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TABLE OF CONTENTS

Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549



FORM 10-Q



(MARK ONE)    

ý

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2010

OR

o

 

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 000-23877

Heritage Commerce Corp
(Exact name of Registrant as Specified in its Charter)

California
(State or Other Jurisdiction of
Incorporation or Organization)
  77-0469558
(I.R.S. Employer
Identification No.)

150 Almaden Boulevard, San Jose, California
(Address of Principal Executive Offices)

 

95113
(Zip Code)

(408) 947-6900
(Registrant's Telephone Number, Including Area Code)

N/A
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

        Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES ý    NO o

        Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES o    NO o

        Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o   Accelerated filer o   Non-accelerated filer o
(Do not check if a
smaller reporting company)
  Smaller reporting company ý

        Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES o    NO ý

        The Registrant had 11,820,509 shares of Common Stock outstanding on July 31, 2010.


Table of Contents


Heritage Commerce Corp and Subsidiaries
Quarterly Report on Form 10-Q
Table of Contents

 
   
 
Page No.
 
PART I. FINANCIAL INFORMATION        

Item 1.

 

Consolidated Financial Statements (unaudited):

 

 

3

 

 

 

Consolidated Balance Sheets

 

 

3

 

 

 

Consolidated Statements of Operations

 

 

4

 

 

 

Consolidated Statement of Changes in Shareholders' Equity

 

 

5

 

 

 

Consolidated Statements of Cash Flows

 

 

6

 

 

 

Notes to Consolidated Financial Statements

 

 

7

 

Item 2.

 

Management's Discussion and Analysis of Financial Condition and Results of Operations

 

 

22

 

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

 

 

56

 

Item 4.

 

Controls and Procedures

 

 

57

 

PART II. OTHER INFORMATION

 

 

 

 

Item 1.

 

Legal Proceedings

 

 

58

 

Item 1A.

 

Risk Factors

 

 

58

 

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

 

 

59

 

Item 3.

 

Defaults Upon Senior Securities

 

 

60

 

Item 4.

 

Reserved

 

 

60

 

Item 5.

 

Other Information

 

 

60

 

Item 6.

 

Exhibits

 

 

61

 

SIGNATURES

 

 

62

 

EXHIBIT INDEX

 

 

63

 

2


Table of Contents

Part I—FINANCIAL INFORMATION

ITEM 1—CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

        


Heritage Commerce Corp

Consolidated Balance Sheets (Unaudited)

 
  June 30,
2010
  December 31,
2009
 
 
  (Dollars in thousands)
 

Assets

             

Cash and due from banks

  $ 108,310   $ 45,372  

Federal funds sold

    100     100  

Interest-bearing deposits in other financial institutions

    90     90  
           
     

Total cash and cash equivalents

    108,500     45,562  

Securities available-for-sale, at fair value

    142,212     109,966  

Loans held-for-sale—SBA, at lower of cost or market, including deferred costs

    12,291     10,742  

Loans held-for-sale—Other, at lower of cost or market, including deferred costs

    17,079      

Loans, including deferred costs

    937,773     1,070,113  

Allowance for loan losses

    (26,753 )   (28,768 )
           
     

Loans, net

    911,020     1,041,345  

Federal Home Loan Bank and Federal Reserve Bank stock, at cost

   
8,299
   
8,454
 

Company owned life insurance

    42,827     42,313  

Premises and equipment, net

    8,726     9,006  

Goodwill

        43,181  

Intangible assets

    3,302     3,589  

Accrued interest receivable and other assets

    49,504     49,712  
           
     

Total assets

  $ 1,303,760   $ 1,363,870  
           

Liabilities and Shareholders' Equity

             

Liabilities:

             
 

Deposits:

             
   

Demand, noninterest bearing

  $ 249,017   $ 260,840  
   

Demand, interest-bearing

    153,173     146,828  
   

Savings and money market

    281,619     295,404  
   

Time deposits—under $100

    38,201     40,197  
   

Time deposits—$100 and over

    133,443     129,831  
   

Time deposits—CDARS

    18,240     38,154  
   

Time deposits—brokered

    163,732     178,031  
           
     

Total deposits

    1,037,425     1,089,285  
 

Securities sold under agreement to repurchase

    20,000     25,000  
 

Subordinated debt

    23,702     23,702  
 

Short-term borrowings

    3,992     20,000  
 

Accrued interest payable and other liabilities

    32,997     33,578  
           
   

Total liabilities

    1,118,116     1,191,565  

Shareholders' equity:

             
 

Preferred stock, no par value; 10,000,000 shares authorized

             
   

Series A fixed rate cumulative preferred stock, 40,000 shares issued and outstanding (liquidation preference of $1,000 per share plus accrued dividends)

    39,846     39,846  
   

Discount on Series A preferred stock

    (1,415 )   (1,598 )
   

Series B mandatorily convertible cumulative perpetual preferred stock, 53,996 shares issued and outstanding at June 30, 2010 and none at December 31, 2009 (liquidation preference of $1,000 per share plus accrued dividends)

    50,385      
   

Series C convertible perpetual preferred stock, 21,004 shares issued and outstanding at June 30, 2010 and none at December 31, 2009 (liquidation preference of $1,000 per share plus accrued dividends)

    19,599      
 

Common stock, no par value; 60,000,000 shares authorized; 11,820,509 shares issued and outstanding

    80,810     80,222  
 

Retained earnings / (Accumulated deficit)

    (3,012 )   56,389  
 

Accumulated other comprehensive loss

    (569 )   (2,554 )
           
   

Total shareholders' equity

    185,644     172,305  
           
   

Total liabilities and shareholders' equity

  $ 1,303,760   $ 1,363,870  
           

See notes to consolidated financial statements

3


Table of Contents


Heritage Commerce Corp

Consolidated Statements of Operations (Unaudited)

 
  Three Months
Ended
June 30,
  Six Months
Ended
June 30,
 
 
  2010   2009   2010   2009  
 
  (Dollars in thousands, except per share data)
 

Interest income:

                         
 

Loans, including fees

  $ 12,737   $ 14,862   $ 25,911   $ 29,892  
 

Securities, taxable

    1,459     954     2,622     1,949  
 

Securities, non-taxable

        4         8  
 

Interest-bearing deposits in other financial institutions

    16     4     26     8  
                   

Total interest income

    14,212     15,824     28,559     31,857  

Interest expense:

                         
 

Deposits

    2,157     3,394     4,521     7,424  
 

Subordinated debt

    468     487     934     987  
 

Repurchase agreements

    113     227     244     469  
 

Short-term borrowings

    46     27     63     54  
 

Note payable

                82  
                   

Total interest expense

    2,784     4,135     5,762     9,016  
                   

Net interest income before provision for loan losses

    11,428     11,689     22,797     22,841  

Provision for loan losses

    18,600     10,704     23,695     21,124  
                   

Net interest income (loss) after provision for loan losses

    (7,172 )   985     (898 )   1,717  

Noninterest income:

                         
 

Service charges and fees on deposit accounts

    579     537     1,128     1,108  
 

Servicing income

    425     408     846     828  
 

Increase in cash surrender value of life insurance

    413     415     822     827  
 

Gain on sale of loans

    163         277      
 

Other

    298     241     489     461  
                   

Total noninterest income

    1,878     1,601     3,562     3,224  

Noninterest expense:

                         
 

Salaries and employee benefits

    5,491     5,643     11,373     12,101  
 

Professional fees

    1,144     1,229     2,421     2,142  
 

FDIC deposit insurance premiums

    1,019     1,220     2,210     1,959  
 

Occupancy and equipment

    983     972     1,942     1,888  
 

Insurance expense

    269     131     525     190  
 

Software subscription

    252     217     486     413  
 

Data processing

    219     260     430     489  
 

Low income housing investment losses

    133     210     358     424  
 

Other real estate owned expense

    69     107     488     170  
 

Impairment of goodwill

    43,181         43,181      
 

Other

    1,792     2,091     3,337     3,666  
                   

Total noninterest expense

    54,552     12,080     66,751     23,442  
                   

Loss before income taxes

    (59,846 )   (9,494 )   (64,087 )   (18,501 )

Income tax benefit

    (5,753 )   (4,113 )   (5,874 )   (9,165 )
                   

Net loss

    (54,093 )   (5,381 )   (58,213 )   (9,336 )

Dividends and discount accretion on preferred stock

    (1,009 )   (591 )   (1,600 )   (1,176 )
                   

Net loss allocable to common shareholders

  $ (55,102 ) $ (5,972 ) $ (59,813 ) $ (10,512 )
                   

Loss per common share:

                         
   

Basic

  $ (4.66 ) $ (0.51 ) $ (5.06 ) $ (0.89 )
   

Diluted

  $ (4.66 ) $ (0.51 ) $ (5.06 ) $ (0.89 )

See notes to consolidated financial statements

4


Table of Contents


Heritage Commerce Corp

Consolidated Statements of Changes in Shareholders' Equity (Unaudited)

Six Months Ended June 30, 2010 and 2009

 
  Preferred Stock   Common Stock   Retained
Earnings
(Accumulated
Deficit)
  Accumulated
Other
Comprehensive
Income (Loss)
   
   
 
 
  Total
Shareholders'
Equity
  Comprehensive
Income (Loss)
 
 
  Shares   Amount   Discount   Shares   Amount  
 
  (Dollars in thousands, except share data)
 

Balance, January 1, 2009

    40,000   $ 39,846   $ (1,946 )   11,820,509   $ 78,854   $ 67,804   $ (291 ) $ 184,267        

Net loss

                        (9,336 )       (9,336 ) $ (9,336 )

Net change in unrealized gain on securities available-for-sale and interest-only strips, net of deferred income taxes

                            157     157     157  

Net increase in pension and other postretirement obligations, net of deferred income taxes

                            66     66     66  
                                                       
 

Total comprehensive loss

                                                  $ (9,113 )
                                                       

Amortization of restricted stock award

                    76             76        

Cash dividends accrued on Series A preferred stock

                        (1,006 )       (1,006 )      

Accretion of discount on Series A preferred stock

            170             (170 )              

Cash dividend declared on common stock, $0.02 per share

                        (236 )       (236 )      

Stock option expense

                    663             663        

Income tax effect of restricted stock award vesting

                    (69 )           (69 )      
                                         

Balance, June 30, 2009

    40,000   $ 39,846   $ (1,776 )   11,820,509   $ 79,524   $ 57,056   $ (68 ) $ 174,582        
                                         

Balance, January 1, 2010

    40,000   $ 39,846   $ (1,598 )   11,820,509   $ 80,222   $ 56,389   $ (2,554 ) $ 172,305        

Net loss

                        (58,213 )       (58,213 ) $ (58,213 )

Net change in unrealized gain/loss on securities available-for-sale and interest-only strips, net of deferred income taxes

                            1,848     1,848     1,848  

Net increase in pension and other postretirement obligations, net of deferred income taxes

                            137     137     137  
                                                       
   

Total comprehensive loss

                                                  $ (56,228 )
                                                       

Issuance of Series B manditorily convertible cumulative perpetual preferred stock, net of issuance costs

    53,996     50,385                                 50,385        

Issuance of Series C convertible perpetual preferred stock, net of issuance costs

    21,004     19,599                                 19,599        

Amortization of restricted stock award

                    77             77        

Cash dividends accrued on Series A preferred stock

                        (1,005 )       (1,005 )      

Accretion of unearned discount on Series A preferred stock

            183             (183 )              

Stock option expense

                    586             586        

Income tax effect of restricted stock award vesting

                    (75 )           (75 )      
                                         

Balance, June 30, 2010

    115,000   $ 109,830   $ (1,415 )   11,820,509   $ 80,810   $ (3,012 ) $ (569 ) $ 185,644        
                                         

See notes to consolidated financial statements

5


Table of Contents


Heritage Commerce Corp

Consolidated Statements of Cash Flows (Unaudited)

 
  Six Months Ended
June 30,
 
 
  2010   2009  
 
  (Dollars in thousands)
 

CASH FLOWS FROM OPERATING ACTIVITIES:

             

Net loss

  $ (58,213 ) $ (9,336 )

Adjustments to reconcile net loss to net cash used in operating activities:

             

Depreciation and amortization

    402     400  

Provision for loan losses

    23,695     21,124  

Stock option expense

    586     663  

Amortization of other intangible assets

    287     321  

Amortization of restricted stock award

    77     76  

Amortization (accretion) of discounts and premiums on securities

    (137 )   81  

Writedowns and losses (gains) on sale of foreclosed assets, net

    416     (62 )

Gain on sale of SBA loans

    (277 )    

Proceeds from sale of SBA loans

    5,504      

Net change in SBA loans originated held-for-sale

    (9,167 )    

Increase in cash surrender value of life insurance

    (822 )   (827 )

Goodwill impairment

    43,181      

Effect of changes in:

             
     

Accrued interest receivable and other assets

    (2,821 )   (8,189 )
     

Accrued interest payable and other liabilities

    (1,349 )   (1,940 )
           

Net cash provided by operating activities

    1,362     2,311  
           

CASH FLOWS FROM INVESTING ACTIVITIES:

             

Net change in loans

    91,493     47,859  

Net change in loans previously transferred to held-for-sale

    (630 )    

Purchases of securities available-for-sale

    (39,351 )   (24,993 )

Maturities/Paydowns/Calls of securities available-for-sale

    10,333     27,769  

Purchase of premises and equipment

    (122 )   (195 )

Redemption (Purchase) of restricted stock and other investments

    155     (618 )

Proceeds from sale of SBA loans transferred to held-for-sale

    1,079      

Proceeds from sale of foreclosed assets

    1,270     1,011  

Changes in company owned life insurance

    308      
           

Net cash provided by investing activities

    64,535     50,833  
           

CASH FLOWS FROM FINANCING ACTIVITIES:

             

Net change in deposits

    (51,860 )   9,497  

Issuance of preferred stock, net of offering costs

    69,984      

Income tax effect of restricted stock award vesting

    (75 )   (69 )

Payment of cash dividends—common stock

        (236 )

Payment of cash dividends—preferred stock

        (967 )

Net change in short-term borrowings

    (16,008 )   (40,000 )

Net change in note payable

        (15,000 )

Net change in securities sold under agreement to repurchase

    (5,000 )   (5,000 )
           

Net cash used in financing activities

    (2,959 )   (51,775 )
           

Net increase in cash and cash equivalents

    62,938     1,369  

Cash and cash equivalents, beginning of period

    45,562     30,096  
           

Cash and cash equivalents, end of period

  $ 108,500   $ 31,465  
           

Supplemental disclosures of cash flow information:

             
 

Cash paid during the period for:

             
   

Interest paid

  $ 4,864   $ 9,092  
   

Income taxes paid

  $   $ 1,250  

Supplemental schedule of non-cash investing and financing activities:

             
   

Transfer from portfolio loans to loans held-for-sale

  $ 17,079   $ 20,506  
   

Transfer from loans held-for-sale to the loan portfolio

  $ 1,942   $  
   

Loans transferred to foreclosed assets

  $   $ 3,867  

See notes to consolidated financial statements

6


Table of Contents


HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements

June 30, 2010

(Unaudited)

1) Basis of Presentation

        The unaudited consolidated financial statements of Heritage Commerce Corp (the "Company") and its wholly owned subsidiary, Heritage Bank of Commerce (sometimes referred to as "HBC"), have been prepared pursuant to the rules and regulations for reporting on Form 10-Q. Accordingly, certain information and notes required by accounting principles generally accepted in the United States of America ("GAAP") for annual financial statements are not included herein. The interim statements should be read in conjunction with the consolidated financial statements and notes that were included in the Company's Form 10-K for the year ended December 31, 2009. The Company has also established the following unconsolidated subsidiary grantor trusts: Heritage Capital Trust I; Heritage Statutory Trust I; Heritage Statutory Trust II; and Heritage Commerce Corp Statutory Trust III which are Delaware Statutory business trusts formed for the exclusive purpose of issuing and selling trust preferred securities.

        HBC is a commercial bank serving customers located in Santa Clara, Alameda, and Contra Costa counties of California. No customer accounts for more than 10 percent of revenue for HBC or the Company. Management evaluates the Company's performance as a whole and does not allocate resources based on the performance of different lending or transaction activities. Accordingly, the Company and its subsidiary operate as one business segment.

        In the Company's opinion, all adjustments necessary for a fair presentation of these consolidated financial statements have been included and are of a normal and recurring nature. All intercompany transactions and balances have been eliminated.

        The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ significantly from these estimates.

        The results for the three and six months ended June 30, 2010 are not necessarily indicative of the results expected for any subsequent period or for the entire year ending December 31, 2010.

Adoption of New Accounting Standards

        In June 2009, the FASB amended previous guidance relating to transfers of financial assets and eliminates the concept of a qualifying special purpose entity. This guidance must be applied as of the beginning of each reporting entity's first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter. This guidance must be applied to transfers occurring on or after the effective date. Additionally, on and after the effective date, the concept of a qualifying special purpose entity is no longer relevant for accounting purposes. Therefore, formerly qualifying special purpose entities should be evaluated for consolidation by reporting entities on and after the effective date in accordance with the applicable consolidation guidance. The disclosure provisions were also amended and apply to transfers that occurred both before and after the effective date of this guidance. See Note 3 to the consolidated financial statements for the impact of the adoption of this guidance.

7


Table of Contents


HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements (Continued)

June 30, 2010

(Unaudited)

1) Basis of Presentation (Continued)

        In January 2010, the FASB issued guidance clarifying the accounting for shareholder distributions where the shareholder has the ability to elect to have his or her distribution in the form of cash (up to a pre-determined maximum), stock or a combination of the two. The amendments of the update provide that the stock portion of a distribution where the shareholder had the ability to elect the distribution as stock or cash (up to a pre-determined maximum) should be accounted for as a share issuance and thereby eliminate diversity in practice. The provisions of this update became effective for financial statements dated on or after December 15, 2009. The adoption of this standard did not have a material impact on the Company's financial statements.

        In January 2010, the FASB issued guidance requiring increased fair value disclosures. There are two components to the increased disclosure requirements set forth in the update: (1) a description of, as well as the disclosure of, the dollar amount of transfers in or out of level one or level two (2) in the reconciliation for fair value measurements using significant unobservable inputs (level 3), a reporting entity should present separately information about purchases, sales, issuances and settlements (that is, gross amounts shall be disclosed as opposed to a single net figure). Increased disclosures regarding the transfers in or out of level one and two are required for interim and annual periods beginning after December 15, 2009. The adoption of this portion of the standard did not have a material impact on the Company's financial statements. Increased disclosures regarding the level three fair value reconciliation are required for fiscal years beginning after December 15, 2010.

Newly Issued, but not yet Effective Accounting Standards

        In July 2010, the FASB updated disclosure requirements with respect to the credit quality of financing receivables and the allowance for credit losses. According to the guidance there are two levels of detail at which credit information will presented—the portfolio segment and class levels. The portfolio segment level is defined as the level where financing receivables are aggregated in developing a Company's systematic method for calculating its allowance for credit losses. The class level is the second level at which credit information will be presented and represents the categorization of financing related receivables at a slightly less aggregated level than the portfolio segment level. Companies will now be required to provide the following disclosures as a result of this update: a rollforward of the allowance for credit losses at the portfolio segment level with the ending balances further categorized according to impairment method along with the balance reported in the related financing receivables at period end; additional disclosure of nonaccrual and impaired financing receivables by class as of period end; credit quality and past due/ aging information by class as of period end; information surrounding the nature and extent of loan modifications and troubled-debt restructurings and their effect on the allowance for credit losses during the period; and detail of any significant purchases or sales of financing receivables during the period. The increased period-end disclosure requirements become effective for periods ending on or after December 15, 2010. The increased disclosures for activity within a reporting period become effective for periods beginning on or after December 15, 2010. The provisions of this update will expand the Company's current disclosures with respect to the allowance for loan losses.

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HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements (Continued)

June 30, 2010

(Unaudited)

2) Securities

        The amortized cost and estimated fair value of securities at June 30, 2010 and December 31, 2009 were as follows:

June 30, 2010
  Amortized
Cost
  Gross
Unrealized
Gains
  Gross
Unrealized
Losses
  Estimated
Fair
Value
 
 
  (Dollars in thousands)
 

Securities available-for-sale:

                         
 

U.S. Government Sponsored Entities

  $ 2,000   $ 2   $   $ 2,002  
 

Mortgage-Backed Securities—Residential

    132,355     4,337         136,692  
 

Collateralized Mortgage Obligations—Residential

    3,384     134         3,518  
                   

Total securities available-for-sale

  $ 137,739   $ 4,473   $   $ 142,212  
                   

 

December 31, 2009
  Amortized
Cost
  Gross
Unrealized
Gains
  Gross
Unrealized
Losses
  Estimated
Fair
Value
 
 
  (Dollars in thousands)
 

Securities available-for-sale:

                         
 

U.S. Government Sponsored Entities

  $ 2,000   $   $ (27 ) $ 1,973  
 

Mortgage-Backed Securities—Residential

    101,356     1,653     (463 )   102,546  
 

Collateralized Mortgage Obligations—Residential

    5,227     220         5,447  
                   

Total securities available-for-sale

  $ 108,583   $ 1,873   $ (490 ) $ 109,966  
                   

        Securities classified as U.S. Government Sponsored Entities as of June 30, 2010 and December 31, 2009 were issued by the Federal National Mortgage Association ("Fannie Mae"). At June 30, 2010 and December 31, 2009, all mortgage backed securities and collateralized mortgage obligations were issued by Fannie Mae, Freddie Mac, or the Government National Mortgage Association ("Ginnie Mae").

        At June 30, 2010 and December 31, 2009, there were no holdings of securities of any one issuer, other than the U.S. Government and its sponsored entities, in an amount greater than 10% of shareholders' equity.

        There were no securities with unrealized losses at June 30, 2010. Securities with unrealized losses at December 31, 2009, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, are as follows:

 
  Less Than 12 Months   12 Months or More   Total  
December 31, 2009
  Fair
Value
  Unrealized
Losses
  Fair
Value
  Unrealized
Losses
  Fair
Value
  Unrealized
Losses
 
 
  (Dollars in thousands)
 

U.S. Government Sponsored Entities

  $ 1,973   $ (27 ) $   $   $ 1,973   $ (27 )

Mortgage-Backed Securities—Residential

    43,600     (463 )           43,600     (463 )
                           
 

Total

  $ 45,573   $ (490 ) $   $   $ 45,573   $ (490 )
                           

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HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements (Continued)

June 30, 2010

(Unaudited)

2) Securities (Continued)

        At December 31, 2009, the Company held 75 securities, of which 23 had fair values below amortized cost. No securities have been carried with an unrealized loss for over 12 months. The Company did not consider these securities to be other-than-temporarily impaired at December 31, 2009.

3) Loans

        Loans were as follows:

 
  June 30,
2010
  December 31,
2009
 
 
  (Dollars in thousands)
 

Loans held-for-sale:

             
   

Loans held-for-sale—SBA

  $ 12,291   $ 10,742  
   

Loans held-for-sale—Other

    17,079      
           

Total loans held-for-sale

  $ 29,370   $ 10,742  
           

Loans held for investment:

             
 

Commercial

  $ 388,471   $ 427,177  
 

Real estate—mortgage

    373,000     400,731  
 

Real estate—land and construction

    110,194     182,871  
 

Home equity

    52,419     51,368  
 

Consumer

    12,837     7,181  
           

Loans

    936,921     1,069,328  

Deferred loan origination costs and fees, net

    852     785  
           

Loans, including deferred costs

    937,773     1,070,113  

Allowance for loan losses

    (26,753 )   (28,768 )
           

Loans, net

  $ 911,020   $ 1,041,345  
           

        At June 30, 2010, included in the balance of loans held-for-sale are $3,992,000 of SBA loans that have been transferred to third parties. However, these loans are subject to a SBA warranty for a period of 90 days, which under new accounting guidance requires the Company to treat these as secured borrowings during the warranty period. The secured borrowings are classified as "short-term borrowings" on the consolidated balance sheets. The warranty period for these loans expires in the following quarter. Provided the loans remain current through the end of the warranty period all elements necessary to record the sale will have been met. The Company has deferred gains of $230,000 associated with these loans, which are included in other liabilities on the consolidated balance sheets.

        During the second quarter of 2010, the Company identified $31,005,000 of real estate loans classified as substandard or substandard-nonaccrual that it intends to sell. The sale is expected to be completed in the third quarter of 2010. These loans were written down to $17,079,000, to reflect the estimated market value of the loans and this amount was transferred to loans held-for-sale. The

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HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements (Continued)

June 30, 2010

(Unaudited)

3) Loans (Continued)


write-down of these real estate loans resulted in net charge-offs of $13,926,000 in the second quarter of 2010. The following table shows the detail of the real estate loans we intend to sell at June 30, 2010:

 
  June 30, 2010  
 
  Balance
Prior to
Transfer
  Amount
Charged-off
  Balance
Transferred
to Loans
Held-for-Sale
 
 
  (Dollars in thousands)
 

Real estate-mortgage

  $ 9,893   $ (2,781 ) $ 7,112  

Real estate-land and construction

    21,112     (11,145 )   9,967  
               
 

Total

  $ 31,005   $ (13,926 ) $ 17,079  
               

        Changes in the allowance for loan losses were as follows:

 
  Six Months Ended
June 30,
 
 
  2010   2009  
 
  (Dollars in thousands)
 

Balance, beginning of period

  $ 28,768   $ 25,007  

Loans charged-off

    (26,383 )   (15,254 )

Recoveries

    673     521  
           

Net charge-offs

    (25,710 )   (14,733 )

Provision for loan losses

    23,695     21,124  
           

Balance, end of period

  $ 26,753   $ 31,398  
           

        Impaired loans were as follows:

 
  June 30,    
 
 
  December 31,
2009
 
 
  2010   2009  
 
  (Dollars in thousands)
 

Period-end loans with no allocated allowance for loan losses

  $ 17,127   $ 6,099   $ 13,202  

Period-end loans with allocated allowance for loan losses

    42,458     49,706     49,173  
               
 

Total

  $ 59,585   $ 55,805   $ 62,375  
               

Amount of the allowance for loan losses allocated to above at period-end

  $ 9,756   $ 11,638   $ 9,103  
               

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HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements (Continued)

June 30, 2010

(Unaudited)

3) Loans (Continued)

        Nonperforming loans include both smaller dollar balance homogeneous loans that are collectively evaluated for impairment and individually classified loans. Nonperforming loans were as follows:

 
  Six Months Ended
June 30,
   
 
 
  December 31,
2009
 
 
  2010   2009  
 
  (Dollars in thousands)
 

Nonaccrual loans—held-for-sale portfolio

  $ 9,806   $   $  

Restructured and loans past due over 90 days still on accrual

    2,516     786     2,895  

Nonaccrual loans—held-for-investment portfolio

    47,263     57,889     59,480  
               
 

Total

  $ 59,585   $ 58,675   $ 62,375  
               

4) Private Placement

        The Company entered into a securities purchase agreement, dated June 18, 2010, with various institutional investors, pursuant to which the investors purchased for an aggregate of $75,000,000 newly issued shares of Series B Mandatorily Convertible Cumulative Perpetual Preferred Stock ("Series B Preferred Stock") and Series C Convertible Perpetual Preferred Stock ("Series C Preferred Stock"). On June 21, 2010, the Company issued to the investors (i) an aggregate of 53,996 shares of Series B Preferred Stock, each of which will automatically convert into 266.67 shares of our Common Stock (an aggregate of 14,399,000 shares of Common Stock) based on the initial conversion price of $3.75, upon approval of the conversion by the Company's shareholders, and (ii) an aggregate of 21,004 shares of Series C Preferred Stock, each of which will automatically convert into 266.67 shares of our Common Stock (an aggregate of 5,601,000 shares of Common Stock) based on the initial conversion price of $3.75, following both approval of the conversion by the Company's shareholders and, thereafter, a subsequent transfer of the Series C Preferred Stock to third parties not affiliated with the holder in a widely dispersed offering.

        The Series B Preferred Stock is non-voting except in the case of certain transactions that affect the rights of the holders of the Series B Preferred Stock or applicable law. The initial conversion price of $3.75 per share is subject to possible adjustments in the future under certain circumstances, including failure to obtain shareholder approval for the conversion by December 21, 2010, which would decrease the conversion price by 10%. Prior to shareholder approval, the holders of the Series B Preferred Stock will be entitled to receive cumulative cash dividends which shall accrue and be payable at a per annum rate equal to 20%, payable semi-annually in arrears commencing on December 21, 2010; provided, however, if shareholder approval is obtained before December 21, 2010, then no accrued dividends shall be payable. The Series B Preferred Stock is not redeemable by the Company or by the holders and carries a liquidation preference of $1,000 per share, plus the right to participate in any liquidation distribution to holders of common stock on an as-converted basis.

        The Series C Preferred Stock is non-voting except in the case of certain transactions that would affect the rights of the holders of the Series C Preferred Stock or applicable law. The initial conversion price of $3.75 per share is subject to possible adjustments in the future under certain circumstances,

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HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements (Continued)

June 30, 2010

(Unaudited)

4) Private Placement (Continued)


including the failure to obtain shareholder approval for the conversion by December 21, 2010, which would decrease the conversion price by 10%. Prior to shareholder approval, the holders of the Series C Preferred Stock will be entitled to receive cumulative cash dividends which shall accrue and be payable at a per annum rate equal to 20%, payable semi-annually in arrears commencing on December 21, 2010; provided, however, if shareholder approval is obtained on or before December 21, 2010, then no accrued dividends shall be payable. Following shareholder approval, holders of Series C Preferred Stock will receive dividends if and only to the extent dividends are paid to holders of common stock. The Series C Preferred Stock is not redeemable by the Company or by the holders and carries a liquidation preference of $1,000 per share, plus prior to shareholder approval, the right to participate in any liquidation distribution to holders of common stock on an as-converted basis. Following shareholder approval, upon a liquidation of the Company, holders of Series C Preferred Stock will be entitled to a liquidation preference of $1,000 per share.

        The Series B Preferred Stock and the Series C Preferred Stock rank senior to the Company's common stock and rank on parity with the Company's Series A Fixed Rate Cumulative Preferred Stock ("Series A Preferred Stock").

        Dividends and discount accretion on preferred stock on the consolidated statements of operations include dividends on the Series B Preferred Stock and Series C Preferred Stock totaling $411,000 for the three months and six months ended June 30, 2010.

        The Company has scheduled a Special Shareholder Meeting for September 15, 2010, to approve the conversion of the Series B Preferred Stock and the Series C Preferred Stock for purposes of the NASDAQ Listing Rules and the California General Corporation Law (the "Shareholder Approvals"). There is no assurance the Company's shareholders will approve the conversion of the Series B Preferred Stock and Series C Preferred Stock before December 21, 2010 or thereafter. The failure of the Company's shareholders to approve the conversion of the Series B Preferred Stock and the Series C Preferred Stock would have potentially adverse consequences for the Company and its shareholders.

5) Goodwill and Intangible Assets

Goodwill

        Goodwill resulted from the acquisition of Diablo Valley Bank in June 2007 and represented the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually, as of November 30, for impairment with the assistance of an independent valuation firm. Goodwill impairment exists when a reporting unit's carrying value exceeds its fair value, which is determined through a two-step impairment test. Step 1 includes the determination of the carrying value of the Company's single reporting unit, including the existing goodwill and intangible assets, and estimating the fair value of the reporting unit. If the carrying amount of a reporting unit exceeds its fair value, the Company is required to perform a second step to the impairment test. Step 2 requires that the implied fair value of the reporting unit goodwill be compared to the carrying amount of that goodwill. If the carrying amount of the reporting

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HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements (Continued)

June 30, 2010

(Unaudited)

5) Goodwill and Intangible Assets (Continued)


unit goodwill exceeds the implied fair value of that goodwill, an impairment loss will be recognized in an amount equal to that excess.

        Because of concerns about the Company's stock price and banking industry in general, goodwill was tested for impairment in the first quarter of 2010 with the assistance of an independent valuation firm. Based on the assessment, management concluded that there was no impairment of goodwill at March 31, 2010.

        Due to concerns about the Company's stock price, the condition of the banking industry in general, and the pricing of the closed private placement of convertible preferred stock, goodwill was tested for impairment in the second quarter of 2010, with the assistance of an independent valuation firm. Due to the continued depressed economic conditions and the length of time and amount by which the Company's book value exceeded market value per share, and the Company's closing of the private placement at a conversion price of $3.75 per share, the Company determined goodwill related to the acquisition of Diablo Valley Bank of $43,181,000 was fully impaired during the second quarter of 2010. The method for estimating the value of the reporting unit included a weighted average of the discounted cash flows income approach and publicly traded company approach.

Intangible Assets

        Intangible assets consist of core deposit and customer relationship intangible assets arising from the acquisition of Diablo Valley Bank in June 2007. These assets are amortized over their estimated useful lives. Impairment testing of these assets is performed at the individual asset level. Impairment exists if the carrying amount of the asset is not recoverable and exceeds its fair value at the date of the impairment test. For intangible assets, estimates of expected future cash flows (cash inflows less cash outflows) that are directly associated with an intangible asset are used to determine the fair value of that asset. Management makes certain estimates and assumptions in determining the expected future cash flows from core deposit and customer relationship intangibles including account attrition, expected lives, discount rates, interest rates, servicing costs and other factors. Significant changes in these estimates and assumptions could adversely impact the valuation of these intangible assets. If an impairment loss exists, the carrying amount of the intangible asset is adjusted to a new cost basis. The new cost basis is then amortized over the remaining useful life of the asset. Based on its assessment, management concluded that there was no impairment of intangible assets at June 30, 2010.

6) Income Taxes

        Under generally accepted accounting principles, a valuation allowance is required if it is "more likely than not" that a deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management's evaluation of both positive and negative evidence, including forecasts of future income, cumulative losses, applicable tax planning strategies, and assessments of current and future economic and business conditions. At June 30, 2010, the Company determined a partial valuation allowance on the state of California net deferred tax asset was necessary, primarily because of the Company's cumulative loss in the most recent three-year period caused by the provision for loan losses recorded during the period.

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Table of Contents


HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements (Continued)

June 30, 2010

(Unaudited)

6) Income Taxes (Continued)


The $5,874,000 income tax benefit for the six months ended June 30, 2010 is net of $3,700,000 of income tax expense to establish the partial valuation allowance. Management is required to re-evaluate the deferred tax asset and the related valuation allowance quarterly.

        The net recorded deferred tax asset, after the partial valuation allowance of $3,700,000, was $24,569,000 at June 30, 2010. The net deferred tax asset was $22,401,000 at December 31, 2009. The net deferred tax asset includes California and Federal net operating loss carryforwards that will begin to expire in 2019 and 2030, respectively, if not utilized to reduce future taxable income. The remaining deferred tax asset was supported by available tax planning strategies and projected future taxable income.

7) Supplemental Retirement Plan

        The Company has a supplemental retirement plan covering current and former key executives and directors. The Plan is a nonqualified defined benefit plan. Benefits are unsecured as there are no Plan assets. The following table presents the amount of periodic cost recognized for the three and six months ended June 30, 2010 and 2009:

 
  Three Months
Ended
June 30,
  Six Months
Ended
June 30,
 
 
  2010   2009   2010   2009  
 
  (Dollars in thousands)
 

Components of net periodic benefits cost

                         
 

Service cost

  $ 244   $ 241   $ 488   $ 482  
 

Interest cost

    209     191     418     382  
 

Prior service cost

    9     9     18     18  
 

Amortization of loss

    17     48     34     96  
                   
 

Net periodic cost

  $ 479   $ 489   $ 958   $ 978  
                   

8) Fair Value

        Accounting guidance establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

    Level 1:    Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

    Level 2:    Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical assets or liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data (for example, interest rates and yield curves observable at commonly quoted intervals, prepayment speeds, credit risks, and default rates).

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Table of Contents


HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements (Continued)

June 30, 2010

(Unaudited)

8) Fair Value (Continued)

    Level 3:    Significant unobservable inputs that reflect a reporting entity's own assumptions about the assumptions that market participants would use in pricing an asset or liability.

Financial Assets and Liabilities Measured on a Recurring Basis

        The fair values of securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the securities' relationship to other benchmark quoted securities (Level 2 inputs).

        The fair value of interest-only ("I/O") strip receivable assets is based on a valuation model used by a third party. The Company is able to compare the valuation model inputs and results to widely available published industry data for reasonableness (Level 2 inputs).

 
   
  Fair Value Measurements Using  
 
  Balance   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
  Significant
Other
Obeservable
Inputs
(Level 2)
  Significant
Unobservable
Inputs
(Level 3)
 
 
  (Dollars in thousands)
 

Assets at June 30, 2010:

                         
 

Available-for-sale securities

                         
   

U.S. Government Sponsored Entities

  $ 2,002       $ 2,002      
   

Mortgage-Backed Securities—Residential

    136,692         136,692      
   

Collateralized Mortgage Obligations—Residential

    3,518         3,518      
 

I/O strip receivables

    2,059         2,059      

Assets at December 31, 2009:

                         
 

Available-for-sale securities

                         
   

U.S. Government Sponsored Entities

  $ 1,973       $ 1,973      
   

Mortgage-Backed Securities—Residential

    102,546         102,546      
   

Collateralized Mortgage Obligations—Residential

    5,447         5,447      
 

I/O strip receivables

    2,116         2,116      

Assets and Liabilities Measured on a Non-Recurring Basis

        The fair value of loans held-for-sale is based upon binding contracts or quotes from third party investment banker valuations, resulting in Level 2 classification of inputs for determining fair value.

        The fair value of impaired loans held for investment with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals, brokers' opinion of value, letters of intent, purchase and sale agreements, financial statements and equipment evaluations. Real estate

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HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements (Continued)

June 30, 2010

(Unaudited)

8) Fair Value (Continued)


appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

        Nonrecurring adjustments to certain commercial and residential estate properties classified as other real estate owned are measured at the lower of carrying amount or fair value, less costs to sell. Fair values are generally based on third party appraisals of the property, resulting in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.

 
   
  Fair Value Measurements Using  
 
  Balance   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
  Significant
Other
Obeservable
Inputs
(Level 2)
  Significant
Unobservable
Inputs
(Level 3)
 
 
  (Dollars in thousands)
 

Assets at June 30, 2010:

                         
 

Loans held-for-sale:

                         
   

Real estate—mortgage

  $ 7,112       $ 7,112      
   

Real estate—land and construction

    9,967         9,967      
                       
     

Total

  $ 17,079       $ 17,079      
                       
 

Impaired loans held for investment:

                         
   

Commercial

  $ 8,166           $ 8,166  
   

Real estate—mortgage

    11,891             11,891  
   

Real estate—land and construction

    16,863             16,863  
   

Consumer

    208             208  
                       
     

Total

  $ 37,128           $ 37,128  
                       
 

Other real estate owned

  $ 555           $ 555  
                       

Assets at December 31, 2009:

                         
 

Impaired loans held for investment

  $ 48,410           $ 48,410  
                       
 

Other real estate owned

  $ 812           $ 812  
                       

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Table of Contents


HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements (Continued)

June 30, 2010

(Unaudited)

8) Fair Value (Continued)

        The following table shows the detail of the impaired loans held for investment and the impaired loans held for investment carried at fair value for the periods indicated:

 
  June 30, 2010   December 31, 2009  
 
  (Dollars in thousands)
 

Impaired loans held for investment:

             
 

Book value of impaired loans held for investment carried at fair value

  $ 46,884   $ 57,513  
 

Book value of impaired loans held for investment carried at cost

    2,895     4,862  
           
   

Total impaired loans held for investment

  $ 49,779   $ 62,375  
           

Impaired loans held for investment carried at fair value:

             
 

Book value of impaired loans held for investment carried at fair value

  $ 46,884   $ 57,513  
 

Specific valuation allowance

    (9,756 )   (9,103 )
           
   

Impaired loans held for investment carried at fair value, net

  $ 37,128   $ 48,410  
           

        Of the total provision for loan losses during the six months ended June 30, 2010 and the year ended December 31, 2009, $12,764,000 and $16,574,000 was a result of the decline in the fair value of impaired loans held for investment that were carried at fair value at June 30, 2010 and December 31, 2009, respectively.

        Total other real estate owned, consisting of one property, had a fair value of $555,000 at June 30, 2010.

        Total other real estate owned, consisting of two properties, had a carrying value of $2,241,000 at December 31, 2009. One property is carried at fair value, less costs to sell, of $812,000 at December 31, 2009. The other property is carried at cost as of December 31, 2009. There were no impairment write downs subsequent to acquisition in 2009.

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HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements (Continued)

June 30, 2010

(Unaudited)

8) Fair Value (Continued)

        The carrying amounts and estimated fair values of the Company's financial instruments, at June 30, 2010 and December 31, 2009 were as follows:

 
  June 30,
2010
  December 31,
2009
 
 
  Carrying
Amounts
  Estimated
Fair
Value
  Carrying
Amounts
  Estimated
Fair
Value
 
 
  (Dollars in thousands)
 

Assets

                         
 

Cash and cash equivalents

  $ 108,500   $ 108,500   $ 45,562   $ 45,562  
 

Securities available-for-sale

    142,212     142,212     109,966     109,966  
 

Loans (including loans held-for-sale), net

    940,390     854,678     1,052,087     955,242  
 

FHLB and FRB stock

    8,299     N/A     8,454     N/A  
 

Accrued interest receivable

    3,194     3,194     3,472     3,472  
 

Loan servicing rights and I/O strips receivables

    3,016     5,044     3,183     4,972  

Liabilities

                         
 

Time deposits

  $ 353,616   $ 355,618   $ 386,213   $ 389,027  
 

Other deposits

    683,809     683,809     703,072     703,072  
 

Securities sold under agreement to repurchase

    20,000     20,165     25,000     25,341  
 

Short-term borrowings

    3,992     3,992     20,000     20,000  
 

Subordinated debt

    23,702     18,585     23,702     14,938  
 

Accrued interest payable

    2,092     2,092     1,194     1,194  

        The methods and assumptions, not previously discussed, used to estimate the fair value are described as follows:

Cash and Cash Equivalents and Accrued Interest Receivable and Payable

        The carrying amount approximates fair value because of the short maturities of these instruments.

Loans

        Loans with similar financial characteristics are grouped together for purposes of estimating their fair value. Loans are segregated by type such as commercial, term real estate, construction and land development, and consumer. Each loan category is further segmented into fixed and adjustable rate interest terms.

        The fair value of performing, fixed rate loans is calculated by discounting scheduled future cash flows using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The fair value of variable rate loans approximates the carrying amount as these loans generally reprice within 90 days.

        The fair value of loans held-for-sale is based on estimated market values from third party investors.

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HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements (Continued)

June 30, 2010

(Unaudited)

8) Fair Value (Continued)

FHLB and FRB Stock

        It was not practical to determine the fair value of FHLB and FRB stock due to the restrictions placed on transferability.

Deposits

        The fair value of deposits with no stated maturity, such as demand deposits, savings, and money market accounts, approximates the amount payable on demand. The carrying amount approximates the fair value of time deposits with a remaining maturity of less than 90 days. The fair value of all other time deposits is calculated based on discounting the future cash flows using rates currently offered for time deposits with similar remaining maturities.

Subordinated debt and Securities Sold Under Agreement to Purchase

        The fair values of subordinated debt and securities sold under agreement to repurchase were determined based on the current market value for like kind instruments of a similar maturity and structure.

Short-term Borrowings and Note Payable

        The carrying amount approximates the fair value of short-term borrowings and the note payable that reprice frequently and fully.

Off-Balance Sheet Items

        The fair value of off-balance sheet items, such as commitments to extend credit, is not considered material and therefore is not included in the table above.

Limitations

        Fair value estimates are made at a specific point in time, based on relevant market information about the financial instruments. These estimates do not reflect any premium or discount that could result from offering for sale at one time the entire holdings of a particular financial instrument. Fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

9) Regulatory Matters

        On February 17, 2010, the Company and HBC entered into a written agreement ("Written Agreement") with the Federal Reserve Bank of San Francisco ("FRB") and the California Department of Financial Institutions ("DFI"). Under the terms of the Written Agreement, the Company must obtain the prior written approval of the Federal Reserve and DFI before it may (i) declare or pay any dividends, (ii) make any distributions of principal or interest on the Company's outstanding trust

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HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements (Continued)

June 30, 2010

(Unaudited)

9) Regulatory Matters (Continued)


preferred securities and related subordinated debt, (iii) incur, increase or guarantee any debt, (iv) redeem any outstanding stock, or (v) take dividends or any other form of payment that represents a reduction in capital from HBC. The Written Agreement also requires the Company to (i) submit a written plan to strengthen credit risk management practices, (ii) submit a written capital plan for sufficient capitalization of both the Company and HBC, (iii) submit a written business plan for 2010 to improve the Company's earnings and overall financial condition, (iv) comply with notice and approval requirements related to the appointment of directors and senior executive officers or change in the responsibility of any current senior executive officer, (v) comply with restrictions on paying or agreeing to pay certain indemnification and severance payments without prior written approval, (vi) submit a written plan to improve management of the Company's liquidity position and funds management practices, (vii) notify the Federal Reserve and DFI no more than 30 days after the end of any quarter in which the capital ratios of the Company or HBC fall below approved capital plan's minimum ratios, together with an acceptable written plan to increase capital ratios to or above the approved capital plan's minimum levels, (viii) comply with specified procedures for board (or a committee of the board) approval for the extension, renewal or restructure of any "criticized loan", (ix) submit plans to improve the Company's position on outstanding past due and other problem loans in excess of $2 million, (x) maintain policies and procedures and submit a plan for the maintenance of an adequate allocation for loan losses, and (xi) provide quarterly progress reports to the Federal Reserve and DFI.

        Prior to entering into the Written Agreement in February 2010, the Company had already ceased paying dividends on its common stock (in the second quarter of 2009), suspended interest payments on its trust preferred securities and related subordinated debt (in the fourth quarter of 2009), and suspended dividend payments on its preferred stock (also in the fourth quarter of 2009).

        The Company is addressing the requirements of the Written Agreement. The Company submitted specific plans to the FRB and DFI relating to improving asset quality and credit risk management, improving profitability and liquidity management and these plans were accepted as satisfactory by the FRB and DFI. The Company submitted its capital plan and it is being reviewed by the FRB and DFI.

        Failure to comply with the Written Agreement may subject the Company and HBC to additional supervisory actions and orders.

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ITEM 2—MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

        The following discussion provides information about the results of operations, financial condition, liquidity, and capital resources of Heritage Commerce Corp (the "Company") and its wholly owned subsidiary, Heritage Bank of Commerce (sometimes referred to as "HBC"). This information is intended to facilitate the understanding and assessment of significant changes and trends related to our financial condition and the results of operations. This discussion and analysis should be read in conjunction with our consolidated financial statements and the accompanying notes presented elsewhere in this report. Unless we state otherwise or the context indicates otherwise, references to the "Company," "Heritage," "we," "us," and "our," in this Report on Form 10-Q refer to Heritage Commerce Corp and Heritage Bank of Commerce. Reference to "HCC" refers only to Heritage Commerce Corp, the holding company of HBC.

        This Report on Form 10-Q contains various statements that may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, or Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or Exchange Act, and are intended to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Any statements about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and may be forward-looking. These forward-looking statements often can be, but are not always, identified by the use of words such as "assume," "expect," "intend," "plan," "project," "believe," "estimate," "predict," "anticipate," "may," "might," "should," "could," "goal," "potential" and similar expressions. We base these forward-looking statements on our current expectations and projections about future events, our assumptions regarding these events and our knowledge of facts at the time the statements are made. These statements include statements relating to our projected growth, anticipated future financial performance, and management's long-term performance goals, as well as statements relating to the anticipated effects on results of operations and financial condition.

        These forward-looking statements are subject to various risks and uncertainties that may be outside our control and our actual results could differ materially from our projected results. In addition, our past results of operations do not necessarily indicate our future results. Please see our most recent Annual Report on Form 10-K for the year ended December 31, 2009 and our subsequent Quarterly Reports on Form 10-Q and the other information contained in this Report on Form 10-Q for a further discussion of these and other risks and uncertainties applicable to our business. The forward looking statements could be affected by many factors, including but not limited to:

    Our ability to attract new deposits and loans;

    Local, regional, and national economic conditions and events and the impact they may have on us and our customers;

    Risks associated with concentrations in real estate related loans;

    Increasing levels of classified assets, including nonperforming assets, which could adversely affect our earnings and liquidity;

    Market interest rate volatility;

    Stability of funding sources and continued availability of borrowings;

    Changes in legal or regulatory requirements or the results of regulatory examinations that could restrict growth and constrain our activities, including the terms of our Written Agreement entered into by the Company, the Board of Governors of the Federal Reserve System and the Department of Financial Institutions;

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    Changes in accounting standards and interpretations;

    Our ability to raise capital or incur debt on reasonable terms;

    Regulatory limits on the HBC's ability to pay dividends to the Company;

    Effectiveness of the Emergency Economic Stabilization Act of 2008, the American Recovery and Reinvestment Act of 2009 and other legislative and regulatory efforts to help stabilize the U.S. financial markets;

    Future legislative or administrative changes to the U.S. Treasury Capital Purchase Program enacted under the Emergency Economic Stabilization Act of 2008;

    The impact of the Emergency Economic Stabilization Act of 2008 and the American Recovery and Reinvestment Act of 2009 and related rules and regulations on our business operations and competitiveness, including the impact of executive compensation restrictions, which may affect our ability to retain and recruit executives in competition with other firms who do not operate under those restrictions;

    The impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act signed by President Obama on July 21, 2010; and

    Our success in managing the risks involved in the foregoing items.

        We are not able to predict all the factors that may affect future results. You should not place undue reliance on any forward-looking statement, which speaks only as of the date of this Report on Form 10-Q. Except as required by applicable laws or regulations, we do not undertake any obligation to update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.

EXECUTIVE SUMMARY

        This summary is intended to identify the most important matters on which management focuses when it evaluates the financial condition and performance of the Company. When evaluating financial condition and performance, management looks at certain key metrics and measures. The Company's evaluation includes comparisons with peer group financial institutions and its own performance objectives established in the internal planning process.

        The primary activity of the Company is commercial banking. The Company's operations are located entirely in the southern and eastern regions of the general San Francisco Bay Area of California in the counties of Santa Clara, Alameda and Contra Costa. The largest city in this area is San Jose and the Company's market includes the headquarters of a number of technology based companies in the region known commonly as Silicon Valley. The Company's customers are primarily closely held businesses and professionals.

Performance Overview

        For the three months ended June 30, 2010, the net loss was $54.1 million. The net loss allocable to common shareholders was $55.1 million, or $(4.66) per common share for the three months ended June 30, 2010, which included a $43.2 million charge for impairment of goodwill, an $18.6 million provision for loan losses, and a $3.7 million partial valuation allowance on the deferred tax asset. In the three months ended June 30, 2009, the net loss was $5.4 million. The net loss allocable to common shareholders was $6.0 million, or $(0.51) per common share, including a provision for loan losses of $10.7million.

        For the six months ended June 30, 2010, the net loss was $58.2 million. The net loss allocable to common shareholders was $59.8 million, or $(5.06) per common share, which included a $43.2 million

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charge for impairment of goodwill, a $23.7 million provision for loan losses, and a $3.7 million partial valuation allowance on the deferred tax asset. In the six months ended June 30, 2009, the net loss was $9.3 million. The net loss allocable to common shareholders was $10.5 million, or $(0.89) per common share, including a provision for loan losses of $21.1 million.

        During the second quarter of 2010, there were several significant events that impacted the Company's financial condition and operations. First, the Company completed a private placement of convertible preferred stock for $75 million which significantly improved the Company's regulatory capital ratios. Second, the Company identified $31.0 million of real estate loans classified as substandard or substandard-nonaccrual that it intends to sell in the third quarter of 2010. The loans were transferred to the held-for-sale portfolio and the Company recorded a $13.9 million of related loan charge-offs in the second quarter of 2010. In addition, due to the continued depressed economic conditions and amount by which the Company's book value exceeded the market value per common share, and the Company's closing of a private placement at a conversion price of $3.75 per share, the Company determined that goodwill related to the acquisition of Diablo Valley Bank of $43.2 million was fully impaired. Also, after an analysis in the second quarter of 2010 of both the positive and negative evidence regarding the realization of the deferred tax asset, the Company recorded a $3.7 million partial valuation allowance on the Company's deferred tax asset.

        The following are major factors that impacted the Company's results of operations:

    The net interest margin increased 33 basis points to 3.88% for the second quarter of 2010, compared with 3.55% for the second quarter of 2009, and increased 7 basis points to 3.88% compared to 3.81% for the first quarter of 2010. The Company's net interest margin increased to 3.85% for the six months ended June 30, 2010, compared to 3.45% for the first six months of 2009.

    The provision for loan losses was $18.6 million for the second quarter of 2010, compared to $10.7 million for the second quarter of 2009. The provision for loan losses for the six months ended June 30, 2010 was $23.7 million, compared to $21.1 million for the same period a year ago.

    Noninterest income increased 17% to $1.9 million in the second quarter of 2010 from $1.6 million in the second quarter of 2009, and increased 10% to $3.6 million in the first six months of 2010 from $3.2 million in the first six months of 2009.

    A $43.2 million non-cash charge was recorded during the second quarter of 2010 to reflect an impairment of goodwill related to a prior acquisition.

    Noninterest expense, including the $43.2 million impairment of goodwill, was $54.6 million for the second quarter of 2010, compared to $12.1 million in the second quarter of 2009. In the first six months of 2010, noninterest expense including the $43.2 million impairment of goodwill was $66.8 million, compared to $23.4 million in the first six months a year ago.

    The income tax benefit for the quarter ended June 30, 2010 was $5.8 million, which included $3.7 million of additional income tax expense to establish a partial valuation allowance on the Company's net deferred tax asset. The income tax benefit was $4.1 million in the second quarter a year ago, and $120,000 in the first quarter of 2010. In the first six months of 2010, the income tax benefit was $5.9 million, compared to $9.2 million in the first six months a year ago. The negative effective income tax rates are due to the loss before income taxes. The difference in the effective tax rate compared to the combined Federal and state statutory tax rate of 42% is primarily the result of the Company's investment in life insurance policies whose earnings are not subject to taxes, and tax credits related to investments in low income housing limited partnerships.

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        The following are important factors in understanding our current financial condition and liquidity position:

    Cash and securities increased to $250.7 million at June 30, 2010, from $133.3 million at June 30, 2009, and $155.5 million at December 31, 2009.

    Classified assets will be reduced as a result of the planned sale of $17.1 million of real estate loans classified as substandard or substandard-nonaccrual assets.

    Total loans, excluding loans held-for-sale, decreased $224,000, or 19%, to $937.8 million at June 30, 2010, compared to $1.16 billion at June 30, 2009, and decreased $132.3 million, or 12%, from December 31, 2009. Land and construction loans decreased $120.6 million, or 52%, to $110.2 million at June 30, 2010, compared to $230.8 million at June 30, 2009, and decreased $72.7 million, or 40%, from $182.9 million at December 31, 2009.

    The allowance for loan losses at June 30, 2010 was $26.8 million, or 2.85% of total loans, and represented 44.90% of nonperforming loans, and 53.74% of nonperforming loans excluding nonaccrual loans in the loans held-for-sale portfolio. The allowance for loan losses a year ago was $31.4 million, or 2.70% of total loans and 53.51% of nonperforming loans. The allowance for loan losses at December 31, 2009, was $28.8 million, or 2.69% of total loans and 46.12% of nonperforming loans.

    Nonperforming assets decreased to $60.1 million, or 4.61% of total assets at June 30, 2010, which included $9.8 million of real estate loans classified as substandard or substandard-nonaccrual transferred to the loans held-for-sale portfolio. Excluding the loans held-for-sale, nonperforming assets were $50.3 million, or 3.86% of total assets at June 30, 2010. Nonperforming assets were $61.7 million, or 4.30% of total assets at June 30, 2009, and $64.6 million, or 4.74% of total assets at December 31, 2009.

    Net charge-offs were $18.4 million in the second quarter of 2010, of which $13.9 million related to substandard and substandard-nonaccrual real estate loans transferred to the loans held-for-sale portfolio, and $4.5 million related to the remaining loan portfolio. Net charge-offs were $3.2 million in the second quarter of 2009, and $5.9 million in the fourth quarter of 2009.

    Brokered deposits decreased to $163.7 million at June 30, 2010, compared to $212.8 million at June 30, 2009, and $178.0 million at December 31, 2009.

    The ratio of noncore funding (which consists of time deposits $100,000 and over, CDARS deposits, brokered deposits, securities under agreement to repurchase, notes payable and short-term borrowings) to total assets was 26% at June 30, 2010, compared to 31% at June 30, 2009, and 29% at December 31, 2009.

    The loan to deposit ratio improved to 90.39% at June 30, 2010, compared to 99.84% at June 30, 2009, and 98.24% at December 31, 2009.

    The $75 million of new capital raised in June 2010 increased tangible equity to $182.3 million at June 30, 2010, from $127.5 million at June 30, 2009, and $125.5 million at December 31, 2009.

    HCC downstreamed $40 million of the proceeds from the June 2010 private placement to the capital of HBC.

    On a consolidated basis, the Company's capital ratios continue to exceed regulatory well-capitalized standards with a leverage ratio of 8.65%, a Tier 1 risk-based capital ratio of 10.73%, and a total risk-based capital ratio of 18.66% at June 30, 2010.

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    HBC's capital ratios continue to exceed regulatory well-capitalized standards with a leverage ratio of 11.68%, a Tier 1 risk-based capital ratio of 14.49%, and a total risk-based capital ratio of 15.75% at June 30, 2010.

Deposits

        The composition and cost of the Company's deposit base are important in analyzing the Company's net interest margin and balance sheet liquidity characteristics. Except for brokered time deposits, the Company's depositors are generally located in its primary market area. Depending on loan demand and other funding requirements, the Company also obtains deposits from wholesale sources including deposit brokers. The Company had $163.7 million in brokered deposits at June 30, 2010, compared to $212.8 million at June 30, 2009, and $178.0 million at December 31, 2009. The Company has a policy to monitor all deposits that may be sensitive to interest rate changes to help assure that liquidity risk does not become excessive due to concentrations. Deposits at June 30, 2010 were $1.04 billion, compared to $1.16 billion at June 30, 2009, and $1.09 billion at December 31, 2009.

        HBC is a member of the Certificate of Deposit Account Registry Service ("CDARS") program. The CDARS program allows customers with deposits in excess of FDIC insured limits to obtain coverage on time deposits through a network of banks within the CDARS program. Deposits gathered through this program are considered brokered deposits under regulatory guidelines. Deposits in the CDARS program totaled $18.2 million at June 30, 2010, compared to $11.9 million at June 30, 2009 and $38.2 million at December 31, 2009.

        HBC is a participant in the FDIC's Transaction Account Guarantee Program ("TAGP"), which provides HBC's depositors with unlimited FDIC insurance coverage for certain noninterest-bearing transaction accounts. Unless extended by the FDIC, the TAGP will expire on December 31, 2010, at which time the amount of coverage for each depositor will be limited to $250,000. The impact of the TAGP expiration in December 2010 could have an adverse effect on HBC's deposit base.

Liquidity

        Our liquidity position refers to our ability to maintain cash flows sufficient to fund operations and to meet obligations and other commitments in a timely fashion. We believe that our liquidity position is more than sufficient to meet our operating expenses, borrowing needs and other obligations for 2010. At June 30, 2010, we had $108.5 million in cash and cash equivalents and approximately $198.1 million in available borrowing capacity from various sources including the Federal Home Loan Bank ("FHLB"), the Federal Reserve Bank of San Francisco ("FRB"), and Federal funds facilities with several financial institutions. The Company also had $88.1 million in unpledged securities available at June 30, 2010. The loan to deposit ratio improved to 90.39% at June 30, 2010, compared to 99.84% at June 30, 2009, and 98.24% at December 31, 2009.

Lending

        Our lending business originates primarily through our branch offices located in our primary market. The Company also has SBA loan production offices in Sacramento, Oakland and Santa Rosa, California. As a result of the weakened economy in our primary service area throughout 2009 and the first half of 2010 and loan payoffs, we have seen a contraction in our loan portfolio during the first six months of 2010. At June 30, 2010, commercial and industrial loans accounted for 41% of the total loan portfolio. Commercial real estate loans accounted for another 40% of the total loan portfolio at June 30, 2010, of which 51% were owner occupied by businesses. Land and construction loans continued to decrease and accounted for 12% of the total loan portfolio, and consumer and home equity loans accounted for the remaining 7% of total loans at June 30, 2010.

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Net Interest Income

        The management of interest income and expense is fundamental to the performance of the Company. Net interest income, the difference between interest income and interest expense, is the largest component of the Company's total revenue. Management closely monitors both total net interest income and the net interest margin (net interest income divided by average earning assets).

        Because of our focus on commercial lending to closely held businesses, the Company will continue to have a high percentage of floating rate loans and other assets. Given the current volume, mix and repricing characteristics of our interest-bearing liabilities and interest-earning assets, we believe our interest rate spread is expected to increase in a rising rate environment, and decrease in a declining interest rate environment.

        The Company, through its asset and liability policies and practices, seeks to maximize net interest income without exposing the Company to an excessive level of interest rate risk. Interest rate risk is managed by monitoring the pricing, maturity and repricing options of all classes of interest bearing assets and liabilities. This is discussed in more detail under Liquidity and Asset/Liability Management.

        From January 22, 2008 through December 16, 2008, the Board of Governors of the Federal Reserve System reduced short-term interest rates by 325 basis points. This decrease in short-term rates immediately affected the rates applicable to the majority of the Company's loans. While the decrease in interest rates also lowered the cost of interest bearing deposits, which represents the Company's primary funding source, these deposits tend to price more slowly than floating rate loans, which resulted in compression of the Company's net interest margin. The Company's net interest margin expanded in the first half of 2010, as the costs of deposits and borrowings have continued to decline.

        The net interest margin is also impacted by the reversal of interest on nonaccrual loans, and the reinvestment of loan payoffs into lower yielding investment securities and other short-term investments.

Management of Credit Risk

        We continue to proactively identify, quantify, and manage our problem loans. Early identification of problem loans and potential future losses helps enable us to resolve credit issues with potentially less risk and ultimate losses. We maintain an allowance for loan losses in an amount that we believe is adequate to absorb probable incurred losses in the portfolio. While we strive to carefully manage and monitor credit quality and to identify loans that may be deteriorating, circumstances can change at any time for loans included in the portfolio that may result in future losses, that as of the date of the financial statements have not yet been identified as potential problem loans. Through established credit practices, we adjust the allowance for loan losses accordingly. However, because future events are uncertain, there may be loans that deteriorate some of which could occur in an accelerated time frame. As a result, future additions to the allowance may be necessary. Because the loan portfolio contains a number of commercial loans, commercial real estate, construction and land development loans with relatively large balances, deterioration in the credit quality of one or more of these loans may require a significant increase to the allowance for loan losses. Future additions to the allowance may also be required based on changes in the financial condition of borrowers, such as have resulted due to the current, and potentially worsening, economic conditions. Additionally, Federal and state banking regulators, as an integral part of their supervisory function, periodically review our allowance for loan losses. These regulatory agencies may require us to recognize further loan loss provisions or charge-offs based upon their judgments, which may be different from ours. Any increase in the allowance for loan losses would have an adverse effect, which may be material, on our financial condition and results of operation.

        Further discussion of the management of credit risk appears under "Provision for Loan Losses" and "Allowance for Loan Losses."

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Noninterest Income

        While net interest income remains the largest single component of total revenues, noninterest income is an important component. Prior to the third quarter of 2007, a significant percentage of the Company's noninterest income was associated with its SBA lending activity, consisting of gains on the sale of loans sold in the secondary market and servicing income from loans sold with servicing retained. From the third quarter of 2007 through the second quarter of 2009, the Company retained its SBA production. In the third quarter of 2009, the Company began to again sell loans in the secondary market. During the first quarter of 2010, $3.9 million of SBA loans were transferred to third parties, which were subject to a 90 day SBA warranty. The Company adopted new accounting guidance in the first quarter of 2010 that requires the Company to treat the SBA loans sold as secured borrowings during the warranty period. The warranty period for loans transferred in the first quarter of 2010 expired in the second quarter of 2010, and resulted in a gain on sale of loans of $163,000. Additionally, $4.0 million of SBA loans have been transferred to third parties during the second quarter of 2010. Provided the loans remain current through the end of the warranty period, all elements necessary to record the sale will have been met. The Company has deferred gains of $230,000 associated with these loans, which are included in other liabilities on the consolidated balance sheet. We expect to continue to sell loans in the secondary market in 2010 to enhance liquidity and improve noninterest income. Other sources of noninterest income include loan servicing fees, service charges and fees, and cash surrender value from company owned life insurance policies.

Noninterest Expense

        Management considers the control of operating expenses to be a critical element of the Company's performance. Over the last several quarters the Company has undertaken several initiatives to reduce its noninterest expense and improve its efficiency. Nonetheless, noninterest expense increased in the second quarter of 2010 compared to the second quarter of 2009, as a result of the goodwill impairment. Noninterest expense, including the $43.2 million impairment of goodwill, was $54.6 million for the second quarter of 2010, compared to $12.1 million in the second quarter of 2009.

Capital Management

        As part of its asset and liability process, the Company continually assesses its capital position to take into consideration growth, expected earnings, risk profile and potential corporate activities that it may choose to pursue.

        On June 21, 2010, the Company issued Series B Mandatorily Convertible Cumulative Perpetual Preferred Stock ("Series B Preferred Stock") and Series C Convertible Perpetual Preferred Stock ("Series C Preferred Stock") to a limited number of institutional investors for an aggregate amount of $75.0 million. HCC downstreamed $40 million of the proceeds from the private placement to the capital of HBC.

        At June 30, 2010, HBC's total risk-based capital ratio was 15.75%, compared to the 10% regulatory requirement for well-capitalized banks under the regulatory framework for prompt corrective actions. HBC's Tier 1 risk-based capital ratio of 14.49% and our leverage ratio of 11.68% at June 30, 2010 also exceeded regulatory guidelines for well-capitalized banks under the prompt corrective actions framework. On a consolidated basis, the Company has a leverage ratio of 8.65%, a Tier 1 risk-based capital ratio of 10.73%, and a total risk-based capital ratio of 18.66% at June 30, 2010.

        Under the Written Agreement we are required to obtain the prior approval of the Federal Reserve Bank of San Francisco and the Director of the Division of Banking Supervision and Regulation of the Federal Reserve to make any interest payments on our outstanding trust preferred securities and related subordinate debt, or to any dividends on our common stock or preferred stock.

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        Under the terms of the Capital Purchase Program with the U.S. Treasury, so long as our Series A Preferred Stock is outstanding, we are prohibited from increasing quarterly dividends on our common stock in excess of $0.08 per share, and from making certain repurchases of equity securities, including our common stock, without the U.S. Treasury consent until the third anniversary of the U.S. Treasury investment or until the U.S. Treasury has transferred all of the Series A Preferred Stock it purchased under the Capital Purchase Program to third parties. As long as the Series A Preferred Stock is outstanding, dividend payments and repurchases or redemptions relating to certain equity securities, including our common stock, the Series B Preferred Stock and the Series C Preferred Stock, are also prohibited until all accrued and unpaid dividends are paid on such preferred stock, subject to certain limited exceptions. On November 6, 2009, we suspended dividend payments on our Series A Preferred Stock. So long as dividends on the Series A Preferred Stock remain suspended, we may not, among other things and with limited exceptions, pay cash dividends on or repurchase our common stock or preferred stock.

        We have supported our growth through the issuance of trust preferred securities from special purpose trusts and accompanying sales of subordinated debt to these trusts. The subordinated debt that we issued to the trusts is senior to our shares of common stock, Series A Preferred Stock, Series B Preferred Stock and Series C Preferred Stock. As a result, we must make payments on the subordinated debt before any dividends can be paid on our common stock, Series A Preferred Stock, Series B Preferred Stock and Series C Preferred Stock. Under the terms of the subordinated debt, we may defer interest payments for up to five years. On November 6, 2009, we exercised our right to defer regularly scheduled interest payments on our outstanding $23.7 million of subordinated debt relating to our trust preferred securities. So long as interest payments remain deferred, we may not pay cash dividends on or repurchase our common stock or preferred stock.

        We may not pay dividends on our common stock until all accrued and unpaid dividends have been paid on our Series B Preferred Stock. The Series B Preferred stock will convert automatically and no longer be outstanding upon shareholder approval of the conversion of the Series B Preferred Stock. Prior to the shareholder approval of the conversion of the Series C Preferred Stock, we may not pay dividends on our common stock until all accrued and unpaid dividends have been paid on our Series C Preferred Stock.

        At such time as we become current with the dividends payable on our preferred stock and interest payments on our trust preferred securities and related subordinated debt, the decision whether to pay dividends will be made by our board of directors in light of conditions then existing, including factors such as our results of operations, financial condition, business conditions, regulatory capital requirements and covenants under any applicable contractual arrangements, including agreements with regulatory authorities.

RESULTS OF OPERATIONS

        The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on interest-bearing liabilities. The second is noninterest income, which primarily consists of gains on the sale of loans, loan servicing fees, customer service charges and fees, the increase in cash surrender value of life insurance, and gains on the sale of securities. The majority of the Company's noninterest expenses are operating costs that relate to providing a full range of banking services to our customers.

Net Interest Income and Net Interest Margin

        The level of net interest income depends on several factors in combination, including yields on earning assets, the cost of interest-bearing liabilities, the relative volumes of earning assets and interest-bearing liabilities, and the mix of products which comprise the Company's earning assets, deposits, and other interest-bearing liabilities. To maintain its net interest margin, the Company must manage the relationship between interest earned and paid.

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        The following Distribution, Rate and Yield table presents the average amounts outstanding for the major categories of the Company's balance sheet, the average interest rates earned or paid thereon, and the resulting net interest margin on average interest earning assets for the periods indicated. Average balances are based on daily averages.

Distribution, Rate and Yield

 
  For the Three Months Ended
June 30, 2010
  For the Three Months Ended
June 30, 2009
 
NET INTEREST INCOME AND
NET INTEREST MARGIN
  Average
Balance
  Interest
Income/
Expense
  Average
Yield/
Rate
  Average
Balance
  Interest
Income/
Expense
  Average
Yield/
Rate
 
 
  (Dollars in thousands)
 

Assets:

                                     

Loans, gross(1)

  $ 1,002,987   $ 12,737     5.09 % $ 1,206,479   $ 14,862     4.94 %

Securities

    151,875     1,459     3.85 %   107,158     958     3.59 %

Federal funds sold

    100         0.00 %   139         0.00 %

Interest-bearing deposits in other financial institutions

    26,970     16     0.24 %   6,828     4     0.23 %
                               
 

Total interest earning assets

    1,181,932     14,212     4.82 %   1,320,604     15,824     4.81 %
                                   

Cash and due from banks

    34,875                 23,090              

Premises and equipment, net

    8,825                 9,380              

Goodwill and other intangible assets

    46,088                 47,189              

Other assets

    61,207                 56,899              
                                   
 

Total assets

  $ 1,332,927               $ 1,457,162              
                                   

Liabilities and shareholders' equity:

                                     

Deposits:

                                     

Demand, interest-bearing

  $ 150,565     83     0.22 % $ 134,141     79     0.24 %

Savings and money market

    294,628     363     0.49 %   346,847     662     0.77 %

Time deposits—under $100

    38,514     133     1.39 %   44,612     259     2.33 %

Time deposits—$100 and over

    132,062     470     1.43 %   169,954     718     1.69 %

Time deposits—CDARS

    18,849     48     1.02 %   12,124     42     1.39 %

Time deposits—brokered

    177,184     1,060     2.40 %   187,531     1,634     3.49 %

Subordinated debt

    23,702     468     7.92 %   23,702     487     8.24 %

Securities sold under agreement to repurchase

    20,000     113     2.27 %   30,000     227     3.03 %

Short-term borrowings

    5,393     46     3.42 %   43,099     27     0.25 %
                               
 

Total interest-bearing liabilities

    860,897     2,784     1.30 %   992,010     4,135     1.67 %
                                   

Demand, noninterest bearing

    258,902                 255,011              

Other liabilities

    34,961                 28,745              
                                   
 

Total liabilities

    1,154,760                 1,275,766              

Shareholders' equity

    178,167                 181,396              
                                   
 

Total liabilities and shareholders' equity

  $ 1,332,927               $ 1,457,162              
                                   

Net interest income / margin

        $ 11,428     3.88 %       $ 11,689     3.55 %
                                   

(1)
Includes loans held-for-sale. Yields and amounts earned on loans include loan fees and costs. Nonaccrual loans are included in the average balance calculation above.

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  For the Six Months Ended
June 30, 2010
  For the Six Months Ended
June 30, 2009
 
 
  Average
Balance
  Interest
Income/
Expense
  Average
Yield/
Rate
  Average
Balance
  Interest
Income/
Expense
  Average
Yield/
Rate
 
 
  (Dollars in thousands, unaudited)
 

Assets:

                                     

Loans, gross(1)

  $ 1,033,270   $ 25,911     5.06 % $ 1,221,329   $ 29,892     4.94 %

Securities

    138,190     2,622     3.83 %   108,655     1,957     3.63 %

Federal funds sold

    101         0.00 %   157         0.00 %

Interest-bearing deposits in other financial institutions

    22,286     26     0.24 %   6,021     8     0.27 %
                               
 

Total interest earning assets

    1,193,847     28,559     4.82 %   1,336,162     31,857     4.81 %
                                 

Cash and due from banks

    27,977                 23,786              

Premises and equipment, net

    8,891                 9,424              

Goodwill and other intangible assets

    46,400                 47,269              

Other assets

    66,286                 54,141              
                                   
 

Total assets

  $ 1,343,401               $ 1,470,782              
                                   

Liabilities and shareholders' equity:

                                     

Deposits:

                                     
   

Demand, interest-bearing

  $ 149,966     169     0.23 % $ 135,223     178     0.27 %
   

Savings and money market

    298,111     762     0.52 %   346,851     1,454     0.85 %
   

Time deposits—under $100

    39,036     281     1.45 %   45,356     555     2.47 %
   

Time deposits—$100 and Over

    132,215     968     1.48 %   173,377     1,592     1.85 %
   

Time deposits—CDARS

    19,110     101     1.07 %   11,479     89     1.56 %
   

Time deposits—brokered

    177,301     2,240     2.55 %   190,312     3,556     3.77 %

Subordinated debt

    23,702     934     7.95 %   23,702     987     8.40 %

Securities sold under agreement to repurchase

    21,354     244     2.30 %   31,354     469     3.02 %

Note payable

            N/A     5,110     82     3.24 %

Short-term borrowings

    13,064     63     0.97 %   41,370     54     0.26 %
                               
 

Total interest-bearing liabilities

    873,859     5,762     1.33 %   1,004,134     9,016     1.81 %
                                   

Demand, noninterest bearing

    256,671                 254,250              

Other liabilities

    36,882                 28,997              
                                   
 

Total liabilities

    1,167,412                 1,287,381              

Shareholders' equity

    175,989                 183,401              
                                   
 

Total liabilities and shareholders' equity

  $ 1,343,401               $ 1,470,782              
                                   

Net interest income / margin

        $ 22,797     3.85 %       $ 22,841     3.45 %
                                   

(1)
Includes loans held-for-sale. Yields and amounts earned on loans include loan fees and costs. Nonaccrual loans are included in the average balance calculation above.

Volume and Rate Variances

        The Volume and Rate Variances table below sets forth the dollar difference in interest earned and paid for each major category of interest-earning assets and interest-bearing liabilities for the noted periods, and the amount of such change attributable to changes in average balances (volume) or changes in average interest rates. Volume variances are equal to the increase or decrease in the average

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balance times the prior period rate, and rate variances are equal to the increase or decrease in the average rate times the prior period average balance. Variances attributable to both rate and volume changes are equal to the change in rate times the change in average balance and are included below in the average volume column.

 
  Three Months Ended June 30,
2010 vs. 2009
Increase (Decrease)
Due to Change In:
 
 
  Average
Volume
  Average
Rate
  Net
Change
 
 
  (Dollars in thousands)
 

Income from interest earning assets:

                   
 

Loans, gross

  $ (2,573 ) $ 448   $ (2,125 )
 

Securities

    430     71     501  
 

Federal funds sold

             
 

Interest-bearing deposits in other financial institutions

    12         12  
               

Total interest income from interest earnings assets

  $ (2,131 ) $ 519   $ (1,612 )
               

Expense on interest-bearing liabilities:

                   
 

Demand, interest-bearing

  $ 9   $ (5 ) $ 4  
 

Savings and money market

    (61 )   (238 )   (299 )
 

Time deposits—under $100

    (22 )   (104 )   (126 )
 

Time deposits—$100 and over

    (136 )   (112 )   (248 )
 

Time deposits—CDARS

    17     (11 )   6  
 

Time deposits—brokered

    (62 )   (512 )   (574 )
 

Subordinated debt

        (19 )   (19 )
 

Securities sold under agreement to repurchase

    (57 )   (57 )   (114 )
 

Short-term borrowings

    (321 )   340     19  
               

Total interest expense on interest-bearing liabilities

  $ (633 ) $ (718 ) $ (1,351 )
               

Net interest income

  $ (1,498 ) $ 1,237   $ (261 )
               

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  Six Months Ended June 30,
2010 vs. 2009
Increase (Decrease)
Due to Change In:
 
 
  Average
Volume
  Average
Rate
  Net
Change
 
 
  (Dollars in thousands)
 

Income from interest earning assets:

                   
 

Loans, gross

  $ (4,735 ) $ 754   $ (3,981 )
 

Securities

    558     107     665  
 

Federal funds sold

             
 

Interest-bearing deposits in other financial institutions

    19     (1 )   18  
               

Total interest income from interest earnings assets

  $ (4,158 ) $ 860   $ (3,298 )
               

Expense on interest-bearing liabilities:

                   
 

Demand, interest-bearing

  $ 15   $ (24 ) $ (9 )
 

Savings and money market

    (132 )   (560 )   (692 )
 

Time deposits—under $100

    (45 )   (229 )   (274 )
 

Time deposits—$100 and over

    (304 )   (320 )   (624 )
 

Time deposits—CDARS

    40     (28 )   12  
 

Time deposits—brokered

    (167 )   (1,149 )   (1,316 )
 

Subordinated debt

        (53 )   (53 )
 

Securities sold under agreement to repurchase

    (114 )   (111 )   (225 )
 

Note payable

        (82 )   (82 )
 

Short-term borrowings

    (136 )   145     9  
               

Total interest expense on interest-bearing liabilities

  $ (843 ) $ (2,411 ) $ (3,254 )
               

Net interest income

  $ (3,315 ) $ 3,271   $ (44 )
               

        The Company's net interest margin, expressed as a percentage of average earning assets, increased to 3.88% and 3.85% for the second quarter and six months ended June 30, 2010 compared to 3.55% and 3.45% for the same periods in 2009, respectively. A substantial portion of the Company's earning assets are variable-rate loans that re-price when the Company's prime lending rate is changed, versus a large base of core deposits that are generally slower to re-price. This causes the Company's balance sheet to be asset-sensitive, which means that all else being equal, the Company's net interest margin will be lower during periods when short-term interest rates are falling and higher when rates are rising.

        Net interest income in the second quarter of 2010 decreased to $11.4 million, or 2%, from $11.7 million in the second quarter of 2009. The decrease in 2010 was primarily due to a decrease in average loan volume, including loans held-for-sale, of $203.5 million. Net interest income in the first half of 2010 remained relatively the same as the first half of 2009 at $22.8 million.

Provision for Loan Losses

        Credit risk is inherent in the business of making loans. The Company establishes an allowance for loan losses through charges to earnings, which are shown in the statements of operations as the provision for loan losses. Specifically identifiable and quantifiable known losses are promptly charged off against the allowance. The provision for loan losses is determined by conducting a quarterly evaluation of the adequacy of the Company's allowance for loan losses and charging the shortfall, if any, to the current quarter's expense. This has the effect of creating variability in the amount and frequency of charges to the Company's earnings. The provision for loan losses and level of allowance for each period are dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management's assessment of the quality of the loan portfolio, the valuation of problem loans and the general economic conditions in the Company's market area.

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        The Company had a provision for loan losses of $18.6 million for the quarter ended June 30, 2010 and $23.7 million for the six months ended June 30, 2010. The Company had a provision for loan losses of $10.7 million for the quarter ended June 30, 2009 and $21.1 million for the six months ended June 30, 2009.

        Provisions for loan losses are charged to operations to bring the allowance for loan losses to a level deemed appropriate by the Company based on the factors discussed under "Allowance for Loan Losses."

Noninterest Income

        The following table sets forth the various components of the Company's noninterest income for the periods indicated:

 
  For the
Three Months
Ended
June 30,
  Increase (decrease)
2010 versus 2009
 
  2010   2009   Amount   Percent
 
  (Dollars in thousands)

Noninterest income:

                     
 

Service charges and fees on deposit accounts

  $ 579   $ 537   $ 42   8%
 

Servicing income

    425     408     17   4%
 

Increase in cash surrender value of life insurance

    413     415     (2 ) 0%
 

Gain on sale of loans

    163         163   N/A
 

Other

    298     241     57   24%
                 

Total noninterest income

  $ 1,878   $ 1,601   $ 277   17%
                 

 

 
  For the
Six Months
Ended
June 30,
  Increase (decrease)
2010 versus 2009
 
  2010   2009   Amount   Percent
 
  (Dollars in thousands)

Noninterest income:

                     
 

Service charges and fees on deposit accounts

  $ 1,128   $ 1,108   $ 20   2%
 

Servicing income

    846     828     18   2%
 

Increase in cash surrender value of life insurance

    822     827     (5 ) -1%
 

Gain on sale of loans

    277         277   N/A
 

Other

    489     461     28   6%
                 

Total noninterest income

  $ 3,562   $ 3,224   $ 338   10%
                 

        The increase in noninterest income in the second quarter and first half of 2010 compared to the same periods in 2009 was primarily attributable to the gain on sale of loans. Other sources of noninterest income include loan servicing fees, service charges and fees, and the cash surrender value from company owned life insurance policies.

        Historically, a significant percentage of the Company's noninterest income has been associated with its SBA lending activity, as gains on the sale of loans sold in the secondary market and servicing income from loans sold with servicing rights retained. From the third quarter of 2007 through the second quarter of 2009, the Company changed its strategy regarding its SBA loan business by retaining new SBA production in lieu of selling the loans. Reflecting the strategic shift to retain SBA loan production, there were no gains from sales of loans during 2008 and for the first six months of 2009. During the first six months of 2010, loans were sold resulting in a gain on sale of $277,000.

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        The servicing assets that result from the sale of SBA loans, with servicing retained, are amortized over the expected term of the loans using a method approximating the interest method. Servicing income generally declines as the respective loans are repaid.

        The increase in cash surrender value of life insurance approximates a 3.94% after tax yield on the policies. To realize this tax advantaged yield, the policies must be held until death of the insured individuals, who are current and former officers and directors of the Company.

Noninterest Expense

        The following table sets forth the various components of the Company's noninterest expense for the periods indicated:

 
  For the
Three Months
Ended
June 30,
  Increase (decrease)
2010 versus 2009
 
  2010   2009   Amount   Percent
 
  (Dollars in thousands)

Noninterest Expense:

                     
 

Salaries and employee benefits

  $ 5,491   $ 5,643   $ (152 ) -3%
 

Professional fees

    1,144     1,229     (85 ) -7%
 

FDIC deposit insurance premiums

    1,019     1,220     (201 ) -16%
 

Occupancy and equipment

    983     972     11   1%
 

Insurance expense

    269     131     138   105%
 

Software subscription

    252     217     35   16%
 

Data processing

    219     260     (41 ) -16%
 

Low income housing investment losses

    133     210     (77 ) -37%
 

Other real estate owned expense

    69     107     (38 ) -36%
 

Impairment of goodwill

    43,181         43,181   N/A
 

Other

    1,792     2,091     (299 ) -14%
                 

Total noninterest expense

  $ 54,552   $ 12,080   $ 42,472   352%
                 

 

 
  For the
Six Months
Ended
June 30,
  Increase (decrease)
2010 versus 2009
 
  2010   2009   Amount   Percent
 
  (Dollars in thousands)

Noninterest Expense:

                     
 

Salaries and employee benefits

  $ 11,373   $ 12,101   $ (728 ) -6%
 

Professional fees

    2,421     2,142     279   13%
 

FDIC deposit insurance premiums

    2,210     1,959     251   13%
 

Occupancy and equipment

    1,942     1,888     54   3%
 

Insurance expense

    525     190     335   176%
 

Software subscription

    486     413     73   18%
 

Data processing

    430     489     (59 ) -12%
 

Low income housing investment losses

    358     424     (66 ) -16%
 

Other real estate owned expense

    488     170     318   187%
 

Impairment of goodwill

    43,181         43,181   N/A
 

Other

    3,337     3,666     (329 ) -9%
                 

Total noninterest expense

  $ 66,751   $ 23,442   $ 43,309   185%
                 

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        Salaries and employee benefits, the single largest component of noninterest expense, decreased $152,000, or 3%, for the second quarter of 2010 and $728,000, or 6%, for the first six months of 2010, compared to the same periods in 2009, primarily due to a reduction in workforce implemented in the fourth quarter of 2009. Full-time equivalent employees were 202 and 217 at June 30, 2010 and 2009, respectively.

        Professional fees decreased $85,000, or 7% for the quarter ended June 30, 2010 and increased $279,000 or 13% for the six months ended June 30, 2010, from the same periods a year ago. The increase in professional fees in the first six months of 2010 compared to the same period in 2009 was primarily due to legal fees related to loan workouts and increased expenses for bank regulatory compliance.

        FDIC deposit insurance premiums decreased $201,000, or 16%, for the quarter ended June 30, 2010 compared to the same period in 2009, mainly due to a $657,000 charge for the FDIC special assessment in the second quarter of 2009, partially offset by an increase in the FDIC deposit assessment rate. FDIC deposit insurance premiums increased $251,000, or 13%, for the six months ended June 30, 2010 compared to the same period in 2009, primarily due to an increase in the FDIC deposit assessment rate.

        Insurance expense increased $138,000, or 105%, for the quarter ended June 30, 2010 and increased $335,000, or 176%, for the six months ended June 30, 2010 from the same periods in 2009, primarily due to an increase in the directors and officers insurance premiums.

        OREO expense decreased $38,000, or 36% in the second quarter of 2010, compared to the same period in 2009. For the six months ended June 30, 2010, OREO expense increased $318,000, or 187%, compared to the same period in 2009, primarily due to the write-down of an OREO property in the first quarter of 2010.

        Due to the continued depressed economic conditions and the length of time and amount by which the Company's book value exceeded market value per share, and the Company's closing of the private placement at a conversion price of $3.75 per share, the Company determined the entire $43.2 million of goodwill related to the acquisition of Diablo Valley Bank was impaired during the second quarter of 2010.

Income Tax Expense

        The Company computes its provision for income taxes on a monthly basis. The effective tax rate is determined by applying the Company's statutory income tax rates to pre-tax book income as adjusted for permanent differences between pre-tax book income and actual taxable income. These permanent differences include, but are not limited to, tax-exempt interest income, increases in the cash surrender value of life insurance policies, California Enterprise Zone deductions, certain expenses that are not allowed as tax deductions, and tax credits.

        The Company's Federal and state income tax benefit for the quarter and six months ended 2010 was $5.8 million and $5.9 million, respectively, which included $3.7 million of additional income tax expense to establish a partial valuation allowance on the Company's net deferred tax asset. The income tax benefit was $4.1 million and $9.2 million for the same periods in 2009. The following table shows the effective income tax rates for the second quarter and first six months of 2010 and 2009:

 
  For the
Three Months
Ended
June 30,
  For the
Six Months
Ended
June 30,
 
 
  2010   2009   2010   2009  

Effective income tax rate

    -9.6 %   -43.3 %   -9.2 %   -49.5 %

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        The difference in the effective tax rate compared to the combined Federal and state statutory tax rate of 42% is primarily the result of the Company's investment in life insurance policies whose earnings are not subject to taxes and tax credits related to investments in low income housing limited partnerships.

        The Company has total investments of $5.1 million in low-income housing limited partnerships as of June 30, 2010. These investments have generated annual tax credits of approximately $1.1 million in each of the years ended December 31, 2009 and 2008.

        Some items of income and expense are recognized in different years for tax purposes than when applying generally accepted accounting principles, leading to timing differences between the Company's actual tax liability and the amount accrued for this liability based on book income. These temporary differences comprise the "deferred" portion of the Company's tax expense or benefit, which is accumulated on the Company's books as a deferred tax asset or deferred tax liability until such time as they reverse. At June 30, 2010, the Company had a net deferred tax asset of approximately $24.6 million, compared to $21.7 million at June 30, 2009, and $22.4 million at December 31, 2009.

        Realization of the Company's deferred tax assets is primarily dependent upon the Company generating sufficient taxable income to obtain benefit from the reversal of net deductible temporary differences and utilization of tax credit carryforwards and the net operating loss carryforwards for California state income tax purposes. The amount of deferred tax assets considered realizable is subject to adjustment in future periods based on estimates of future taxable income. Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is "more likely than not" that a deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management's evaluation of both positive and negative evidence, including forecasts of future income, cumulative losses, applicable tax planning strategies, and assessments of current and future economic and business conditions. At June 30, 2010, the Company determined a partial valuation allowance on the state of California net deferred tax asset was necessary, largely based on the negative evidence represented by a cumulative loss in the Company's most recent three-year period caused by the loan loss provisions recorded during the periods. The $5.9 million income tax benefit for the six months ended June 30, 2010 is net of $3.7 million of income tax expense to establish the partial valuation allowance. Management is required to re-evaluate the deferred tax asset and the related valuation allowance quarterly.

        The net recorded deferred tax asset, after the partial valuation allowance, was $24.6 million at June 30, 2010. The remaining deferred tax asset was supported by available tax planning strategies and projected future taxable income.

FINANCIAL CONDITION

        As of June 30, 2010, total assets were $1.30 billion, compared to $1.44 billion as of June 30, 2009 and $1.36 billion as of December 31, 2009. Total securities available-for-sale (at fair value) were $142.2 million, a increase of 40% from $101.8 million the year before. The total loan portfolio (excluding loans held-for-sale) was $937.8 million, a decrease of 19% from $1.16 billion at June 30, 2009, and a decrease of 12% from $1.07 billion at December 31, 2009. Total deposits decreased 11% to $1.04 billion at June 30, 2010, from $1.16 million at June 30, 2009, and decreased 5% from $1.09 billion at December 31, 2009. Securities sold under agreement to repurchase decreased $10 million, or 33%, to $20.0 million at June 30, 2010, from $30.0 million at June 30, 2009 and decreased 20% from $25.0 million at December 31, 2009. In addition, short-term borrowings decreased 73% to $4.0 million at June 30, 2010, from $15.0 million at June 30, 2009, and decreased 80% from $20.0 million at December 31, 2009.

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Securities Portfolio

        The following table reflects the estimated fair values for each category of securities at the dates indicated:

 
  June 30,    
 
 
  December 31,
2009
 
 
  2010   2009  
 
  (Dollars in thousands)
 

Securities available-for-sale (at fair value)

                   
 

U.S. Treasury

  $   $ 29,494   $  
 

U.S. Government Sponsored Entities

    2,002     6,574     1,973  
 

Mortgage-Backed Securities—Residential

    136,692     59,621     102,546  
 

Municipals—Tax Exempt

        326      
 

Collateralized Mortgage Obligations—Residential

    3,518     5,822     5,447  
               

Total

  $ 142,212   $ 101,837   $ 109,966  
               

        The following table summarizes the weighted average life and weighted average yields of securities at June 30, 2010:

 
  Weighted Average Life  
 
  Within
One Year
  After One
and Within
Five Years
  After Five
and Within
Ten Years
  After
Ten Years
  Total  
 
  Amount   Yield   Amount   Yield   Amount   Yield   Amount   Yield   Amount   Yield  
 
  (Dollars in thousands)
 

Securities available-for-sale (at fair value)

                                                             
 

U.S. Government Sponsored Entities

  $ 2,002     2.20 % $       $       $       $ 2,002     2.20 %
 

Mortgage-Backed Securities—Residential

    8     5.89 %   33,992     4.42 %   99,434     3.68 %   3,258     5.05 %   136,692     3.90 %
 

Collateralized Mortgage Obligations—Residential

    2,645     5.12 %   873     6.47 %                   3,518     5.46 %
                                                     
   

Total

  $ 4,655     3.87 % $ 34,865     4.47 % $ 99,434     3.68 % $ 3,258     5.05 % $ 142,212     3.91 %
                                                     

        The securities portfolio is the second largest component of the Company's interest-earning assets, and the structure and composition of this portfolio is important to any analysis of the financial condition of the Company. The portfolio serves the following purposes: (i) it provides a source of pledged assets for securing certain deposits and borrowed funds, as may be required by law or by specific agreement with a depositor or lender; (ii) it can be used as an interest rate risk management tool, since it provides a large base of assets, the maturity and interest rate characteristics of which can be changed more readily than the loan portfolio to better match changes in the deposit base and other funding sources of the Company; and (iii) it is an alternative interest-earning use of funds when loan demand is weak or when deposits grow more rapidly than loans.

        The Company's securities are all currently classified under existing accounting rules as "available-for-sale" to allow flexibility for the management of the portfolio. Accounting guidance requires available-for-sale securities to be marked to fair value with an offset to accumulated other comprehensive income (loss), a component of shareholders' equity. Monthly adjustments are made to reflect changes in the fair value of the Company's available-for-sale securities.

        The Company's portfolio is historically comprised primarily of: (i) U.S. Treasury securities and U.S. Government sponsored entities' debt securities for liquidity and pledging; (ii) mortgage-backed securities, which in many instances can also be used for pledging, and which generally enhance the yield of the portfolio; (iii) municipal obligations, which provide tax free income and limited pledging potential; and (iv) collateralized mortgage obligations, which generally enhance the yield of the portfolio.

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        In the second quarter of 2010, the securities portfolio increased by $40.4 million, or 40%, and increased to 11% of total assets at June 30, 2010 from 7% at June 30, 2009, and increased by $32.2 million, or 29%, from December 31, 2009. U.S. Treasury and U.S. Government sponsored entity securities decreased to 1% of the portfolio at June 30, 2010 from 35% at June 30, 2009 and 2% at December 31, 2009. The Company increased its holding of mortgage-back securities by $77.1 million to $136.7 million at June 30, 2010, from $59.6 million at June 30, 2009, and increased $34.1 million from $102.5 million at December 31, 2009 to take advantage of higher yields and offset a portion of the contraction in the loan portfolio. No securities of a single issuer exceeded 10% of shareholders' equity at June 30, 2010. The Company has not used interest rate swaps or other derivative instruments to hedge fixed rate loans or securities to otherwise mitigate interest rate risk.

Loans

        The Company's loans represent the largest portion of invested assets, substantially greater than the securities portfolio or any other asset category, and the quality and diversification of the loan portfolio is an important consideration when reviewing the Company's financial condition.

        Gross loans, excluding loans held-for-sale, represented 72% of total assets at June 30, 2010 and 81% at June 30, 2009 and represented 78% of total assets at December 31, 2009. The ratio of loans to deposits decreased to 90.39% at June 30, 2010 from 99.84% at June 30, 2009 and 98.24% at December 31, 2009. Demand for loans has weakened within the Company's markets due to the current economic environment.

        During the second quarter of 2010, the Company identified $31.0 million of real estate loans classified as substandard or substandard-nonaccrual that it intends to sell. The sale is expected to be finalized in the third quarter of 2010. These loans were written down to $17.1 million to reflect the estimated market value of the loans and this amount was transferred to loans held-for-sale. The write-down of these real estate loans resulted in net charge-offs of $13.9 million in the second quarter of 2010. The following table shows the detail of the real estate loans we intend to sell at June 30, 2010:

 
  Balance
Prior to
Transfer
  Amount
Charged-off
  Balance
Transferred
to Loans
Held-for-Sale
 
 
  (Dollars in thousands)
 

Realestate—mortgage

  $ 9,893   $ (2,781 ) $ 7,112  

Real estate—land and construction

    21,112     (11,145 )   9,967  
               
 

Total

  $ 31,005   $ (13,926 ) $ 17,079  
               

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Loan Distribution

        The Loan Distribution table that follows sets forth the Company's gross loans, excluding loans held-for-sale, outstanding and the percentage distribution in each category at the dates indicated:

 
  June 30, 2010   June 30, 2009   December 31, 2009  
 
  Balance   % to Total   Balance   % to Total   Balance   % to Total  
 
  (Dollars in thousands)
 

Commercial

  $ 388,471     41 % $ 457,981     39 % $ 427,177     40 %

Real estate—mortgage

    373,000     40 %   412,430     36 %   400,731     37 %

Real estate—land and construction

    110,194     12 %   230,798     20 %   182,871     17 %

Home equity

    52,419     6 %   55,372     5 %   51,368     5 %

Consumer

    12,837     1 %   3,596     0 %   7,181     1 %
                           
 

Total loans

    936,921     100 %   1,160,177     100 %   1,069,328     100 %

Deferred loan costs

    852         1,489         785      
                           
 

Loans, including deferred costs

    937,773     100 %   1,161,666     100 %   1,070,113     100 %
                                 

Allowance for loan losses

    (26,753 )         (31,398 )         (28,768 )      
                                 

Loans, net

  $ 911,020         $ 1,130,268         $ 1,041,345        
                                 

        The Company's loan portfolio is concentrated in commercial loans, primarily manufacturing, wholesale, and services, and real estate mortgage loans, with the balance in land development, construction and home equity and consumer loans. The decrease in the Company's loan portfolio in 2010 is due to diminished loan demand, and loan payoffs exceeding draw downs of loan commitments. The Company does not have any concentrations by industry or group of industries in its loan portfolio, however, 58% of its gross loans were secured by real property as of June 30, 2010, compared to 60% as of June 30, 2009, and 59% as of December 31, 2009. While no specific industry concentration is considered significant, the Company's lending operations are located in areas that are dependent on the technology and real estate industries and their supporting companies.

        The Company's commercial loans are made for working capital, financing the purchase of equipment or for other business purposes. Commercial loans include loans with maturities ranging from thirty days to one year and "term loans" with maturities normally ranging from one to five years. Short-term business loans are generally intended to finance current transactions and typically provide for periodic principal payments, with interest payable monthly. Term loans normally provide for floating interest rates, with monthly payments of both principal and interest.

        The Company is an active participant in the SBA and U.S. Department of Agriculture guaranteed lending programs, and has been approved by the SBA as a lender under the Preferred Lender Program. The Company regularly makes such guaranteed loans (collectively referred to as "SBA loans"). The guaranteed portion of these loans is typically sold in the secondary market depending on market conditions. When the guaranteed portion of an SBA loan is sold, the Company retains the servicing rights for the sold portion. During the first six months of 2010, loans were sold resulting in a gain on sale of $277,000.

        As of June 30, 2010, real estate mortgage loans of $373.0 million consist primarily of adjustable and fixed rate loans secured by deeds of trust on commercial property. The real estate mortgage loans at June 30, 2010 consist of $192.0 million, or 51%, of owner occupied properties, and $181.0 million, or 49%, of investment properties. Properties securing the commercial real estate mortgage loans are primarily located in the Company's primary market, which is the Greater San Francisco Bay Area.

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        The Company's real estate mortgage loans consist primarily of loans based on the borrower's cash flow and are secured by deeds of trust on commercial and residential property to provide a secondary source of repayment. The Company generally restricts real estate term loans to generally 75%, or less, of the property's appraised value or the purchase price of the property during the initial underwriting of the credit, depending on the type of property and its utilization. The Company offers both fixed and floating rate loans. Maturities on real estate mortgage loans are generally between five and ten years (with amortization ranging from fifteen to twenty-five years and a balloon payment due at maturity); however, SBA and certain other real estate loans that can be sold in the secondary market may be granted for longer maturities.

        The Company's land and construction loans are primarily to finance the development/construction of commercial and single family residential properties. The Company utilizes underwriting guidelines to assess the likelihood of repayment from sources such as sale of the property or availability of permanent mortgage financing prior to making the construction loan. Land and construction loans decreased $120.6 million to $110.2 million, or 12% of total loans at June 30, 2010, from $230.8 million, or 20% of total loans at June 30, 2009, and decreased $72.7 million from $182.9 million, or 17% of total loans at December 31, 2009.

        The Company makes consumer loans for the purpose of financing automobiles, various types of consumer goods, and other personal purposes. Consumer loans generally provide for the monthly payment of principal and interest. Most of the Company's consumer loans are secured by the personal property being purchased or, in the instances of home equity loans or lines, real property.

        Additionally, the Company makes home equity lines of credit available to its existing customers. Home equity lines of credit are underwritten with a maximum 70% loan to value ratio. Home equity lines are reviewed at least semiannually, with specific emphasis on loans with a loan to value ratio greater than 70% and loans that were underwritten from mid-2005 through 2008, when real estate values were at the peak in the cycle. The Company takes measures to work with customers to reduce line commitments and minimize potential losses.

        With certain exceptions, state chartered banks are permitted to make extensions of credit to any one borrowing entity up to 15% of the bank's capital and reserves for unsecured loans and up to 25% of the bank's capital and reserves for secured loans. For HBC, these lending limits were $30.3 million and $50.4 million at June 30, 2010, respectively.

Loan Maturities

        The following table presents the maturity distribution of the Company's loans (excluding loans held-for-sale) as of June 30, 2010. The table shows the distribution of such loans between those loans with predetermined (fixed) interest rates and those with variable (floating) interest rates. Floating rates generally fluctuate with changes in the prime rate as reflected in the Western Edition of The Wall

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Street Journal. As of June 30, 2010, approximately 69% of the Company's loan portfolio consisted of floating interest rate loans.

 
  Due in
One Year
or Less
  Over One
Year But
Less than
Five Years
  Over
Five Years
  Total  
 
  (Dollars in thousands)
 

Commercial

  $ 346,938   $ 40,737   $ 796   $ 388,471  

Real estate—mortgage

    130,661     196,853     45,486     373,000  

Real estate—land and construction

    96,104     14,090         110,194  

Home equity

    50,453         1,966     52,419  

Consumer

    12,141     696         12,837  
                   
 

Loans

  $ 636,297   $ 252,376   $ 48,248   $ 936,921  
                   

Loans with variable interest rates

  $ 575,759   $ 72,215   $ 704   $ 648,678  

Loans with fixed interest rates

    60,539     180,161     47,543     288,243  
                   
 

Loans

  $ 636,298   $ 252,376   $ 48,247   $ 936,921  
                   

Loan Servicing

        As of June 30, 2010 and 2009, $166.1 million and $141.7 million, respectively, in SBA loans were serviced by the Company for others. Activity for loan servicing rights was as follows:

 
  For the Three
Months Ended
June 30,
  For the Six
Months Ended
June 30,
 
 
  2010   2009   2010   2009  
 
  (Dollars in thousands)
 

Beginning of period balance

  $ 1,034   $ 867   $ 1,067   $ 1,013  

Additions

    48         129      

Amortization

    (126 )   (122 )   (240 )   (268 )
                   

End of period balance

  $ 956   $ 745   $ 956   $ 745  
                   

        Loan servicing rights are included in Accrued Interest and Other Assets on the consolidated balance sheets and reported net of amortization. There was no valuation allowance as of June 30, 2010 and 2009, as the fair market value of the assets was greater than the carrying value.

        Activity for the I/O strip receivable was as follows:

 
  For the Three
Months Ended
June 30,
  For the Six
Months Ended
June 30,
 
 
  2010   2009   2010   2009  
 
  (Dollars in thousands)
 

Beginning of period balance

  $ 2,015   $ 2,252   $ 2,116   $ 2,247  

Additions

                 

Amortization

    (57 )   (85 )   (129 )   (189 )

Unrealized holding gain (loss)

    102     (56 )   73     53  
                   

End of period balance

  $ 2,060   $ 2,111   $ 2,060   $ 2,111  
                   

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Nonperforming Assets

        Financial institutions generally have a certain level of exposure to credit quality risk, and could potentially receive less than a full return of principal and interest if a debtor becomes unable or unwilling to repay. Since loans are the most significant assets of the Company and generate the largest portion of its revenues, the Company's management of credit quality risk is focused primarily on loan quality. Banks have generally suffered their most severe earnings declines as a result of customers' inability to generate sufficient cash flow to service their debts and/or downturns in national and regional economies and declines in overall asset values including real estate. In addition, certain debt securities that the Company may purchase have the potential of declining in value if the obligor's financial capacity to repay deteriorates.

        The policies and procedures identify market segments, set goals for portfolio growth or contraction, and establish limits on industry and geographic credit concentrations. In addition, these policies establish the Company's underwriting standards and the methods of monitoring ongoing credit quality. The Company's internal credit risk controls are centered in underwriting practices, credit granting procedures, training, risk management techniques, and familiarity with loan customers as well as the relative diversity and geographic concentration of our loan portfolio.

        The Company's credit risk may also be affected by external factors such as the level of interest rates, employment, general economic conditions, real estate values, and trends in particular industries or geographic markets. As an independent community bank serving a specific geographic area, the Company must contend with the unpredictable changes in the general California market and, particularly, primary local markets. The Company's asset quality has suffered in the past from the impact of national and regional economic recessions, consumer bankruptcies, and depressed real estate values.

        Nonperforming assets are comprised of the following: loans and loans held-for-sale for which the Company is no longer accruing interest; restructured loans; loans 90 days or more past due and still accruing interest (although they are generally placed on nonaccrual when they become 90 days past due, unless they are both well-secured and in the process of collection); and OREO from foreclosures. Management's classification of a loan as "nonaccrual" is an indication that there is reasonable doubt as to the full recovery of principal or interest on the loan. At that point, the Company stops accruing interest income, reverses any uncollected interest that had been accrued as income. The Company begins recognizing interest income only as cash interest payments are received and it has been determined the collection of all outstanding principal is not in doubt. The loans may or may not be collateralized, and collection efforts are pursued. Loans may be restructured by management when a borrower has experienced some change in financial status causing an inability to meet the original repayment terms and where the Company believes the borrower will eventually overcome those circumstances and make full restitution. OREO consists of properties acquired by foreclosure or similar means that management is offering or will offer for sale. Total OREO was $555,000 at June 30, 2010, compared to $3.1 million at June 30, 2009.

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        The following table summarizes the Company's nonperforming assets at the dates indicated:

 
  June 30,    
 
 
  December 31,
2009
 
 
  2010   2009  
 
  (Dollars in thousands)
 

Nonaccrual loans—held-for-sale portfolio

  $ 9,806   $   $  

Nonaccrual loans—held-for-investment portfolio

    47,263     57,889     59,480  

Restructured and loans 90 days past due and still accruing

    2,516     786     2,895  
               
 

Total nonperforming loans

    59,585     58,675     62,375  

Other real estate owned

    555     3,062     2,241  
               
 

Total nonperforming assets

  $ 60,140   $ 61,737   $ 64,616  
               

Nonperforming assets as a percentage of total loans and other real estate owned

    6.41 %   5.30 %   6.03 %

        Nonperforming assets, including $9.8 million in the loans held-for-sale portfolio, at June 30, 2010 decreased $1.6 million, or 3%, from June 30, 2009, and decreased by $4.5 million or 7%, compared to December 31, 2009. The following table provides nonperforming loans by loan type as of June 30, 2010:

 
  Nonaccrual   Restructured and
Loans Over 90 Days
Past Due and
Still Accruing
  Total  
 
  (Dollars in thousands)
 

Commercial

  $ 11,417   $ 1,685   $ 13,102  

Real estate—mortgage

    16,299     831     17,130  

Real estate—land and construction

    28,347         28,347  

Consumer

    1,006         1,006  
               
 

Total

  $ 57,069   $ 2,516   $ 59,585  
               

Allowance for Loan Losses

        The allowance for loan losses is an estimate of probable incurred losses in the loan portfolio. Loans are charged-off against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance for loan losses. Management's methodology for estimating the allowance balance consists of several key elements, which include specific allowances on individual impaired loans and the formula driven allowances on pools of loans with similar risk characteristics. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment, should be charged off.

        Specific allowances are established for impaired loans. Management considers a loan to be impaired when it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the loan agreement, including scheduled interest payments. Loans for which the terms have been modified with a concession granted, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. When a loan is considered to be impaired, the amount of impairment is measured based on the fair value of the collateral, less costs to sell, if the loan is collateral dependent or on the present value of expected future cash flows or values that are observable in the secondary market. If the measure of the impaired loans is less than the investment in the loan, the deficiency will be charged off against the allowance for loan losses, if the amount is a confirmed loss, or, alternatively, a specific allocation within the allowance will be established. Loans that are considered impaired are specifically excluded from the formula portion of the allowance for loan losses analysis.

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        The estimated loss factors for pools of loans that are not impaired are based on determining the probability of default and loss given default for loans within each segment of the portfolio, adjusted for significant factors that, in management's judgment, affect collectibility as of the evaluation date. The Company's historical delinquency experience and loss experience are utilized to determine the probability of default and loss given default for segments of the portfolio where the Company has experienced losses in the past. For segments of the portfolio where the Company has no significant prior loss experience, the Company uses quantifiable observable industry data to determine the probability of default and loss given default.

        Loans that demonstrate a weakness, for which there is a possibility of loss if the weakness is not corrected, are categorized as "classified." Classified loans include all loans considered as substandard, substandard-nonaccrual, and doubtful and may result from problems specific to a borrower's business or from economic downturns that affect the borrower's ability to repay or that cause a decline in the value of the underlying collateral (particularly real estate). The principal balance of classified loans, net of SBA guarantees, was $150.6 million at June 30, 2010, $162.6 million at June 30, 2009, and $164.1 million, at December 31, 2009. Included in the $150.6 million of classified assets at June 30, 2010, were $17.1 million of loans held-for-sale. Management of the level of classified loans will continue to be a focus for executive management, the lending staff and the Company's Special Assets Department.

        It is the policy of management to maintain the allowance for loan losses at a level adequate for risks inherent in the loan portfolio. On an ongoing basis, we have engaged an outside firm to perform independent credit reviews of our loan portfolio. The Federal Reserve Bank of San Francisco and the California Department of Financial Institutions also review the allowance for loan losses as an integral part of the examination process. Based on information currently available, management believes that the allowance for loan losses is adequate. However, the loan portfolio can be adversely affected if California economic conditions and the real estate market in the Company's market area were to further weaken. Also, any weakness of a prolonged nature in the technology industry would have a negative impact on the local market. The effect of such events, although uncertain at this time, could result in an increase in the level of nonperforming loans and increased loan losses, which could adversely affect the Company's future growth and profitability. No assurance of the ultimate level of credit losses can be given with any certainty.

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        The following table summarizes the Company's loan loss experience, as well as provisions and charges to the allowance for loan losses and certain pertinent ratios for the periods indicated:

 
  For the Six Months
Ended
June 30,
   
 
 
  For the Year
Ended
December 31,
2009
 
 
  2010   2009  
 
  (Dollars in thousands)
 

Balance, beginning of period / year

  $ 28,768   $ 25,007   $ 25,007  

Net (charge-offs) recoveries

    (25,710 )   (14,733 )   (30,167 )

Provision for loan losses

    23,695     21,124     33,928  
               

Balance, end of period / year

  $ 26,753   $ 31,398   $ 28,768  
               

RATIOS:

                   
 

Net (charge-offs) recoveries to average loans*

    -5.08 %   -2.43 %   -2.59 %
 

Allowance for loan losses to total loans*

    2.85 %   2.70 %   2.69 %
 

Allowance for loan losses to nonperforming loans

    44.90 %   53.51 %   46.12 %
 

Allowance for loan losses to nonperforming loans, excluding nonaccrual loans—loans held-for-sale portfolio

    53.74 %   53.51 %   46.12 %

*
Excluding loans held-for-sale.

        The net charge-offs of $25.7 million for the six months ended June 30, 2010 included $13.9 million of charge-offs related to the real estate loans transferred to "held-for-sale." Historical net loan charge-offs are not necessarily indicative of the amount of net charge-offs that the Company will realize in the future.

Goodwill

        Goodwill resulted from the acquisition of Diablo Valley Bank in June 2007 and represented the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually, as of November 30, for impairment with the assistance of an independent valuation firm. Goodwill impairment exists when a reporting unit's carrying value exceeds its fair value, which is determined through a two-step impairment test. Step 1 includes the determination of the carrying value of the Company's single reporting unit, including the existing goodwill and intangible assets, and estimating the fair value of the reporting unit. If the carrying amount of a reporting unit exceeds its fair value, the Company is required to perform a second step to the impairment test. Step 2 requires that the implied fair value of the reporting unit goodwill be compared to the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss will be recognized in an amount equal to that excess.

        Because of concerns about the Company's stock price and banking industry in general, goodwill was tested for impairment in the first quarter of 2010 with the assistance of an independent valuation firm. Based on the assessment, management concluded that there was no impairment of goodwill at March 31, 2010.

        Due to concerns about the Company's stock price, the condition of the banking industry in general, and the closing of the private placement of convertible preferred stock, goodwill was tested for impairment in the second quarter of 2010, with the assistance of an independent valuation firm. Due to the continued depressed economic conditions and the length of time and amount by which the Company's book value exceeded market value per share, and the Company's closing of the private placement at a conversion price of $3.75 per share, the Company determined goodwill related to the

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acquisition of Diablo Valley Bank of $43.2 million was fully impaired during the second quarter of 2010.

Intangible Assets

        Intangible assets consist of core deposit and customer relationship intangible assets arising from the acquisition of Diablo Valley Bank in June 2007. These assets are amortized over their estimated useful lives. Impairment testing of these assets is performed at the individual asset level. Impairment exists if the carrying amount of the asset is not recoverable and exceeds its fair value at the date of the impairment test. For intangible assets, estimates of expected future cash flows (cash inflows less cash outflows) that are directly associated with an intangible asset are used to determine the fair value of that asset. Management makes certain estimates and assumptions in determining the expected future cash flows from core deposit and customer relationship intangibles including account attrition, expected lives, discount rates, interest rates, servicing costs and other factors. Significant changes in these estimates and assumptions could adversely impact the valuation of these intangible assets. If an impairment loss exists, the carrying amount of the intangible asset is adjusted to a new cost basis. The new cost basis is then amortized over the remaining useful life of the asset. Based on its assessment, management concluded that there was no impairment of intangible assets at June 30, 2010.

Deposits

        The composition and cost of the Company's deposit base are important components in analyzing the Company's net interest margin and balance sheet liquidity characteristics, both of which are discussed in greater detail in other sections herein. The Company's liquidity is impacted by the volatility of deposits or other funding instruments or, in other words, by the propensity of that money to leave the institution for rate-related or other reasons. Deposits can be adversely affected if economic conditions in California, and the Company's market area in particular, continue to weaken. Potentially, the most volatile deposits in a financial institution are jumbo certificates of deposit, meaning time deposits with balances that equal or exceed $100,000, as customers with balances of that magnitude are typically more rate-sensitive than customers with smaller balances.

        The following table summarizes the distribution of deposits and the percentage of distribution in each category of deposits for the periods indicated:

 
  June 30, 2010   June 30, 2009   December 31, 2009  
 
  Balance   % to Total   Balance   % to Total   Balance   % to Total  
 
  (Dollars in thousands)
 

Demand Deposits—Noninterest Bearing

  $ 249,017     24 % $ 258,464     22 % $ 260,840     24 %

Demand Deposits—Interest Bearing

    153,173     15 %   134,318     12 %   146,828     13 %

Savings and Money Market

    281,619     27 %   331,444     28 %   295,404     27 %

Time Deposits—under $100

    38,201     3 %   43,772     4 %   40,197     4 %

Time Deposits—$100 and over

    133,443     13 %   170,858     15 %   129,831     12 %

Time Deposits—CDARS

    18,240     2 %   11,867     1 %   38,154     4 %

Time Deposits—brokered

    163,732     16 %   212,824     18 %   178,031     16 %
                           
 

Total deposits

  $ 1,037,425     100 % $ 1,163,547     100 % $ 1,089,285     100 %
                           

        The Company obtains deposits from a cross-section of the communities it serves. The Company's business is not generally seasonal in nature. The Company is not dependent upon funds from sources outside the United States. At June 30, 2010 and 2009, less than 1% and 4% of deposits were from public sources, respectively.

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        Noninterest-bearing and low interest-bearing demand deposit accounts increased $9.4 million, or 2%, at June 30, 2010 from June 30, 2009, and decreased $5.5 million, or 1%, from December 31, 2009. Time deposits $100,000 and over decreased $37.4 million, or 22% from June 30, 2009, primarily due to the withdrawal of public deposits, and increased $3.6 million, or 3%, from December 31, 2009. At June 30, 2010, brokered deposits decreased $49.1 million, or 23%, to $163.7 million, compared to $212.8 million at June 30, 2009, decreased $14.3 million, or 8%, and from $178.0 million at December 31, 2009.

        The following table indicates the contractual maturity schedule of the Company's time deposits of $100,000 and over, and all CDARS and brokered deposits as of June 30, 2010:

 
  Balance   % of
Total
 
 
  (Dollars in thousands)
 

Three months or less

  $ 115,580     37 %

Over three months through six months

    69,189     22 %

Over six months through twelve months

    88,587     28 %

Over twelve months

    42,059     13 %
           
 

Total

  $ 315,415     100 %
           

        The Company focuses primarily on providing and servicing business deposit accounts that are frequently over $100,000 in average balance per account. As a result, certain types of business clients that the Company serves typically carry average deposits in excess of $100,000. The account activity for some account types and client types necessitates appropriate liquidity management practices by the Company to help ensure its ability to fund deposit withdrawals.

Loss on Equity and Assets

        The following table indicates the ratios for loss on average assets and average equity, dividend payout, and average equity to average assets for the periods indicated:

 
  Three Months Ended
June 30,
  Six Months Ended
June 30,
 
 
  2010   2009   2010   2009  

Annualized loss on average assets

    -16.28 %   -1.48 %   -8.74 %   -1.28 %

Annualized loss on average tangible assets

    -16.86 %   -1.53 %   -9.05 %   -1.32 %

Annualized loss on average equity(1)

    -121.78 %   -11.90 %   -66.70 %   -10.27 %

Annualized loss on average tangible equity(1)

    -164.27 %   -16.08 %   -90.59 %   -13.83 %

Dividend payout ratio(2)

    N/A     N/A     N/A     -2.25 %

Average equity to average assets ratio(1)

    13.37 %   12.45 %   13.10 %   12.47 %

(1)
The three months and six months ended June 30, 2010 ratios reflect the $70 million net proceeds from the private placement completed in the second quarter of 2010.

(2)
Percentage is calculated based on dividends paid on common stock divided by net income (loss) available to common shareholders.

Off-Balance Sheet Arrangements

        In the normal course of business, the Company makes commitments to extend credit to its customers as long as there are no violations of any conditions established in the contractual arrangements. These commitments are obligations that represent a potential credit risk to the Company, yet are not reflected on the Company's consolidated balance sheets. Total unused

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commitments to extend credit were $293.7 million at June 30, 2010, as compared to $360.5 million at June 30, 2009 and $328.2 million at December 31, 2009.

        The effect on the Company's revenues, expenses, cash flows and liquidity from the unused portion of the commitments to provide credit cannot be reasonably predicted, because there is no certainty that lines of credit and letters of credit will ever be fully utilized. The following table presents the Company's commitments to extend credit for the periods indicated:

 
  June 30,   December 31,
 
 
  2010   2009   2009  
 
  (Dollars in thousands)
   
 
 
  Fixed Rate   Variable Rate   Fixed Rate   Variable Rate   Fixed Rate   Variable Rate  

Unused lines of credit and commitments to make loans

  $ 8,109   $ 267,154   $ 16,670   $ 321,432   $ 10,540   $ 297,900  

Standby letters of credit

    417     18,013     2,967     19,387     557     19,218  
                           

  $ 8,526   $ 285,167   $ 19,637   $ 340,819   $ 11,097   $ 317,118  
                           

Liquidity and Asset/Liability Management

        Liquidity refers to the Company's ability to maintain cash flows sufficient to fund operations and to meet obligations and other commitments in a timely and cost effective fashion. At various times the Company requires funds to meet short-term cash requirements brought about by loan growth or deposit outflows, the purchase of assets, or liability repayments. An integral part of the Company's ability to manage its liquidity position appropriately is the Company's large base of core deposits, which are generated by offering traditional banking services in its service area and which have, historically, been a stable source of funds. To manage liquidity needs properly, cash inflows must be timed to coincide with anticipated outflows or sufficient liquidity resources must be available to meet varying demands. The Company manages liquidity to be able to meet unexpected sudden changes in levels of its assets or deposit liabilities without maintaining excessive amounts of balance sheet liquidity. Excess balance sheet liquidity can negatively impact the Company's interest margin. In order to meet short-term liquidity needs, the Company utilizes overnight Federal funds purchase arrangements and other borrowing arrangements with correspondent banks, solicits brokered deposits if cost effective deposits are not available from local sources and maintains collateralized lines of credit with the FHLB and FRB. In addition, the Company can raise cash for temporary needs by selling securities under agreements to repurchase and selling securities available-for-sale.

        At June 30, 2010, the Company had loan contraction, including loans held-for-sale, of $215.0 million from June 30, 2009, and loan contraction, including loans held-for-sale, of $113.7 million from December 31, 2009, and it has experienced an improvement in its liquidity position. One of the measures we analyze for liquidity is our loan to deposit ratio. Our loan to deposit ratio improved to 90.39% at June 30, 2010, compared to 99.84% at June 30, 2009, and 98.24% at December 31, 2009.

FHLB and FRB Borrowings & Available Lines of Credit

        The Company has off-balance sheet liquidity in the form of Federal funds purchase arrangements with correspondent banks, including the FHLB and FRB. The Company can borrow from the FHLB on a short-term (typically overnight) or long-term (over one year) basis. At June 30, 2010, the Company had no overnight borrowings from the FHLB. At June 30, 2009, the Company had $15.0 million of overnight borrowings from the FHLB, bearing interest at 0.11%. At December 31, 2009, the Company had $20.0 million of overnight borrowings from the FHLB, bearing interest at 0.04%. The Company had $181.3 million of loans pledged to the FHLB as collateral on an available line of credit of $116.8 million at June 30, 2010.

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        The Company can also borrow from FRB's discount window. The Company had $112.1 million of loans pledged to the FRB as collateral on an available line of credit of $51.3 million at June 30, 2010, none of which was outstanding.

        At June 30, 2010, the Company had Federal funds purchase arrangements available of $30.0 million. There were no Federal funds purchased outstanding at June 30, 2010, June 30, 2009, and December 31, 2009.

        The Company also had a $4.0 million secured borrowing at June 30, 2010. Secured borrowings represent the guaranteed portions of SBA 7a loans transferred to third parties subject to a SBA warranty for a period of 90 days. This requires the Company to treat these as secured borrowings during the warranty period. The warranty period for these loans expires in the following quarter. Provided the loans remain current through the end of the warranty period all elements necessary to record the sale will have been met.

        The Company also utilizes securities sold under repurchase agreements to manage our liquidity position. Repurchase agreements are accounted for as collateralized financial transactions and are secured by mortgage-backed securities carried at an amortized cost of approximately $21.0 million at June 30, 2010, and approximately $32.9 million at June 30, 2009. Securities sold under agreements to repurchase totaled $20.0 million at June 30, 2010, compared to $30.0 million at June 30, 2009, and $25.0 million at December 31, 2009.

        The following table summarizes the Company's borrowings under its Federal funds purchased, security repurchase arrangements and lines of credit for the periods indicated:

 
  June 30,    
 
 
  December 31,
2009
 
 
  2010   2009  
 
  (Dollars in thousands)
 

Average balance year-to-date

  $ 31,674   $ 77,834   $ 56,269  

Average interest rate year-to-date

    1.61 %   1.57 %   1.65 %

Maximum month-end balance during the period

  $ 30,708   $ 122,000   $ 50,000  

Average rate at June 30

    2.27 %   1.65 %   1.32 %

Capital Resources

        On June 21, 2010, the Company completed a private placement of Series B Preferred Stock and Series C Preferred Stock to a limited number of institutional investors for gross proceeds of $75 million. HCC downstreamed $40 million of the proceeds from the private placement to HBC as Tier 1 capital for regulatory purposes. At the HCC level, proceeds from the issuance of the Series B Preferred Stock constitute Tier 2 capital for regulatory purposes. The proceeds from the issuance of the Series B Preferred Stock and Series C Preferred Stock constitute Tier 2 capital. Upon receipt of shareholder approval for the conversion of the Series B Preferred Stock and Series C Preferred Stock, the proceeds will constitute Tier 1 capital for regulatory purposes. As discussed below, the proceeds from the private placement have significantly improved the Company's regulatory ratios.

        The new capital increased tangible equity to $182.3 million at June 30, 2010, from $127.5 million at June 30, 2009, and $125.5 million at December 31, 2009.

        The Company uses a variety of measures to evaluate capital adequacy. Management reviews various capital measurements on a regular basis and takes appropriate action to ensure that such measurements are within established internal and external guidelines. The external guidelines, which are issued by the Federal Reserve Board and the FDIC, establish a risk-adjusted ratio relating capital to different categories of assets and off-balance sheet exposures. There are two categories of capital under the Federal Reserve Board and FDIC guidelines: Tier 1 and Tier 2 Capital. Our Tier 1 Capital currently consists of total shareholders' equity (excluding accumulated other comprehensive income or

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loss) and the proceeds from the issuance of trust preferred securities (trust preferred securities are counted only up to a maximum of 25% of Tier 1 capital), less goodwill and other intangible assets, disallowed deferred tax assets, and the newly issued Series B Preferred Stock and Series C Preferred Stock. Our Tier 2 Capital includes the allowances for loan losses, off balance sheet credit losses, and the Series B Preferred Stock and Series C Preferred Stock.

        The following table summarizes risk-based capital, risk-weighted assets, and risk-based capital ratios of the consolidated Company:

 
  June 30,    
   
 
 
  December 31,
2009
   
 
 
  2010   2009    
 
 
  (Dollars in thousands)
   
 

Capital components:

                         
 

Tier 1 Capital

  $ 112,797   $ 138,697   $ 134,833        
 

Tier 2 Capital

    83,295     15,956     14,720        
                     
   

Total risk-based capital

  $ 196,092   $ 154,653   $ 149,553        
                     

Risk-weighted assets

  $ 1,050,949   $ 1,260,709   $ 1,163,125        

Average assets (regulatory purposes)

  $ 1,304,239   $ 1,393,157   $ 1,341,670        

 

 

 


 

 


 

 


 

Minimum
Regulatory
Requirements

 

Capital ratios:

                         
 

Total risk-based capital

    18.7 %   12.3 %   12.9 %   8.00 %
 

Tier 1 risk-based capital

    10.7 %   11.0 %   11.6 %   4.00 %
 

Leverage(1)

    8.6 %   10.0 %   10.1 %   4.00 %

(1)
Tier 1 capital divided by quarterly average assets (excluding goodwill, other intangible assets and disallowed deferred tax assets).

        The table above presents the capital ratios of the consolidated Company computed in accordance with applicable regulatory guidelines and compared to the standards for minimum capital adequacy requirements for bank holding companies.

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        The following table summarizes risk-based capital, risk-weighted assets, and risk-based capital ratios of HBC:

 
  June 30,    
   
   
 
 
  December 31,
2009
   
   
 
 
  2010   2009    
   
 
 
  (Dollars in thousands)
   
   
 

Capital components:

                               
 

Tier 1 Capital

  $ 152,251   $ 135,606   $ 133,216              
 

Tier 2 Capital

    13,310     16,005     14,743              
                           
   

Total risk-based capital

  $ 165,561   $ 151,611   $ 147,959              
                           

Risk-weighted assets

  $ 1,050,908   $ 1,264,684   $ 1,165,014              

Average assets (regulatory purposes)

  $ 1,303,879   $ 1,396,746   $ 1,344,407              

 

 

 


 

 


 

 


 

Well-Capitalized
Regulatory
Requirements

 

Minimum
Regulatory
Requirements

 

Capital ratios:

                               
 

Total risk-based capital

    15.8 %   12.0 %   12.7 %   10.00 %   8.00 %
 

Tier 1 risk-based capital

    14.5 %   10.7 %   11.4 %   6.00 %   4.00 %
 

Leverage(1)

    11.7 %   9.7 %   9.9 %   5.00 %   4.00 %

(1)
Tier 1 capital divided by quarterly average assets (excluding goodwill, other intangible assets and disallowed deferred tax assets).

        The table above presents the capital ratios of HBC computed in accordance with applicable regulatory guidelines and compared to the standards for minimum capital adequacy requirements under the FDIC's prompt corrective action authority. In July 2010, we submitted a written plan for sufficient capitalization of both HBC and the Company (on a consolidated basis), based on their respective risk profiles to the Federal Reserve and DFI.

        At June 30, 2010 and 2009, and December 31, 2009, HCC's and HBC's capital met all minimum regulatory requirements. As of June 30, 2010, HBC's capital ratios exceed the highest regulatory capital requirement of "well-capitalized" under the prompt corrective action provisions.

        At June 30, 2010, the Company had total shareholders' equity of $185.6 million, including $108.4 million in preferred stock, and $569,000 of accumulated other comprehensive loss.

Mandatory Redeemable Cumulative Trust Preferred Securities

        To enhance regulatory capital and to provide liquidity, the Company, through unconsolidated subsidiary grantor trusts, issued the following mandatory redeemable cumulative trust preferred securities of subsidiary grantor trusts: In the first quarter of 2000, the Company issued $7.2 million aggregate principal amount of 10.875% subordinated debt due on March 8, 2030 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2000, the Company issued $7.2 million aggregate principal amount of 10.60% subordinated debt due on September 7, 2030 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2001, the Company issued $5.2 million aggregate principal amount of Floating Rate Junior Subordinated Deferrable Interest Debentures due on July 31, 2031 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2002, the Company issued $4.1 million of aggregate principal amount of Floating Rate Junior Subordinated Deferrable Interest Debentures due on September 26, 2032 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. The subordinated debt is recorded as a component of

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long-term debt and includes the value of the common stock issued by the trusts to the Company. The common stock is recorded as other assets for the amount issued. Under applicable regulatory guidelines, the trust preferred securities currently qualify as Tier I capital. The subsidiary trusts are not consolidated in the Company's consolidated financial statements. Under the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act the Company's trust preferred securities will continue to qualify as Tier I capital.

        In November 2009, the Company announced that it was exercising its right to defer interest payments on its outstanding trust preferred subordinated debt securities. The Company will continue to accrue the cost and recognize the expense of the interest at the normal rate on a compounded basis until such time as the deferred arrearage has been paid current.

U.S. Treasury Capital Purchase Program

        The Company received $40 million in November 2008 through the issuance of its Series A Preferred Stock and a warrant to purchase 462,963 shares of its common stock to the Treasury through the U.S. Treasury Capital Purchase Program. The Series A Preferred Stock qualifies as a component of Tier 1 capital. In November 2009, the Company announced that it was exercising its right to suspend payment of dividends on its Series A Preferred Stock. The Company accrues the cumulative unpaid dividends at the compounded dividend rate.

Private Placement

        The Company entered into a securities purchase agreement, dated June 18, 2010, with various institutional investors, pursuant to which the investors purchased for an aggregate of $75.0 million newly issued shares of Series B Preferred Stock and Series C Preferred Stock. On June 21, 2010, we issued to the investors (i) an aggregate of 53,996 shares of Series B Preferred Stock, each of which will automatically convert into 266.67 shares of our Common Stock (an aggregate of 14.4 million shares of our Common Stock) based on the initial conversion price of $3.75, upon approval of the conversion by our shareholders, and (ii) an aggregate of 21,004 shares of Series C Preferred Stock, each of which will automatically convert into 266.67 shares of our Common Stock (an aggregate of 5.6 million shares of our Common Stock) based on the initial conversion price of $3.75, following both approval of the conversion by our shareholders and, thereafter, a subsequent transfer of the Series C Preferred Stock to third parties not affiliated with the holder in a widely dispersed offering.

        The Series B Preferred Stock is non-voting except in the case of certain transactions that affect the rights of the holders of the Series B Preferred Stock or applicable law. The initial conversion price of $3.75 per share is subject to possible adjustments in the future under certain circumstances, including failure to obtain shareholder approval for the conversion by December 21, 2010, which would decrease the conversion price by 10%. The holders of the Series B Preferred Stock will be entitled to receive cumulative cash dividends which shall accrue and be payable at a per annum rate equal to 20%, payable semi-annually in arrears commencing on December 21, 2010; provided, however, if shareholder approval is obtained before December 21, 2010, then no accrued dividends shall be payable. The Series B Preferred Stock is not redeemable by the Company or by the holders and carries a liquidation preference of $1,000 per share, plus the right to participate in any liquidation distribution to holders of common stock on an as-converted basis.

        The Series C Preferred Stock is non-voting except in the case of certain transactions that would affect the rights of the holders of the Series C Preferred Stock or applicable law. The initial conversion price of $3.75 per share is subject to possible adjustments in the future under certain circumstances, including the failure to obtain shareholder approval for the conversion by December 21, 2010, which would decrease the conversion price by 10%. Prior to shareholder approval, the holders of the Series C Preferred Stock will be entitled to receive cumulative cash dividends which shall accrue and be payable

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at a per annum rate equal to 20%, payable semi-annually in arrears commencing on December 21, 2010; provided, however, if shareholder approval is obtained on or before December 21, 2010, then no accrued dividends shall be payable. Following shareholder approval, holders of Series C Preferred Stock will receive dividends if and only to the extent dividends are paid to holders of common stock. The Series C Preferred Stock is not redeemable by the Company or by the holders and carries a liquidation preference of $1,000 per share, plus prior to shareholder approval, the right to participate in any liquidation distribution to holders of common stock on an as-converted basis. Following shareholder approval, upon a liquidation of the Company, holders of Series C Preferred Stock will be entitled to a liquidation preference of $1,000 per share.

        The Series B Preferred Stock and the Series C Preferred Stock rank senior to the Company's common stock and rank on parity with the Company's Series A Fixed Rate Cumulative Preferred Stock ("Series A Preferred Stock").

        Dividends and discount accretion on preferred stock on the consolidated statements of operations include dividends on the Series B Preferred Stock and Series C Preferred Stock totaling $411,000 for the three months and six months ended June 30, 2010.

        The Company has scheduled a Special Shareholder Meeting for September 15, 2010, to approve the conversion of the Series B Preferred Stock and the Series C Preferred Stock for purposes of the NASDAQ Listing Rules and the California General Corporation Law (the "Shareholder Approvals"). There is no assurance the Company's shareholders will approve the conversion of the Series B Preferred Stock and Series C Preferred Stock before December 21, 2010 or thereafter. The failure of the Company's shareholders to approve the conversion of the Series B Preferred Stock and the Series C Preferred Stock would have potentially adverse consequences for the Company and its shareholders, see "Part II—Other Information—Item 1A—Risk Factors."

Market Risk

        Market risk is the risk of loss of future earnings, fair values, or future cash flows that may result from changes in the price of a financial instrument. The value of a financial instrument may change as a result of changes in interest rates, foreign currency exchange rates, commodity prices, equity prices and other market changes that affect market risk sensitive instruments. Market risk is attributed to all market risk sensitive financial instruments, including securities, loans, deposits and borrowings, as well as the Company's role as a financial intermediary in customer-related transactions. The objective of market risk management is to avoid excessive exposure of the Company's earnings and equity to loss and to reduce the volatility inherent in certain financial instruments.

Interest Rate Management

        Market risk arises from changes in interest rates, exchange rates, commodity prices and equity prices. The Company's market risk exposure is primarily that of interest rate risk, and it has established policies and procedures to monitor and limit earnings and balance sheet exposure to changes in interest rates. The Company does not engage in the trading of financial instruments, nor does the Company have exposure to currency exchange rates.

        The principal objective of interest rate risk management (often referred to as "asset/liability management") is to manage the financial components of the Company in a manner that will optimize the risk/reward equation for earnings and capital in relation to changing interest rates. The Company's exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. Management realizes certain risks are

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inherent, and that the goal is to identify and manage the risks. Management uses two methodologies to manage interest rate risk: (i) a standard GAP analysis; and (ii) an interest rate shock simulation model.

        The planning of asset and liability maturities is an integral part of the management of an institution's net interest margin. To the extent maturities of assets and liabilities do not match in a changing interest rate environment, the net interest margin may change over time. Even with perfectly matched repricing of assets and liabilities, risks remain in the form of prepayment of loans or securities or in the form of delays in the adjustment of rates of interest applying to either earning assets with floating rates or to interest bearing liabilities. The Company has generally been able to control its exposure to changing interest rates by maintaining primarily floating interest rate loans and a majority of its time certificates with relatively short maturities.

        Interest rate changes do not affect all categories of assets and liabilities equally or at the same time. Varying interest rate environments can create unexpected changes in prepayment levels of assets and liabilities, which may have a significant effect on the net interest margin and are not reflected in the interest sensitivity analysis table. Because of these factors, an interest sensitivity gap report may not provide a complete assessment of the exposure to changes in interest rates.

        The Company uses modeling software for asset/liability management in order to simulate the effects of potential interest rate changes on the Company's net interest margin, and to calculate the estimated fair values of the Company's financial instruments under different interest rate scenarios. The program imports current balances, interest rates, maturity dates and repricing information for individual financial instruments, and incorporates assumptions on the characteristics of embedded options along with pricing and duration for new volumes to project the effects of a given interest rate change on the Company's interest income and interest expense. Rate scenarios consisting of key rate and yield curve projections are run against the Company's investment, loan, deposit and borrowed funds portfolios. These rate projections can be shocked (an immediate and parallel change in all base rates, up or down) and ramped (an incremental increase or decrease in rates over a specified time period), based on current trends and econometric models or stable economic conditions (unchanged from current actual levels).

        The Company applies a market value ("MV") methodology to gauge its interest rate risk exposure as derived from its simulation model. Generally, MV is the discounted present value of the difference between incoming cash flows on interest-earning assets and other investments and outgoing cash flows on interest-bearing liabilities and other liabilities. The application of the methodology attempts to quantify interest rate risk as the change in the MV which would result from a theoretical 100 and 200 basis point (1 basis point equals 0.01%) change in market interest rates. Both a 100 and 200 basis point increase and a 100 and 200 basis point decrease in market rates are considered.

        At June 30, 2010, it was estimated that the Company's MV would increase 14.7% in the event of a 200 basis point increase in market interest rates. In the event of a 100 point increase in market interest rate, the Company's MV would increase 8.1% at the same date. The Company's MV at the same date would decrease 21.2% in the event of a 200 basis point decrease in applicable interest rates. In the event of a 100 point decrease in market interest rate, the Company's MV would decrease 11.6% at the same date.

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        Presented below, as of June 30, 2010 and 2009, is an analysis of the Company's interest rate risk as measured by changes in MV for instantaneous and sustained parallel shifts of 100 and 200 basis points in applicable interest rates:

 
  June 30, 2010   June 30, 2009  
 
   
   
  Market Value as a % of
Present Value of Assets
   
   
  Market Value as a % of
Present Value of Assets
 
 
  $ Change
in Market
Value
  % Change
in Market
Value
  MV Ratio   Change (bp)   $ Change
in Market
Value
  % Change
in Market
Value
  MV Ratio   Change (bp)  
 
  (Dollars in thousands)
 

Change in rates

                                                 
 

+200 bp

  $ 24,905     14.7 %   14.9 %   191   $ 29,534     14.1 %   16.6 %   206  
 

+100 bp

  $ 13,653     8.1 %   14.0 %   105   $ 16,163     7.7 %   15.7 %   113  
   

0 bp

  $     0.0 %   13.0 %     $     0.0 %   14.6 %    
 

-100 bp

  $ (19,653 )   -11.6 %   11.5 %   (151 ) $ (23,790 )   -11.4 %   12.9 %   (166 )
 

-200 bp

  $ (35,833 )   -21.2 %   10.2 %   (275 ) $ (47,268 )   -22.7 %   11.3 %   (330 )

        Management believes that the MV methodology overcomes three shortcomings of the typical maturity gap methodology. First, it does not use arbitrary repricing intervals and accounts for all expected future cash flows. Second, because the MV method projects cash flows of each financial instrument under different interest rate environments, it can incorporate the effect of embedded options on an institution's interest rate risk exposure. Third, it allows interest rates on different instruments to change by varying amounts in response to a change in market interest rates, resulting in more accurate estimates of cash flows.

        However, as with any method of gauging interest rate risk, there are certain shortcomings inherent to the MV methodology. The model assumes interest rate changes are instantaneous parallel shifts in the yield curve. In reality, rate changes are rarely instantaneous. The use of the simplifying assumption that short-term and long-term rates change by the same degree may also misstate historic rate patterns, which rarely show parallel yield curve shifts. Further, the model assumes that certain assets and liabilities of similar maturity or period to repricing will react in the same way to changes in rates. In reality, certain types of financial instruments may react in advance of changes in market rates, while the reaction of other types of financial instruments may lag behind the change in general market rates. Additionally, the MV methodology does not reflect the full impact of annual and lifetime restrictions on changes in rates for certain assets, such as adjustable rate loans. When interest rates change, actual loan prepayments and actual early withdrawals from certificates may deviate significantly from the assumptions used in the model. Finally, this methodology does not measure or reflect the impact that higher rates may have on adjustable-rate loan clients' ability to service their debt. All of these factors are considered in monitoring the Company's exposure to interest rate risk.

CRITICAL ACCOUNTING POLICIES

        Critical accounting policies are discussed in our Form 10-K for the year ended December 31, 2009. There are no changes to these policies as of June 30, 2010.

ITEM 3—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

        The information concerning quantitative and qualitative disclosure or market risk called for by Item 305 of Regulation S-K is included as part of Item 2 above.

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ITEM 4—CONTROLS AND PROCEDURES

Disclosure Control and Procedures

        The Company has carried out an evaluation, under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures as of June 30, 2010. As defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), disclosure controls and procedures are controls and procedures designed to reasonably assure that information required to be disclosed in our reports filed or submitted under the Exchange Act are recorded, processed, summarized and reported on a timely basis. Disclosure controls are also designed to reasonably assure that such information is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded the Company's disclosure controls were effective as of June 30, 2010, the period covered by this report on Form 10-Q.

        During the six months ended June 30, 2010, there were no changes in our internal controls over financial reporting that materially affected, or are reasonably likely to affect, our internal controls over financial reporting.

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Part II—OTHER INFORMATION

ITEM 1—LEGAL PROCEEDINGS

        The Company is involved in certain legal actions arising from normal business activities. Management, based upon the advice of legal counsel, believes the ultimate resolution of all pending legal actions will not have a material effect on the financial statements of the Company.

ITEM 1A—RISK FACTORS

        In addition to the other information contained in this Report on Form 10-Q, the following significant risks may affect the Company and update the risk factors contained in Part I, Item A "Risk Factors" of our Annual Report on Form 10-K for the year ended December 31, 2009. The risk factors identified below are in addition to those contained in any other cautionary statements, written or oral, which may be made or otherwise addressed in connection with a forward-looking statement or contained in any of our subsequent filings with the Securities and Exchange Commission.

If Shareholder Approvals for the conversion of the Series B Preferred Stock and Series C Preferred Stock are not received before December 21, 2010, the consequences could adversely affect the Company, which may negatively impact an investment in our Common Stock.

        If the Shareholder Approvals are not obtained prior to December 21, 2010, on and after December 21, 2010 and until the shareholders approve the conversion of the Series B Preferred Stock and the Series C Preferred Stock, the following consequences will result that could affect our stock price:

We have a significant deferred tax asset and cannot assure that it will be fully realized.

        Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between the carrying amounts and tax basis of assets and liabilities computed using enacted tax rates. If we determine that we will not achieve sufficient future taxable income to realize our net deferred tax asset, we are required under generally accepted accounting principles to establish a full or partial valuation allowance. If we determine that a valuation allowance is necessary, we are required to incur a charge to operations. We regularly assess available positive and negative evidence to determine whether it is more likely than not that our net deferred tax asset will be realized. Realization of a

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deferred tax asset requires us to apply significant judgment and is inherently speculative because it requires estimates that cannot be made with certainty. At June 30, 2010, we had a net deferred tax asset of $24.6 million. For the second quarter ended June 30, 2010, we established a partial valuation allowance of $3.7 million. If we were to determine at some point in the future that we will not achieve sufficient future taxable income to realize our net deferred tax asset, we would be required under generally accepted accounting principles to establish a full or increase our partial valuation allowance which would require us to incur a charge to operations for the period in which the determination was made.

There is no assurance that our planned sale of problem loans in the third quarter will be successful.

        In the second quarter ended June 30, 2010, we identified $31.0 million of problem real estate related loans that we intend to sell in the third quarter. We transferred the loans to loans held-for-sale portfolio and recorded $13.9 million of loan charge-offs in the second quarter of 2010. Although we have been in discussions with third party brokers who we have engaged to conduct the loan sales, there is no assurance that the loan sales will be completed or, if completed, on terms as advantages to the Company as anticipated. If we are unable to complete the loan sales or if the loan sales are completed on less than the terms we have anticipated the Company may record addition losses on these loans.

The Dodd-Frank Wall Street Reform and Consumer Protection Act may affect our business activities, financial position and profitability by increasing our regulatory compliance burden and associated costs, placing restrictions on certain products and services, and limiting our future capital raising strategies.

        On July 21, 2010, the President signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Act"), which implements significant changes in the financial regulatory landscape and will impact all financial institutions, including HCC and HBC. The Act is likely to increase our regulatory compliance burden. However, it is too early for us to fully assess the impact of the Act on our business, financial condition or results of operations in part because many of the Act's provisions require subsequent regulatory rulemaking.

        Among the Act's significant regulatory changes, it creates a new financial consumer protection agency, known as the Bureau of Consumer Financial Protection (the "Bureau"), that is empowered to promulgate new consumer protection regulations and revise existing regulations in many areas of consumer compliance, which will increase our regulatory compliance burden and costs and may restrict the financial products and services we offer to our customers. Moreover, the Act permits states to adopt stricter consumer protection laws and state attorney generals may enforce consumer protection rules issued by the Bureau. The Act also imposes more stringent capital requirements on bank holding companies by, among other things, imposing leverage ratios on bank holding companies and prohibiting new trust preferred issuances from counting as Tier 1 capital. These restrictions will limit future capital strategies. Although we do not use derivative transactions, the Act also increases regulation of derivatives and hedging transactions, which could limit our ability in the future to enter into, or increase the costs associated with, interest rate and other hedging transactions.

        Although certain provisions of the Act, such as direct supervision by the Bureau, will not apply to banking organizations with less than $10 billion of assets, such as Heritage Commerce Corp and Heritage Bank of Commerce, the changes resulting from the legislation will impact our business. These changes will require us to invest significant management attention and resources to evaluate and make necessary changes.

ITEM 2—UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

        None

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ITEM 3—DEFAULTS UPON SENIOR SECURITIES

        None

ITEM 4—RESERVED

ITEM 5—OTHER INFORMATION

        None

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ITEM 6—EXHIBITS

Exhibit
  Description
  3.1   Heritage Commerce Corp Restated Articles of Incorporation, as amended (incorporated by reference to Exhibit 3.1 to the Registrant's Annual Report on Form 10-K filed on March 17, 2009)

 

3.2

 

Heritage Commerce Corp Bylaws, as amended (incorporated by reference to Exhibit 3.2 to the Registrant's Annual Report or Form 10-K filed on March 17, 2010)

 

4.1

 

Certificate of Determination for Fixed Rate Cumulative Perpetual Preferred Stock, Series A (incorporated by reference to Exhibit 3.1 to the Registrant's Form 8-K filed November 26, 2008)

 

4.2

 

Warrant to Purchase Common Stock dated November 21, 2008 (incorporated by reference to Exhibit 4.2 to the Registrant's Form 8-K filed on November 26, 2008)

 

4.3

 

Certificate of Determination for Series B Mandatorily Convertible Perpetual Preferred Stock (incorporated by reference to Exhibit 4.1 to Registrant's Form 8-K filed on June 22, 2010)

 

4.4

 

Certificate of Determination for Series C Convertible Perpetual Preferred Stock (incorporated by reference to Exhibit 4.2 to Registrant's Form 8-K filed on June 22, 2010)

 

12.1

 

Calculation of Ratio of Earnings to Fixed Charges and Ratio of Earnings to Fixed Charges and Preferred Stock Dividends

 

31.1

 

Certification of Registrant's Chief Executive Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002

 

31.2

 

Certification of Registrant's Chief Financial Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002

 

32.1

 

Certification of Registrant's Chief Executive Officer Pursuant To 18 U.S.C. Section 1350

 

32.2

 

Certification of Registrant's Chief Financial Officer Pursuant To 18 U.S.C. Section 1350

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SIGNATURES

        Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

    Heritage Commerce Corp
(Registrant)

August 6, 2010
Date

 

/s/ WALTER T. KACZMAREK

Walter T. Kaczmarek
Chief Executive Officer

August 6, 2010
Date

 

/s/ LAWRENCE D. MCGOVERN

Lawrence D. McGovern
Chief Financial Officer

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EXHIBIT INDEX

Exhibit   Description
  3.1   Heritage Commerce Corp Restated Articles of Incorporation, as amended (incorporated by reference to Exhibit 3.1 to the Registrant's Annual Report on Form 10-K filed on March 16, 2009)

 

3.2

 

Heritage Commerce Corp Bylaws, as amended (incorporated by reference to Exhibit 3.2 to the Registrant's Annual Report or Form 10-K filed on March 17, 2010)

 

4.1

 

Certificate of Determination for Fixed Rate Cumulative Perpetual Preferred Stock, Series A (incorporated by reference to Exhibit 3.1 to the Registrant's Form 8-K filed on November 26, 2008)

 

4.2

 

Warrant to Purchase Common Stock dated November 21, 2008 (incorporated by reference to Exhibit 4.2 to the Registrant's Form 8-K filed on November 26, 2008)

 

4.3

 

Certificate of Determination for Series B Mandatorily Convertible Perpetual Preferred Stock (incorporated by reference to Exhibit 4.1 to Registrant's Form 8-K file June 22, 2010)

 

4.4

 

Certificate of Determination for Series C Convertible Perpetual Preferred Stock (incorporated by reference to Exhibit 4.2 to Registrant's Form 8-K file June 22, 2010)

 

12.1

 

Calculation of Ratio of Earnings to Fixed Charges and Ratio of Earnings to Fixed Charges and Preferred Stock Dividends

 

31.1

 

Certification of Registrant's Chief Executive Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002

 

31.2

 

Certification of Registrant's Chief Financial Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002

 

32.1

 

Certification of Registrant's Chief Executive Officer Pursuant To 18 U.S.C. Section 1350

 

32.2

 

Certification of Registrant's Chief Financial Officer Pursuant To 18 U.S.C. Section 1350

63