a "financial expert" (as defined
by the SEC) and if not, why not. A company's public accounting firm is
prohibited from performing audit services for the company if the company's chief
executive officer, chief financial officer, comptroller, chief accounting
officer or any person serving in equivalent positions had been employed by the
auditor and participated in the company's audit during the year preceding the
audit initiation date. Sarbanes-Oxley also prohibits any officer or director of
a company or any other person acting under their direction from taking any
action to fraudulently influence, coerce, manipulate or mislead any independent
accountant engaged in the audit of the company's financial statements for the
purpose of rendering the financial statements materially misleading.
Sarbanes-Oxley requires the SEC to prescribe rules requiring inclusion of any
internal control report and assessment by management in the annual report to
shareholders. Sarbanes-Oxley also requires the public accounting firm that
issues a company's audit report to attest to and report on management's
assessment of the company's internal controls.
Although the Company anticipates that it will incur additional expense in
complying with the provisions of Sarbanes-Oxley, management does not expect that
compliance will have a material impact on the Company's financial condition or
results of operations.
Source of Strength Policy. According to FRB policy, bank holding companies are
expected to act as a source of financial strength to each subsidiary bank and to
commit resources to support each such subsidiary.
USA PATRIOT Act. Title III of the United and Strengthening America by Providing
Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the
"USA Patriot Act") includes numerous provisions for fighting international money
laundering and blocking terrorism access to the U.S. financial system. The USA
Patriot Act requires certain additional due diligence and record keeping
practices, including, but not limited to, new customers, correspondent and
private banking accounts.
Part of the USA Patriot Act requires covered financial institutions to: (i)
establish an anti-money laundering program; (ii) establish appropriate
anti-money laundering policies, procedures and controls; (iii) appoint a Bank
Secrecy Act officer responsible for day-to-day compliance; and (iv) conduct
independent audits. The USA Patriot Act also expands penalties for violation of
the anti-money laundering laws, including expanding the circumstances under
which funds in a bank account may be forfeited. The USA Patriot Act also
requires covered financial institutions to respond under certain circumstances
to requests for information from federal banking agencies within 120 hours.
Cross-Institution Assessments. Any insured depository institution owned by the
Company can be assessed for losses incurred by the FDIC in connection with
assistance provided to, or the failure of, any other depository institution
owned by the Company.
Audit Requirements. The Bank is required to have an annual independent audit and
to prepare all financial statements in accordance with generally accepted
accounting principles. The Bank is also required to have an independent audit
committee comprised entirely of outside directors. Under National Association of
Securities Dealers (NASD) on-time certifications, the Company has certified that
the audit committee has adopted a formal written charter and meets the requisite
number of directors, independence and qualification standards.
Brokered Deposits. A bank cannot accept brokered deposits (defined to include
payment of an interest rate more than 75 basis points above prevailing rates)
unless (a) the bank is well capitalized or (b) the bank is adequately
capitalized and receives a waiver from the FDIC. A bank that cannot receive
brokered deposits also cannot offer "pass-through" insurance on employee benefit
plan accounts. In addition, a bank that is adequately capitalized may not pay an
interest rate on any deposit in excess of 75 basis points over prevailing market
rates. These restrictions are not imposed on banks that are well capitalized.
The Bank is well capitalized and holds only an insignificant amount of brokered
deposits.
Potential Enforcement Actions; Supervisory Agreements. Under federal law, banks
and their institution-affiliated parties may be the subject of potential
enforcement actions by the FRB, the FDIC or, for national banks, the Office of
the Comptroller of the Currency, for unsafe and unsound practices in conducting
their businesses, or for violations of any law, rule or regulation or provision,
any consent order with any agency, any condition imposed in writing by the
agency or any written agreement with the agency. Enforcement actions may include
the imposition of a conservator or receiver, cease-and-desist orders and written
agreements, the termination of insurance of deposits, the imposition of civil
money penalties and removal and prohibition orders against
institution-affiliated parties.
12
Acquisitions of Control. Under applicable federal and state laws, it is unlawful
for a person to purchase or otherwise acquire beneficial ownership of the
Company's common stock without the prior approval of the Board of Governors of
the Federal Reserve System, if the acquisition would give the person, or any
group of persons acting together (a "Group"), control of the Company. The
applicable government regulations define "control" for these purposes to mean
the direct or indirect power (i) to vote 25% or more of the Company's
outstanding shares or (ii) to direct or cause the direction of the management
and policies of the Company, whether through ownership of voting securities, by
contract or otherwise; provided that no individual will be deemed to control the
Company solely on accord of being a director, officer or employee of the
Company. Persons who directly or indirectly own or control 10% or more of a bank
holding company's outstanding shares are presumed to control the bank holding
company.
Exposure to and Management of Risk. The federal banking agencies examine banks
and bank holding companies with respect to their exposure to and management of
different categories of risk. Categories of risk identified by the agencies
include legal risk, operational risk, market risk, credit risk, interest rate
risk, price risk, foreign exchange risk, transaction risk, compliance risk,
strategic risk, credit risk, liquidity risk, and reputation risk. This
examination approach causes bank regulators to focus on risk management
procedures, rather than simply examining every asset and transaction. This
approach supplements rather than replaces existing rating systems based on the
evaluation of an institution's capital, assets, management, earnings and
liquidity.
Money Laundering Control Act. The Money Laundering Control Act of 1986 provides
sanctions for the failure to report high levels of cash deposits to non-bank
financial institutions. Federal banking regulators possess the power to revoke
the charter or appoint a conservator for any institution convicted of money
laundering. Offending state-chartered banks could lose their federal deposit
insurance, and bank officers could face lifetime bans from working in financial
institutions. The Community Development Act, which includes a number of
provisions that amend the Bank Secrecy Act, allows the Secretary of the Treasury
to exempt specified currency transactions from reporting requirements and
permits the federal bank regulatory agencies to impose civil money penalties on
banks for violations of the currency transaction reporting requirements.
Other Consumer Protection Laws and Regulations. The bank regulatory agencies
closely monitor an institution's compliance with consumer protection laws and
regulations. The examination and enforcement activities conducted by these
agencies are intense, and banks have been advised to focus on compliance with
consumer protection laws and their implementing regulations. The federal
Interagency Task Force on Fair Lending has issued a policy statement on
discrimination in home mortgage lending which describes three methods that
federal agencies will use to prove discrimination: overt evidence of
discrimination, evidence of disparate treatment, and evidence of disparate
impact. In addition to CRA and fair lending requirements, the Bank is subject to
numerous other federal consumer protection statutes and regulations. Due to
heightened regulatory concern related to compliance with consumer protection
laws and regulations generally, the Bank may incur additional compliance costs
or be required to expend additional funds for investments in the local
communities it serves.
Proposed Legislation and Regulation. Certain legislative and regulatory
proposals that could affect the Bank and the banking business in general are
pending or may be introduced before the United States Congress, the California
State Legislature and Federal and state government agencies. The United States
Congress regularly considers bills designed to substantially reform banking
laws. It is not known whether any of these legislative proposals will be enacted
and what effect such legislation would have on the structure, regulation and
competitive relationships of financial institutions. It is likely, however, that
many of these proposals would subject the Bank to increased regulation,
disclosure and reporting requirements and would increase competition to the Bank
and its cost of doing business.
In addition to pending legislative changes, the various banking regulatory
agencies frequently propose rules and regulations to implement and enforce
already existing legislation. It cannot be predicted whether or in what form any
such rules or regulations will be enacted or the effect that such rules and
regulations may have on the Bank's business.
The above description of the business of the Bank should be read in conjunction
with Item 7 herein, Management's Discussion and Analysis of Financial Condition
and Results of Operations.
Conclusions. It is impossible to predict with any degree of accuracy the
competitive impact the laws and regulations described above will have on
commercial banking in general and on the business of the Company and the Bank in
particular, or to predict whether or when any of the proposed legislation and
regulations described above will be adopted. It is anticipated that banking will
continue to be a highly regulated industry. Additionally, there has been a
continued lessening of the historical distinction between the services offered
by financial institutions and other businesses offering financial services.
Also, the trend toward nationwide interstate banking is expected to continue. As
a result of these factors, it is anticipated banks will experience increased
competition for deposits and loans and, possibly, further increases in their
cost of doing business.
13
ITEM 2. PROPERTIES
The Bank owns a 0.861 acre lot located at the corner of Ham Lane and Tokay
Street, Lodi, California. A 34,000 square foot, tri-level commercial building
for the main branch and administrative offices of the Company and the Bank was
constructed on the lot. The Company and the Bank use approximately 75% of the
leasable space in the building and the remaining area is either leased or
available for lease as office space to other tenants. The construction of this
building in 1991 has enabled the Bank to better serve its customers with more
teller windows, four drive-through lanes and expanded safe deposit box capacity.
The Company owns a 10,000 square foot lot located on Lower Sacramento Road in
the unincorporated San Joaquin County community of Woodbridge, California. The
entire parcel has been leased to the Bank on a long-term basis at market rates.
The Bank has constructed, furnished and equipped a 1,437 square foot branch
office on the parcel and commenced operations of the Woodbridge Branch at that
location on December 15, 1986.
The Bank assumed a long-term ground lease on 1.7 acres of land at 19000 North
Highway 88, Lockeford, California. The building previously occupying the Lodi
site at 701 South Ham Lane was moved to Lockeford, California, and has become
the permanent branch office of the Bank at that location. A temporary 1,000
square foot office had been used by the Bank at the Lockeford location. The
permanent office was opened on April 1, 1991. The temporary office, along with a
portion of the permanent building, is leased by the Bank to two tenants.
On February 22, 1997, the Bank acquired the Galt, Plymouth and San Andreas
branches of Wells Fargo Bank. The transaction included the assumption of the
6,000 square foot branch building lease in Galt with a remaining term of two
years, and the purchase of the branch building and land for the Plymouth and San
Andreas offices. The Plymouth and San Andreas offices are approximately 1,200
and 5,500 square feet, respectively. In November 1998, upon expiration of the
Galt lease, the Galt branch was relocated to a new 3,000 square foot leased
facility one block west of the old location. The new Galt location is leased
under a five-year lease with three successive five-year renewal options.
In January 1998, the Bank opened a 1,220 square foot loan production office in
Folsom, California. The office was leased for one year with a one-year renewal
option that has been exercised by the Bank. In July 1999, the Bank received
approval to operate the Folsom office as a full-service branch. In July 2001,
the full-service branch was relocated to a new 2,426 square foot site in the
Folsom area under a 10 year lease.
In August 1998, the Bank opened a 4,830 square foot full service branch in Elk
Grove, California. The office is leased under a three-year lease with two
successive three-year renewal options. In January 2001, the Bank entered into a
three-year lease for a 1,557 square foot Small Business Administration loan
production office in the Folsom area.
In September 2003, the Bank opened 4,485 square foot full service branch and a
2,595 square foot administrative office in downtown Sacramento. The branch and
office are leased under a ten-year lease with three successive five year renewal
options.
ITEM 3. LEGAL PROCEEDINGS
In the normal course of business, the Company and its subsidiaries are involved
in litigation. Management does not believe that any litigation in which it is
currently involved will have a material impact on the company's financial
condition or results of operations. First Financial Bancorp, Bank of Lodi, N.A.
and certain named directors and officers of the Company are party to a lawsuit
brought by two shareholders who allege various charges of breach of fiduciary
duty and corporate mismanagement. See Note 25 - Subsequent Events, to the
Consolidated Financial Statements for more information.
The Company is involved in various other litigation of a routine nature which is
being handled and defended in the ordinary course of the Company's business. In
the opinion of Management, based in part on consultation with legal counsel, the
resolution of these litigation matters will not have a material impact on the
Company's financial position.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not Applicable
14
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS
There is no established public trading market for the common stock of the
Company. The Company's common stock is traded in the over-the-counter market on
the Over-the-Counter Bulletin Board (OTCBB) under the symbol "FLLC" and is not
presently listed on a national exchange or reported by the NASDAQ Stock Market.
Trading of the stock has been limited and has been principally contained within
the Company's general service area. As of March 5, 2004, there were 1,163
shareholders of record of the Company's common stock. Set forth below is the
range of high and low bid prices for the common stock during 2003 and 2002 and
is based on information obtained from the OTCBB.
2003 2002
Bid Price of Common Shares High Low High Low
First Quarter $ 14.00 12.10 11.35 10.40
Second Quarter 17.00 12.80 12.50 11.00
Third Quarter 19.35 16.10 11.88 11.65
Fourth Quarter 19.05 16.75 12.65 11.71
The foregoing prices reflect inter-dealer prices, without retail mark-up,
mark-down or commissions, and may not necessarily represent actual transactions.
The Company has not declared or paid any cash dividends on its common stock in
its three most recent fiscal years. The Company's principal source of funds for
dividend payments is dividends received from the Bank. Future dividend payments
by the Bank, if any, will be subject to regulatory limitations, earnings,
general economic conditions, financial condition, capital requirements, and
other factors as may be appropriate in determining dividend policy. The OCC has
authority to prohibit a bank from engaging in business practices that are
considered to be unsafe or unsound. Depending upon the financial condition of a
bank and upon other factors, the OCC could assert that payments of dividends or
other payments by a bank might be such an unsafe or unsound practice. Also,
under applicable Federal laws a national bank must seek permission from the OCC
to pay a dividend if the total dividend payment in any calendar year exceeds the
net profits of that year, as defined, combined with net profits for the two
preceding years. For legal and regulatory restrictions on the payment of
dividends see "Item I. Business - Supervision and Regulation - The Company." For
the amount available for dividends at December 31, 2003, see Note 15(c) to the
notes to consolidated financial statements filed with this report. No assurance
can be given that the Bank will pay dividends at any time. On March 25, 2004,
the Company's Board of Directors declared a 10% stock dividend payable on May
14, 2004 to shareholders of record on April 19, 2004. The future payment of
dividends is dependent upon the Company's financial condition, earnings, equity
structure, capital needs, regulatory requirements and economic conditions.
15
ITEM 6. SELECTED FINANCIAL DATA
(in thousands except per share amounts)
Consolidated Statement of Income 2003 2002 2001 2000 1999
- ------------------------------------------------------------------------------------------------------------------------------------
Interest Income $ 13,662 13,677 13,858 13,496 12,526
Interest Expense 2,837 3,459 4,644 4,613 3,699
Net Interest Income 10,825 10,218 9,214 8,883 8,827
Provision for Loan Losses 312 625 391 135 1,051
Noninterest Income 4,525 4,703 3,828 2,690 2,461
Noninterest Expense 13,508 12,486 11,226 9,855 8,803
Net Income $ 1,177 1,355 1,207 1,283 1,159
Per Share Data (1)
- ------------------------------------------------------------------------------------------------------------------------------------
Basic Earnings $ .66 .75 .68 .73 .68
Diluted Earnings .62 .72 .66 .72 .66
Cash Dividends Declared $ - - - .05 .20
Consolidated Balance Sheet Data
- ------------------------------------------------------------------------------------------------------------------------------------
Federal Funds Sold and Securities
Purchased Under Resale Agreements $ 8,034 19,634 6,129 10,115 100
Investment Securities 90,270 33,125 41,015 29,560 36,096
Loans held for sale 3,076 7,578 3,876 1,292 647
Loans, net of allowance for loan
losses and deferred fees 175,449 154,090 135,430 110,793 108,947
Total Assets 321,813 255,401 226,175 185,064 176,334
Total Deposits 278,155 210,679 201,571 162,261 156,161
Other Borrowings 19,255 20,040 4,000 4,588 4,300
Total Stockholders' Equity $ 19,967 19,270 17,863 16,454 14,521
(1) All per share data has been adjusted for the 10% stock dividend declared on
March 25, 2004.
16
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
Recent Accounting Pronouncements
In June 2001, FASB Statement No. 143, Accounting for Asset Retirement
Obligations, was issued. Statement 143 requires the Company to record the fair
value of an asset retirement obligation as a liability in the period in which it
incurs a legal obligation associated with the retirement of tangible long-lived
assets that result from the acquisition, construction, development, and/or
normal use of the assets. The Company also would record a corresponding asset
that is depreciated over the life of the asset. Subsequent to the initial
measurement of the asset retirement obligation, the obligation would be adjusted
at the end of each period to reflect the passage of time and changes in the
estimated future cash flows underlying the obligation. The Company was required
to adopt Statement 143 on January 1, 2003. The adoption of Statement 143 had no
effect on the Company's financial statements.
The Financial Accounting Standards Board issued FASB Statement No. 146,
Accounting for Costs Associated with Exit or Disposal Activities in June 2002.
Statement No. 146 requires the Company to recognize costs associated with exit
or disposal activities when they are incurred rather than at the date of a
commitment to an exit or disposal plan. SFAS 146 replaces Emerging Issues Task
Force ("EITF") Issue No. 94-3, "Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity (including Certain
Costs Incurred in a Restructuring)." The provisions of SFAS 146 are to be
applied prospectively to exit or disposal activities initiated after December
31, 2002.
In December 2003, the FASB revised FASB Interpretation No. 46, Consolidation of
Variable Interest Entities, which addresses how a business enterprise should
evaluate whether it has a controlling financial interest in an entity through
means other than voting rights and accordingly should consolidate the entity.
FIN 46R replaces FASB Interpretation No. 46, Consolidation of Variable Interest
Entities (VIEs), which was issued January 2003. The Company will be required to
apply FIN 46R to variable interests in VIEs created after December 31, 2003. For
variable interests in VIEs created before January 1, 2004, the Interpretation
will be applied beginning on January 1, 2005. For any VIEs that must be
consolidated under FIN 46R that were created before January 1, 2004, the assets,
liabilities and noncontrolling interests of the VIE initially would be measured
a their carrying amounts with any difference between the net amount added to the
balance sheet and any previously recognized interest being recognized as the
cumulative effect of an accounting change. If determining the carrying amounts
is not practicable, fair value at the date FIN 46R first applies may be used to
measure assets, liabilities and noncontrolling interest of the VIE. The Company
adopted the disclosure provisions of FIN 46 effective December 31, 2002. On
December 31, 2003, the Company adopted FIN 46R for all existing VIEs. The
adoption of FIN 46 and FIN 46R did not have a material effect on our financial
statements.
Historically, issuer trusts that issued trust preferred securities have been
consolidated by their parent companies and trust preferred securities have been
treated as eligible for Tier 1 capital treatment by bank holding companies under
Federal Reserve rules and regulations relating to minority interests in equity
accounts of consolidated subsidiaries. Applying the provisions of FIN 46R, the
Company is no longer able to consolidate the issuer trust as of December 31,
2003. As a result of deconsolidation, the debentures issued by the Company to
the trust are reflected on the balance sheet as "junior subordinated
debentures." Although the Federal Reserve has stated in its July 2, 2003
Supervisory Letter that trust preferred securities will be treated as Tier 1
capital until notice is given to the contrary, the Supervisory Letter also
indicates that the Federal Reserve will review the regulatory implications of
any accounting treatment changes and will provide further guidance if necessary
or warranted. Accordingly, there can be no assurance that the Federal Reserve
will continue to accord Tier 1 treatment to trust preferred upon completion of
its review.
FASB Statement No. 150, Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity, was issued in May 2003. This
Statement establishes standards for the classification and measurement of
certain financial instruments with characteristics of both liabilities and
equity. The Statement also includes required disclosures for financial
instruments within its scope. For the Company, the Statement was effective for
instruments entered into or modified after May 31, 2003 and otherwise will be
effective January 1, 2004, except for mandatorily redeemable financial
instruments. For certain mandatorily redeemable financial instruments, the
Statement will be effective for the Company on January 1, 2005. The effective
date has been deferred indefinitely for certain other types of mandatorily
redeemable financial instruments.
17
In December 2003, FASB Statement No. 132 (revised), Employers' Disclosures about
Pensions and Other Postretirement Benefits, was issued. Statement 132 (revised)
prescribes employers' disclosures about pension plans and other postretirement
benefit plans; it does not change the measurement or recognition of those plans.
The Statement retains and revises the disclosure requirements contained in the
original Statement 132. It also requires additional disclosures about the
assets, obligations, cash flows, and net periodic benefit cost of defined
benefit pension plans and other postretirement benefit plans. The Statement
generally is effective for fiscal years ending after December 15, 2003.
Critical Accounting Policies and Estimates
The Company's discussion and analysis of its financial condition and results of
operations are based upon the Company's consolidated financial statements, which
have been prepared in accordance with accounting principles generally accepted
in the United States. The preparation of these financial statements requires the
Company to make estimates and judgments that affect the reported amounts of
assets, liabilities, income and expenses, and related disclosure of contingent
assets and liabilities. On an on-going basis, the Company evaluates its
estimates, including those related to the allowance for loan losses, other real
estate owned, investments and income taxes. The Company bases its estimates on
historical experience and on various other assumptions that are believed to be
reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions.
The Company believes the following critical accounting policies affect its more
significant judgments and estimates used in the preparation of its consolidated
financial statements. The Company maintains allowances for loan losses resulting
from the customer's inability to make required loan payments. If the financial
conditions of the Company's customers were to deteriorate, resulting in an
impairment of their ability to make payments, additional allowances may be
required. The Company invests in debt and equity securities. If the Company
believes these securities have experienced a decline in value that is other than
temporary, an investment impairment charge is recorded. Future adverse changes
in market conditions or poor operating results of underlying investments could
result in losses or an inability to recover the carrying value of the
investments that may not be reflected in an investment's carrying value, thereby
requiring an impairment charge in the future. For a more complete discussion of
the Company's accounting policies, see Note 1 to the consolidated financial
statements.
The following discussion addresses information pertaining to the financial
condition and results of operations of the Company that may not be otherwise
apparent from a review of the consolidated financial statements and related
footnotes. It should be read in conjunction with those statements and notes
found on pages 55 through 82, as well as other information presented throughout
this report.
18
Summary of Earnings Performance
- ----------------------------------------------------------------------------------------------------------------------------
For the Year Ended December 31:
----------------------------------------------------------------------
2003 2002 2001
Earnings (in thousands) $ 1,177 1,355
1,207
- ----------------------------------------------------------------------------------------------------------------------------
Basic earnings per share $ .66 .75 .68
Diluted earnings per share $ .62 .72 .66
Return on average assets 0.43% 0.57% 0.59%
Return on average equity 5.97% 7.20% 7.03%
Dividend payout ratio - - -
- ----------------------------------------------------------------------------------------------------------------------------
Average equity to average assets 7.17% 7.92% 8.40%
- ----------------------------------------------------------------------------------------------------------------------------
For the year ended December 31, 2003, net income totaled $1,177 thousand, a
decrease of $178 thousand, or 13.1%, over the prior year. Basic earnings per
share in 2003 was $.66, compared to $.75 and $.68 in 2002 and 2001, respectively
and diluted earnings per share totaled $.62, $.72 and $.66 in 2003, 2002 and
2001, respectively. During 2003, the Company incurred unanticipated costs
totaling $373 thousand in response to disruptive actions initiated by three
dissident directors. On an after tax basis, the expenses incurred as a result of
the actions initiated by the dissident directors totaled $220 thousand,
representing a reduction of $.12 and $.11 in basic and diluted earnings per
share during 2003, respectively. Excluding the expenses associated with the
dissident directors, net income increased $42 thousand, or 3.1% over 2002.
Additionally, in September 2003, the Company opened a branch office in downtown
Sacramento. While the performance of the new branch exceeded management's budget
projections, during 2003 the branch incurred an after tax loss totaling $156
thousand. Excluding the expenses associated with the dissident directors
combined with the startup costs associated with the new branch in downtown
Sacramento, net income increased $198 thousand or 14.6% over 2002.
The growth trend for both average earning assets and deposits continued in 2003,
increasing 18.9% and 18.5%, respectively, over 2002. Net interest income in 2003
increased 5.9%, to $10.8 million from $10.2 million in 2002 and $9.2 million in
2001. The net interest margin decreased to 4.56% for 2003 compared to 5.12% for
2002. The net interest margin in 2001 was 5.41%. Changes in the balance sheet
mix and the decrease in general interest rates as a result of actions undertaken
by the Federal Reserve, have resulted in net interest margin compression over
the past three years. During 2003, the provision for loan losses was $312
thousand in correlation with the growth of the loan portfolio. The Company
experienced a $178 thousand decrease in noninterest income combined with a
$1,022 thousand increase in noninterest expense. The Company's provision for
income taxes decreased $102 thousand in 2003 as compared to 2002.
Total gross loans (total portfolio loans plus loans held for sale) increased
10.3% during 2003. Although the Company experienced growth in loans during the
year, the lower interest rate environment during 2003, when compared to 2002
reduced the overall earnings potential generated by the increase in the
Company's primary earning asset. The Company was successful in collecting
interest totaling $183 thousand and $242 thousand during 2003 and 2002,
respectively, on loans that had previously been on nonaccrual. Interest forgone
on nonaccrual loans amounted to $382 thousand during 2003 compared to $364
thousand during 2002. During 2002, the Company's total gross loans (including
loans held for sale) increased 16.0%. While the Company experienced significant
growth in loans during the year, the lower interest rate environment during
2002, when compared to 2001 reduced the overall earnings potential generated by
the increase in the Company's primary earning asset. As a benefit to interest
income, the Company was successful in collecting interest totaling $242 thousand
and $423 thousand during 2002 and 2001, respectively, on loans that had
previously been on nonaccrual. Interest forgone on nonaccrual loans amounted to
$364 thousand during 2002 compared to $310 thousand during 2001.
19
The Company's interest expense for 2003 decreased $622 thousand, or 18.0%, to
$2.8 million from $3.5 million when compared to 2002. The decrease in interest
expense reflects a lower cost of funds on interest bearing liabilities partially
offset by a 15.4% increase in average interest bearing liabilities during 2003,
as compared to last year. Total average deposits increased $38.4 million during
2003 as compared to 2002. The average balance of non-interest bearing demand
deposits increased by $9.0 million when comparing December 31, 2003 to 2002,
with the average balance of non-interest bearing demand deposits reaching $42.5
million for the year ended December 31, 2003 from $33.5 million for the year
ended December 31, 2002. In addition, the average balance of the Company's money
market deposits increased $10.3 million, to $37.1 million during 2003 from $26.8
million for 2002. The lower interest rate environment during 2002, as compared
to 2001, also resulted in a decrease in the Company's total interest expense.
The reduction in interest expense occurred primarily as a result of a decrease
in the overall interest rate paid for deposits combined with a $14.3 million
reduction in Certificates of Deposit. The reduction in Certificates of Deposit
resulted from the Bank focusing its deposit development efforts on core deposit
relationships. Accordingly, excluding certificates of deposit, total deposits
increased $23.5 million, or 17.8% during 2002 when compared to 2001.
Noninterest income totaled $4.5 million for the year ending December 31, 2003
representing a decrease of $178 thousand, or 3.8% when compared to the prior
year. Income from the servicing of loans increased by 15.5% resulting in $492
thousand of income for 2003 compared to $426 thousand for 2002. Loan sales
generated $1,082 thousand of income an increase of $77 thousand over 2002. The
significant increases in the volume of loans sold during 2003 and 2002 compared
to the prior year relate to record mortgage loan production volumes as consumers
took advantage of historically low market interest rates to refinance or
originate mortgage loans. The increase in gains on sales of loans comparing 2002
to 2001 relates to the Company taking advantage of pricing opportunities
resulting from historically low interest rates and unprecedented loan demand
during 2002. However, gains on sales of loans decreased in 2003 from 2002 as
peak volumes of residential mortgage loans held for sale slowed down during the
latter part of 2003 and pricing spreads began to shrink in response to changing
competitive market factors. Management anticipates a continued reduction in the
level of gains on sales of loans during 2004 primarily due to lower expected
mortgage loan production volumes and competitive market conditions. Included in
noninterest income at December 31, 2003 is the gain on the sale of securities of
$396 thousand, which is a decrease of $207 thousand when compared to 2002. Also
included is an increase in the cash surrender value of life insurance of $524
thousand, which decreased $125 thousand when compared to last year. Excluding
gains on securities and the increase in cash surrender value of life insurance,
total noninterest income amounted to $3,605 thousand in 2003 and $3,451 thousand
in 2002. Noninterest income totaled $4,703 thousand for the year ending December
31, 2002 representing an increase of $875 thousand, or 22.9% over the prior
year. The increase resulted primarily from gains on the sale of investment
securities and loans, increased service charge revenue, which resulted from the
increase in total deposits and increased mortgage lending activity.
The Company experienced an increase in noninterest expense totaling $1,022
thousand 8.2% for 2003. The leading factors contributing to the increase in
noninterest expense were reflected in increases of $859 thousand, or 13.6% in
salaries and employee benefits combined with expenses totaling $373 thousand
associated with actions initiated by three dissident directors. The actions
initiated by the dissidents represent 36.5% of the total increase in noninterest
expense during 2003. The increase in salaries during 2003 was due, in part, to
higher commissions paid to mortgage originators and staff hired in connection
with the opening of a new branch in Sacramento. The average number of full-time
equivalent employees was at 134 at the end of 2003, compared to 121 at the end
of 2002. The opening of the new branch in Sacramento accounted for over 50% of
the increase in full-time equivalent employees during 2003. Total noninterest
expense increased $1,260 thousand, or 11.2%, during 2002 compared to 2001
primarily as a result of additions to personnel and the upgrading of existing
positions in addition to general overall increases in the cost of operations
incurred with strategic expansion projects.
Branch Expansion and Acquisitions
In April 2003, the Bank entered into a ten-year lease for a 4,485 square foot
full service branch and a 2,595 square foot administrative office in downtown
Sacramento. The Sacramento office is approximately 42 miles north of the Bank's
corporate headquarters in Lodi, California and expands the Bank's trade area
into the downtown Sacramento area.
In January 2001, the Bank entered into a three-year lease for a 1,557 square
foot Small Business Administration (SBA) loan production office in the Folsom
area. In May, 2003 the U. S. Small Business Administration for the Sacramento
District granted Preferred Lender status (PLP) to the Bank 's SBA lending
department. The Preferred Lender Program is open only to lenders who have
demonstrated capability and commitment to small business lending, and who
strictly adhere to the SBA lending guidelines provided by the U. S. Small
Business Administration. It is the highest lending designation awarded by the
SBA. As a result of the Bank's desire to expand its SBA lending program, in
January 2004, the Bank entered into a 63 month lease for a 5,172 square foot
office space in the Folsom area to be used as the new location for the SBA loan
production and Credit Administration offices.
20
Net Interest Income
The following table provides a detailed analysis of average earning assets and
liabilities, net interest spread and net interest margin. The net interest
spread is the difference between the average yield earned on assets and the
average rate incurred on liabilities: The table also illustrates the interest
income earned and interest expense charged for each major component of interest
earning assets and interest bearing liabilities for the years ended December 31,
2003, 2002, and 2001, respectively.
- ----------------------------------------------------------------------------------------------------------------------------
For the Year Ended For the Year Ended For the Year Ended
December 31, 2003 December 31, 2002 December 31, 2001
(Dollar amounts in thousands) (Dollar amounts in thousands) (Dollar amounts in thousands)
--------------------------------------------------------------------------------------------------
Average Income/ Average Income/ Average Income/
Balance Expenses Yield Balance Expenses Yield Balance Expense Yield
Earning Assets:
Investment securities(1) $ 54,657 1,215 2.22% 34,076 1,602 4.70% 35,260 2,073 5.88%
Federal funds sold and
securities purchased
under resale agreements $ 12,057 132 1.09% 9,464 158 1.67% 11,360 481 4.23%
Loans(2) $ 170,556 12,315 7.22% 155,986 11,917 7.64% 123,600 11,304 9.15%
------- ------ ----- ------ ----- ------- ------ -----
Total Earning Assets $ 237,270 13,662 5.76% 199,526 13,677 6.85% 170,220 13,858 8.14%
======= ====== ===== ======= ====== ===== ======= ====== =====
Liabilities:
Noninterest bearing
deposits $ 40,058 - - 31,141 - - 25,350 - -
Savings, money market,
& NOW deposits 135,299 1,127 0.83% 112,727 1,296 1.15% 91,600 1,297 1.42%
Time deposits 68,911 1,439 2.09% 62,026 1,880 3.03% 66,630 3,342 5.02%
Other borrowings 7,218 271 3.75% 7,412 283 3.82% 120 5 4.17%
----- --- ----- ------ --- ----- --- - -----
Total Liabilities $ 251,486 2,837 1.12% 213,306 3,459 1.62% 183,700 4,644 2.53%
======= ===== ===== ======= ===== ===== ======= ===== =====
Net Spread 4.64% 5.23% 5.61%
===== ===== =====
- ----------------------------------------------------------------------------------------------------------------------------
Earning Income Earning Income Earning Income
Assets (Expense) Yield Assets (Expense) Yield Assets (Expense) Yield
Yield on average
earning assets $ 237,270 13,662 5.76% 199,526 13,677 6.85% 170,220 13,858 8.14%
Cost of funds for
average earning assets 237,270 (2,837) (1.20%) 199,526 (3,459) (1.73%) 170,220 (4,644) (2.73%)
------- ------- ------- ------- ------- -------
Net Interest Margin 237,270 10,825 4.56% 199,526 10,218 5.12% 170,220 9,214 5.41%
====== ===== ====== ===== ===== =====
- ----------------------------------------------------------------------------------------------------------------------------
(1) Income on tax-exempt securities has not been adjusted to a tax equivalent
basis. (2) Loans held for sale and nonaccrual loans are included in the loan
totals for each year.
21
Net interest income, the difference between income from earning assets and the
interest cost of funding those assets, is the Company's primary source of
earnings. Net interest income increased 6.0% in 2003, following an 11.0%
increase in 2002. Net interest margin, the ratio of net interest income to
average earning assets, is affected by movements in interest rates and changes
in the mix of earning assets and the liabilities that fund those assets. Net
interest margin was 4.56% in 2003 compared to 5.12% in 2002. The decrease in net
interest margin over the past two years, has been impacted by changes in balance
sheet mix coupled with the decrease in general interest rates as a result of
action undertaken by the Federal Reserve.
While the yield on average earning assets declined to 5.76% in 2003 as compared
to 6.85% in 2002, the cost of funds for average earning assets also decreased to
1.20% in 2003 from 1.73% in 2002. The increase in net interest income in 2002 is
attributable to an increase of 17% in average earning assets combined with an
18% increase in average total liabilities.
During 2003, average loans, increased $14,570 thousand, or 9%, while investment
securities and federal funds sold and securities purchased under resale
agreements increased $20,581 thousand and $2,593 thousand, or 60% and 27%,
respectively, compared to 2002. Average deposits increased $38,440 thousand, or
18.5% during 2003 and other borrowings decreased $1,225 thousand. Net interest
margin decreased 56 basis points in 2003 after decreasing by 29 basis points in
2002. This decrease in 2003 was the result of several key items:
-- Interest forgone on nonaccrual loans during 2003 totaled $382
thousand. This reduced the yield on loans by 16 basis points and the
net interest margin by 16 basis points.
-- Interest collected on loans that had previously been on
nonaccrual status totaled $183 thousand. This increased the yield
on loans by 8 basis points and the net interest margin by 7 basis
points.
-- Changes in the mix of the investment portfolio during 2003 resulted in
a decrease of 248 basis points in the average yield earned on
investment securities.
-- The general decrease in interest rates during 2003 resulted in a
decrease of 58 basis points in the average yield earned on federal
funds sold and securities purchased under resale agreements.
-- The general decrease in interest rates during 2002 resulted in a
decrease of 94 basis points in the cost of average certificates of
deposit.
Net interest income increased $1,004 thousand, or 11% in 2002 after increasing
4% in 2001. While the yield on average earning assets declined to 6.85% in 2002
as compared to 8.14% in 2001, the cost of funds for average earning assets also
decreased to 1.73% in 2002 from 2.73% in 2001. The increase in net interest
income in 2002 is attributable to an increase of 17% in average earning assets
combined with a 13% increase in average deposits, which offset the decline in
net interest margin from 5.41% to 5.12% from 2001 to 2002.
During 2002, average loans, increased $32,386 thousand, or 26%, while investment
securities and federal funds sold and securities purchased under resale
agreements decreased $1,184 thousand and $1,896 thousand, or 3% and 17%,
respectively, compared to 2001. Average deposits increased $24,702 thousand, or
13% during 2002 and other borrowings increased $8,323 thousand, primarily as a
result of a $5.2 million floating rate junior subordinated debt issuance on
March 26, 2002.
Net interest margin decreased 29 basis points in 2002 after decreasing by 34
basis points in 2001. This decrease in 2002 was the result of several key items:
-- Interest forgone on nonaccrual loans during 2002 totaled $364
thousand. This reduced the yield on loans by 23 basis points and the
net interest margin by 18 basis points.
-- Interest collected on loans that had previously been on
nonaccrual status totaled $242 thousand. This increased the yield
on loans by 16 basis points and the net interest margin by 12
basis points.
-- Changes in the mix of the investment portfolio during 2002 resulted in
a decrease of 118 basis points in the average yield earned on
investments securities.
-- The general decrease in interest rates during 2002 resulted in a
decrease of 256 basis points in the average yield earned on federal
funds sold and securities purchased under resale agreements.
-- The general decrease in interest rates during 2002 resulted in a
decrease of 199 basis points in the cost of average certificates of
deposit.
22
The following table presents the monetary impact of the aforementioned changes
in earning asset and deposit volumes and yields for the two years ended December
31, 2003 and 2002.
- -------------------------------------------------------------------------------------------------------------------------------
2003 compared to 2002 2002 compared to 2001
(in thousands) (in thousands)
Change due to: Change due to:
Interest Income: Volume Rate Total Volume Rate Total
------ ---- ----- ------ ---- -----
------------------------------------------------- ------------------------------------------------
Investment securities $ 968 (1,355) (387) (70) (401) (471)
Federal funds sold and
securities purchased under
resale agreements 43 (69) (26) (80) (243) (323)
Loans 1,113 (715) 398 2,962 (2,349) 613
----- ----- --- ----- ------- ---
Total interest income $ 2,124 (2,139) (15) 2,812 (2,993) (181)
========= ======= ==== ===== ======= =====
Interest Expense:
Savings, money market, &
NOW accounts $ 306 (475) (169) 384 (385) (1)
Time deposits 209 (650) (441) (231) (1,231) (1,462)
Other borrowings (41) 29 (12) 347 (69) 278
---- -- ---- --- -- ---
Total interest expense $ 474 (1,096) (622) 500 (1,685) (1,185)
========= ======= ===== === ======= =======
Net interest income $ 1,650 (1,043) 607 2,312 (1,308) 1,004
========= ======= === ===== ======= =====
- -------------------------------------------------------------------------------------------------------------------------------
Increases in average loans, investment securities and federal funds sold and
securities purchased under resale agreements of 9%, 60% and 27%, respectively
combined to increase interest income by $2,124 thousand for the year ending
December 31, 2003. However this increase was offset by a reduction in interest
income of $2,139 thousand resulting from the continued low level of the interest
rate environment during 2003. An increase of 17% in average interest bearing
deposits resulted in an increase in interest expense of $515 thousand. However,
due to a decrease of 48 basis points in the average rate paid on interest
bearing accounts, total interest expense decreased $622 thousand when compared
to 2002.
The volume variances for total interest income in 2002 compared to 2001 indicate
that the increase in average loans of 26% together with decreases in average
investment securities and federal funds sold and securities purchased under
resale agreements of 3% and 17%, respectively, combined for a net increase to
interest income of $2,812 thousand. However, the continued decline of the
interest rate environment during 2002 reduced interest income $2,993 thousand,
as compared to the prior year, with $2,349 thousand of the decrease resulting
from a 151 basis point decline in the yield earned on loans, $401 thousand of
the decrease resulting from a 118 basis points decline in the yield earned on
investment securities and a $243 thousand decrease resulting from a 256 basis
points decline in the yield earned on federal funds sold and securities
purchased under resale agreements. While average interest bearing liabilities
increased 16% during 2002, the average rate paid on interest bearing liabilities
declined 100 basis points resulting in a net decrease in total interest expense
of $1,185 thousand. In addition, during 2002, other borrowings (which includes
the proceeds from the junior subordinated debentures) increased $8.3 million
resulting in an increase in total interest expense of $278 thousand.
23
Allowance for Loan Losses
The following table reconciles the beginning and ending allowance for loan
losses for the previous five years. Reconciling activity is broken down into the
three principal items that impact the reserve: (1) reductions from charge-offs;
(2) increases from recoveries; and (3) increases in provisions for loan losses.
- ---------------------------------------------------------------------------------------------------------------------------
(in thousands) 2003 2002 2001 2000 1999
Balance at beginning of period $ 3,057 $ 2,668 $ 2,499 $ 2,580 $ 1,564
Charge-offs:
Commercial 88 178 226 201 90
Real estate - 62 - - -
Consumer 55 30 57 45 20
------- ------- ------- ------- -------
Total Charge-offs 143 270 283 246 110
Recoveries:
Commercial 27 26 21 15 68
Real estate - - - - -
Consumer
9 8 40 15 7
------- ------- ------- ------- -------
Total Recoveries 36 34 61 30 75
------- ------- ------- ------- -------
Net charge-offs (107) (236) (222) (216) (35)
Additions charged to operations 312 625 391 135 1,051
------- ------- ------- ------- -------
Balance at end of period 3,262 3,057 2,668 2,499 2,580
======= ======= ======= ======= =======
Ratio of net charge-offs to average
loans outstanding (0.06%) (0.14%) (0.16%) (0.19%) (0.03%)
======= ======= ======= ======= =======
- ---------------------------------------------------------------------------------------------------------------------------
Note 1(f) to the consolidated financial statement discusses the factors used in
determining the provision for loan losses and the adequacy of the allowance for
loan losses.
The allowance for loan losses, among other things, is based on management's
evaluation of the anticipated impact on the loan portfolio of current economic
conditions, changes in the character and size of the loan portfolio, evaluation
of potential problem loans identified based on existing circumstances known to
management and recent loan loss experience. Specific allowances have been
adjusted on certain loans based on individual reviews of these loans and
management's estimate of the borrower's ability to repay the loan given the
availability of collateral, other sources of cash flow and collection options
available to us. The allowance for loan losses is provided at a level considered
adequate to provide for inherent loan losses. Management continually monitors
the quality of the loan portfolio to ensure timely charge-off of problem loans
and to determine the adequacy of the level of the allowance for loan losses.
Management believes that the allowance was adequate to absorb losses inherent in
the loan portfolio as of December 31, 2003. The Bank has not modified or
significantly compromised its underwriting standards despite growing competition
within the industry.
The allowance for loan losses totaled $3,262 thousand at December 31, 2003 and
$3,057 thousand at December 31, 2002. The provision for loan losses was $312
thousand in 2003 compared to $625 thousand in 2002. The allowance for loan
losses was 1.79% of gross loans (including held for sale) at December 31, 2003
compared to 1.85% at December 31, 2002. As a percentage of average loans, net
charge-offs were 0.06% in 2003 compared to 0.14% in 2002. Action taken during
the year to resolve certain of these problem credits coupled with loan growth,
lowered the ratio of allowance for loan losses to gross loans. Net charge-offs
during 2003 totaled $107 thousand and represents a decrease of $129 thousand, or
55%, over 2002. This activity was comprised of $143 thousand in gross
charge-offs combined with $36 thousand in recoveries representing a decrease of
47% in gross charge-offs and an increase of 6% in recoveries compared to 2002.
The loan loss provision for 2002 totaled $625 thousand and represents an
increase of $234 thousand, or 60%, over 2001. The provision increased primarily
in response to the increases in loan growth and the potential for declines in
the economy. During 2002, average loans and gross loans (including loans held
for sale) increased 26% and 16%, respectively compared to 2001. Management
remained concerned throughout 2002 about declines in the national economy and
the potential for declines in the credit quality of its borrowers as a result.
During 2002, the Company continued to eliminate nonperforming loans without
incurring substantial charge-offs.
24
Noninterest Income
During 2003, noninterest income decreased 4% after increasing 23% in 2002. The
primary components of noninterest income consist of: service charges, SBA and
mortgage income, and other noninterest income. The following table summarizes
the significant elements of service charge, SBA, mortgage and Farmer Mac revenue
for the three years ending 2003, 2002, and 2001:
- ----------------------------------------------------------------------------------------------------------------
(in thousands) 2003 2002 2001
- ----------------------------------------------------------------------------------------------------------------
Periodic deposit account charges $ 444 $ 483 492
Returned item charges 857 849 624
Ancillary services charges 97 97 95
Other service charges 211 169 203
----------------------------------------------------
Total service charge revenue 1,609 1,598 1,414
====================================================
Gain on sale of SBA loans 149 331 95
SBA loan servicing revenue 199 205 223
----------------------------------------------------
Total SBA revenue 348 536 318
Gain on sale of mortgage loans 904 640 409
Mortgage loan servicing revenue 293 221 176
----------------------------------------------------
Total mortgage revenue 1,197 861 585
Farmer Mac origination, sale and servicing 29 34 29
----------------------------------------------------
Total loan origination, sale and servicing revenue 1,574 1,431 932
- ----------------------------------------------------------------------------------------------------------------
When compared to 2002, service charge revenue increased 0.7% in 2003 after
increasing 13% in 2002. These increases are primarily the result of continued
growth in demand deposits. Average total deposits increased 19% in 2003 and 14%
in 2002.
During 2003, SBA revenue decreased 35% after increasing 69% during 2002 and
decreasing 6% during 2001. The declines in 2003 and 2001 SBA revenue resulted
primarily from a decrease in the production of SBA 7a and an increase in the
level of SBA 504 loans. The Company typically sells the SBA 7a loans to the
secondary market whereas the SBA 504 loans are typically held in the Company's
loan portfolio. The increase in 2002 was the result of the sale of $6.9 million
SBA 7a loans.
Due to mortgage lending rates remaining low during 2003, the Company continued
to experience increases in mortgage lending activity for both new loans and
refinancing of existing loans. The increased lending activity resulted in an
increase in the Company's mortgage revenue totaling $336 thousand, or 39% from
2002 to 2003, $276 thousand, or 47% from 2002 to 2001 and $330 thousand, or 129%
in 2001 as compared to 2000. Farmer Mac revenue decreased 15% in 2003 after
increasing 17% in 2002 as compared to 2001 and declining 7% during 2001 as
compared to 2000.
The Company realized gains on the sale of investment securities totaling $396
thousand, $603 thousand and $267 thousand in 2003, 2002 and 2001, respectively.
The Company purchased single-premium life insurance policies written on the
lives of certain officers and directors of the Company and the Bank. Included in
other noninterest income is the increase in the cash surrender value of these
policies. The income totaled $524 thousand, $649 thousand and $658 thousand
during 2003, 2002 and 2001, respectively.
25
Noninterest Expenses
The Company experienced increases in noninterest expense of 8% and 11% for 2003
and 2002, respectively. Cost control and better utilization of resources
continue to be a focus of the Company. The leading factors contributing to the
increase in noninterest expense were reflected in increases of $859 thous