Attached files
file | filename |
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EX-31.1 - HERITAGE OAKS BANCORP | v197395_ex31-1.htm |
EX-32.1 - HERITAGE OAKS BANCORP | v197395_ex32-1.htm |
UNITED
STATES
SECURITIES
AND EXCHANGE COMMISSION
WASHINGTON,
D.C. 20549
FORM
10-Q/A
Amendment
No. 1
x
|
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
¨
|
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: 000-25020
HERITAGE
OAKS BANCORP
(Exact
name of registrant as specified in its charter)
California
|
77-0388249
|
|
(State
or other jurisdiction of
incorporation
or organization)
|
(I.R.S.
Employer
Identification
No.)
|
|
545
12th Street,
|
||
Paso
Robles, California
|
93446
|
|
(Address
of principal offices)
|
(Zip
Code)
|
(805)
369-5200
(Registrant's
telephone number, including area code)
Not
Applicable
(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 twelve (12) months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
YES x NO
¨
Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Website, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding
12 months (or for such shorter period that the registrant was required to submit
and post such files).
YES ¨ NO
¨
Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or smaller reporting
company. See definitions of “large accelerated filer,” “accelerated
filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (check
one.)
Large
accelerated filer ¨ Accelerated
filer ¨ Non-accelerated
filer ¨ Smaller
reporting company x
Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).
YES ¨ NO
x
Indicate
the number of shares outstanding of each of the issuer's classes of common
stock, as of the latest practicable date:
As of
August 6, 2010 there were 25,062,682 shares outstanding of the Registrant’s
common stock.
Explanatory
Note
Heritage
Oaks Bancorp (the “Company”) is filing this Amendment No. 1 on Form 10-Q/A
to amend its Quarterly Report on Form 10-Q as of and for the quarter ended June
30, 2010 that was originally filed with the Securities and Exchange Commission
on August 9, 2010 (the “Original Filing”). As disclosed in the
Company’s Form 8-K filing dated September
24, 2010, the Company is filing this Amendment No. 1 to reflect the change
in its accounting treatment of the Series B Preferred Stock and to provide
additional disclosure regarding the Series C Preferred Stock it issued in its
March 2010 private placement. Upon reevaluating the accounting for
the transaction, the Company determined it did not account for the contingent
beneficial conversion feature of the Series B Preferred Stock and as such has
revised its consolidated financial statements and the notes thereto as of and
for the period ended June 30, 2010. The Company also revised the
related Management’s Discussion and Analysis of Financial Condition and Results
of Operations. These revisions are included in this Amendment No.
1.
The
revised accounting relates to the intrinsic value of the contingent beneficial
conversion feature of the Series B Preferred Stock and the additional disclosure
of the contingent beneficial conversion feature of the Series C Preferred
Stock. As more fully disclosed in Note 11. Preferred Stock, the
Company issued a total of 56,160 shares of Series B Preferred Stock and
1,189,538 shares of its Series C Preferred Stock for total gross proceeds of
approximately $60.0 million. On March 10, 2010 (the “commitment
date”), the date the Company made a firm commitment to issue the Series B and
Series C Preferred Stock, the price of the Company’s common stock at the close
of the market was $3.45 per share compared to the $3.25 per common share
conversion price of the Series B and Series C Preferred Stock. This
$0.20 difference between the market value of the Company’s common stock and
conversion price on the commitment date represented a contingent beneficial
conversion feature of the Series B and Series C Preferred Stock of approximately
$3.5 million, and $238 thousand, respectively.
The
conversion of the Series B Preferred Stock as of the commitment date was
contingent upon the approval of the Company’s common shareholders of additional
authorized common shares sufficient to convert the Series B Preferred Stock to
common stock and the approval of the issuance of common stock on conversion of
the Series B Preferred Stock under NASDAQ rules. Such approvals were
received during the second quarter of 2010 at which time the Company should have
recorded the beneficial conversion feature related to the Series B Preferred
Stock.
The
conversion of the Series C Preferred Stock as of the commitment date was
contingent upon the approval of the Company’s common shareholders to approve the
contingent conversion of Series C Preferred Stock to common stock, under NASDAQ
rules, upon the transfer of the Series C Preferred Stock from the investor to an
unaffiliated third party. Approval of the contingent conversion of
Series C Preferred Stock was received during the second quarter of 2010; however
conversion of Series C Preferred Stock remains contingent upon the transfer from
the investor to an unaffiliated third party. Therefore, the
contingent beneficial conversion feature related to the Series C Preferred Stock
has not resulted in any accounting adjustment, rather it will represent a
disclosure item in the Company’s financial statements until such time that the
contingency is removed.
The
Company’s revised financial statements filed on this Form 10-Q/A as of and for
the three and six month periods ended June 30, 2010 reflect the impact of the
recognition of the beneficial conversion feature on the Series B Preferred
Stock. The initial recognition of the beneficial conversion feature
on the Series B Preferred Stock is accomplished through the establishment of a
discount on Series B Preferred Stock and a corresponding increase in additional
paid in capital. These adjustments also reflect the recognition of
the immediate accretion of the discount on Series B Preferred Stock through
retained earnings which should have occurred on June 11, 2010, the date the
Company converted the outstanding Series B Preferred Stock to common
stock.
The
calculation of net loss applicable to common shareholders and basic earnings per
share for the three and six months ended June 30, 2010 to properly reflect the
accretion of the Series B Preferred Stock discount is shown in the tables
below:
For the three months ending,
|
||||||||||||
Accretion of
|
||||||||||||
beneficial conversion
|
||||||||||||
June 30, 2010
|
discount on Series B
|
June 30, 2010
|
||||||||||
(dollar amounts in thousands except per share data)
|
As reported
|
Preferred Stock
|
Restated
|
|||||||||
Net
loss
|
$ | (5,835 | ) | $ | (5,835 | ) | ||||||
Less:
dividends and accretion on preferred stock
|
(353 | ) | (3,456 | ) | (3,809 | ) | ||||||
Net
loss applicable to common shareholders
|
$ | (6,188 | ) | $ | (9,644 | ) | ||||||
Weighted
average shares outstanding
|
11,250,989 | 11,250,989 | ||||||||||
Basic
loss per share
|
$ | (0.55 | ) | $ | (0.86 | ) |
For the six months ending,
|
||||||||||||
Accretion of
|
||||||||||||
beneficial conversion
|
||||||||||||
June 30, 2010
|
discount on Series B
|
June 30, 2010
|
||||||||||
(dollar amounts in thousands except per share data)
|
As reported
|
Preferred Stock
|
Restated
|
|||||||||
Net
loss
|
$ | (7,174 | ) | $ | (7,174 | ) | ||||||
Less:
dividends and accretion on preferred stock
|
(704 | ) | (3,456 | ) | (4,160 | ) | ||||||
Net
loss applicable to common shareholders
|
$ | (7,878 | ) | $ | (11,334 | ) | ||||||
Weighted
average shares outstanding
|
9,492,421 | 9,492,421 | ||||||||||
Basic
loss per share
|
$ | (0.83 | ) | $ | (1.19 | ) |
As
previously mentioned, the Company adjusted the balances of additional paid in
capital and retained earnings to properly reflect the issuance of the Series B
Preferred Stock as well as the immediate accretion of the Series B Preferred
Stock discount as of the date the Company converted the Series B Preferred Stock
to common stock. The table below reflects the impact of those adjustments at
June 30, 2010:
June 30, 2010
|
||||||||
Additional Paid
|
Retained
|
|||||||
(dollar amounts in thousands)
|
in Capital
|
Earnings
|
||||||
Balance
as of June 30, 2010, as previously reported
|
$ | 3,430 | $ | 5,529 | ||||
Increase
in additional paid in capital / (accretion) of beneficial conversion
discount on Series B Preferred Stock
|
$ | 3,456 | $ | (3,456 | ) | |||
Balance
as of June 30, 2010, as adjusted
|
$ | 6,886 | $ | 2,073 |
This
Amendment No. 1 on Form 10-Q/A amends:
Part I.
Financial Information
Item 1.
Consolidated Financial Statements (un-audited, except for Balance Sheet as of
12/31/2009)
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of
Operations
Item 4.
Controls and Procedures
This
Amendment No. 1 includes the Original Filing in its entirety and the
Company is only amending those portions affected by the revisions described
above. The only exhibits included with this Amendment No. 1 are Exhibits
31.1 and 32.1 related to the certifications by the principal executive officer
and the principal financial officer, as required by Rule 12b-15 of the
Securities Exchange Act of 1934, as amended.
The
Company also reassessed the effectiveness of the design and operation of its
disclosure controls and procedures. Based on that evaluation and due to the
restatement of the unaudited consolidated financial statements as of and for the
quarter ended June 30, 2010, Management concluded that the Company’s disclosure
controls and procedures were not effective as of June 30, 2010. However,
Management believes that the consolidated financial statements included in this
Amendment No. 1 on Form 10-Q/A were prepared in accordance with U.S. generally
accepted accounting principles in all material respects.
Page
|
||
Part
I. Financial Information
|
5
|
|
Item
1. Consolidated Financial Statements (un-audited, except for
Balance Sheet as of 12/31/2009)
|
5
|
|
Consolidated
Balance Sheets
|
6
|
|
Consolidated
Statements of Income
|
7
|
|
Consolidated
Statements of Stockholders' Equity
|
8
|
|
Consolidated
Statements of Cash Flows
|
9
|
|
|
||
Notes
to Consolidated Financial Statements
|
10
|
|
Note
1. Consolidated Financial Statements
|
10
|
|
Note
2. Investment Securities
|
10
|
|
Note
3. Loans and the Allowance for Loan Losses
|
14
|
|
Note
4. Other Real Estate Owned
|
17
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|
Note
5. Deferred Tax Assets
|
17
|
|
Note
6. Earnings / (Loss) Per Share
|
18
|
|
Note
7. Recent Accounting Pronouncements
|
19
|
|
Note
8. Share-Based Compensation
|
21
|
|
Note
9. Fair Value Disclosures
|
23
|
|
Note
10. Fair Value of Financial Instruments
|
25
|
|
Note
11. Preferred Stock
|
27
|
|
Note
12. Regulatory Order and Written Agreement
|
29
|
|
Note
13. Junior Subordinated Debentures
|
31
|
|
Note
14. Reclassifications
|
31
|
|
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||
Forward
Looking Statements
|
32
|
|
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||
Item
2. Management's Discussion and Analysis of Financial Condition
and Results of Operations
|
33
|
|
The
Company
|
33
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|
Where
You Can Find More Information
|
33
|
|
Executive
Summary
|
34
|
|
Recent
Developments
|
36
|
|
Dividends
and Stock Repurchases
|
37
|
|
Selected
Financial Data
|
38
|
|
Local
Economy
|
38
|
|
Critical
Accounting Policies
|
39
|
|
Results
of Operations
|
42
|
|
Net
Interest Income and Margin
|
42
|
|
Non-Interest
Income
|
47
|
|
Non-Interest
Expenses
|
49
|
|
Provision
for Income Taxes
|
50
|
|
Provision
for Loan Losses
|
50
|
|
Financial
Condition
|
52
|
|
Loans
|
52
|
|
Credit
Quality
|
57
|
|
Allowance
for Loan Losses
|
57
|
|
Non-Performing
Assets
|
60
|
|
Total
Cash and Cash Equivalents
|
65
|
|
Investment
Securities and Other Earning Assets
|
65
|
|
Deposits
and Borrowed Funds
|
67
|
|
Capital
|
69
|
|
Liquidity
|
72
|
|
Inflation
|
73
|
|
Off-Balance
Sheet Arrangements
|
73
|
|
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||
Item
3. Quantative and Qualitative Disclosure About Market
Risk
|
74
|
|
Item
4. Controls and Procedures
|
75
|
|
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||
Part
II. Other Information
|
76
|
|
Item
1. Legal Proceedings
|
76
|
|
Item
1A. Risk Factors
|
77
|
|
Item
2. Unregistered Sales of Equity Securities and Use of
Proceeds
|
77
|
|
Item
3. Defaults upon Senior Securities
|
77
|
|
Item
4. (Removed and Reserved)
|
77
|
|
Item
5. Other Information
|
77
|
|
Item
6. Exhibits
|
78
|
|
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||
Signatures
|
79
|
Heritage
Oaks Bancorp | - 4 -
|
Part
I. Financial Information
Item
1. Consolidated Financial Statements
The
financial statements and the notes thereto begin on next page.
Heritage
Oaks Bancorp | - 5 -
|
Heritage Oaks Bancorp
|
||||||||
and Subsidiaries
|
||||||||
Consolidated Balance Sheets
|
||||||||
(audited)
|
||||||||
June 30,
|
December 31,
|
|||||||
(dollars in thousands except per share data)
|
2010
|
2009
|
||||||
Assets
|
||||||||
Cash
and due from banks
|
$ | 17,849 | $ | 19,342 | ||||
Interest
bearing due from banks
|
38,682 | 17,046 | ||||||
Federal
funds sold
|
5,500 | 4,350 | ||||||
Total
cash and cash equivalents
|
62,031 | 40,738 | ||||||
Interest
bearing deposits with other banks
|
119 | 119 | ||||||
Securities
available for sale
|
192,904 | 121,180 | ||||||
Federal
Home Loan Bank stock, at cost
|
5,611 | 5,828 | ||||||
Loans
held for sale
|
9,429 | 9,487 | ||||||
Loans,
net of deferred fees of $1,698 and $1,825 and allowance for loan loss of
$22,134 and $14,372 at June 30, 2010 and December 31, 2009,
respectively.
|
673,344 | 712,482 | ||||||
Property,
premises and equipment, net
|
6,410 | 6,779 | ||||||
Deferred
tax assets
|
19,174 | 10,553 | ||||||
Bank
owned life insurance
|
12,811 | 12,549 | ||||||
Goodwill
|
11,049 | 11,049 | ||||||
Core
deposit intangible
|
2,385 | 2,642 | ||||||
Other
real estate owned
|
4,953 | 946 | ||||||
Other
assets
|
10,302 | 10,825 | ||||||
Total
assets
|
$ | 1,010,522 | $ | 945,177 | ||||
Liabilities
|
||||||||
Deposits
|
||||||||
Demand,
non-interest bearing
|
$ | 182,846 | $ | 174,635 | ||||
Savings,
NOW, and money market deposits
|
380,257 | 365,602 | ||||||
Time
deposits of $100 or more
|
116,372 | 117,420 | ||||||
Time
deposits under $100
|
116,358 | 117,808 | ||||||
Total
deposits
|
795,833 | 775,465 | ||||||
Short
term FHLB borrowing
|
65,000 | 65,000 | ||||||
Junior
subordinated debentures
|
8,248 | 13,403 | ||||||
Other
liabilities
|
8,091 | 7,558 | ||||||
Total
liabilities
|
877,172 | 861,426 | ||||||
Commitments
and contingencies
|
- | - | ||||||
Stockholders'
Equity
|
||||||||
Series
A senior preferred stock, $1,000 per share stated value, 21,000 shares
issued and outstanding
|
19,610 | 19,431 | ||||||
Series
C preferred stock, $3.25 per share stated value, 1,189,538 shares issued
and outstanding
|
3,608 | - | ||||||
Common
stock, no par value; 100,000,000 shares authorized, issued and outstanding
25,062,682 and 7,771,952 as of June 30, 2010 and December 31, 2009,
respectively.
|
101,197 | 48,747 | ||||||
Additional
paid in capital
|
6,886 | 3,242 | ||||||
Retained
earnings
|
2,073 | 13,407 | ||||||
Accumulated
other comprehensive loss, net of tax benefit of $17 and $752 as of June
30, 2010 and December 31, 2009, respectively.
|
(24 | ) | (1,076 | ) | ||||
Total
stockholders' equity
|
133,350 | 83,751 | ||||||
Total
liabilities and stockholders' equity
|
$ | 1,010,522 | $ | 945,177 |
See notes
to condensed consolidated financial statements.
Heritage
Oaks Bancorp | - 6 -
|
Heritage Oaks Bancorp
|
||||||||||||||||
and Subsidiaries
|
||||||||||||||||
Consolidated Statements of Income
|
||||||||||||||||
For the three months
|
For the six months
|
|||||||||||||||
ended June 30,
|
ended June 30,
|
|||||||||||||||
(dollars in thousands except per share data)
|
2010
|
2009
|
2010
|
2009
|
||||||||||||
Interest
Income
|
||||||||||||||||
Interest
and fees on loans
|
$ | 11,429 | $ | 11,416 | $ | 22,570 | $ | 22,563 | ||||||||
Interest
on investment securities
|
||||||||||||||||
Mortgage
backed securities
|
1,425 | 625 | 2,444 | 1,173 | ||||||||||||
Obligations
of state and political subdivisions
|
287 | 208 | 544 | 394 | ||||||||||||
Interest
on time deposits with other banks
|
1 | 1 | 1 | 2 | ||||||||||||
Interest
on due from Federal Reserve Bank
|
24 | - | 52 | - | ||||||||||||
Interest
on federal funds sold
|
1 | 10 | 2 | 17 | ||||||||||||
Interest
on other securities
|
9 | 9 | 13 | 16 | ||||||||||||
Total
interest income
|
13,176 | 12,269 | 25,626 | 24,165 | ||||||||||||
Interest
Expense
|
||||||||||||||||
Interest
on savings, NOW and money market deposits
|
802 | 839 | 1,884 | 1,656 | ||||||||||||
Interest
on time deposits in denominations of $100 or more
|
519 | 631 | 1,095 | 1,175 | ||||||||||||
Interest
on time deposits under $100
|
577 | 664 | 1,190 | 1,228 | ||||||||||||
Other
borrowings
|
138 | 293 | 370 | 697 | ||||||||||||
Total
interest expense
|
2,036 | 2,427 | 4,539 | 4,756 | ||||||||||||
Net
interest income before provision for possible loan losses
|
11,140 | 9,842 | 21,087 | 19,409 | ||||||||||||
Provision
for possible loan losses
|
16,100 | 2,700 | 21,300 | 4,810 | ||||||||||||
Net
interest (loss) / income after provision for possible loan
losses
|
(4,960 | ) | 7,142 | (213 | ) | 14,599 | ||||||||||
Non
Interest Income
|
||||||||||||||||
Fees
and service charges
|
614 | 752 | 1,239 | 1,464 | ||||||||||||
(Loss)
/ gain on sale of investment securities
|
(97 | ) | - | (97 | ) | 122 | ||||||||||
Gain
/ (loss) on sale of OREO
|
62 | (104 | ) | 62 | (131 | ) | ||||||||||
Gain
on sale of furniture fixtures and equipment
|
58 | - | 58 | - | ||||||||||||
Gain
on sale of SBA loans
|
209 | - | 209 | - | ||||||||||||
Gain
on extinguishment of debt
|
1,700 | - | 1,700 | - | ||||||||||||
Other
|
1,067 | 852 | 2,028 | 1,705 | ||||||||||||
Total
non interest income
|
3,613 | 1,500 | 5,199 | 3,160 | ||||||||||||
Non
Interest Expenses
|
||||||||||||||||
Salaries
and employee benefits
|
4,351 | 3,745 | 8,729 | 7,548 | ||||||||||||
Equipment
|
370 | 376 | 698 | 701 | ||||||||||||
Occupancy
|
941 | 826 | 1,874 | 1,678 | ||||||||||||
Other
|
3,166 | 3,067 | 6,393 | 5,512 | ||||||||||||
Total
non interest expenses
|
8,828 | 8,014 | 17,694 | 15,439 | ||||||||||||
(Loss)
/ income before provision for income taxes
|
(10,175 | ) | 628 | (12,708 | ) | 2,320 | ||||||||||
(Benefit)
/ provision for income taxes
|
(4,340 | ) | 121 | (5,534 | ) | 711 | ||||||||||
Net
(loss) / income
|
(5,835 | ) | 507 | (7,174 | ) | 1,609 | ||||||||||
Dividends
and accretion on preferred stock
|
3,809 | 250 | 4,160 | 261 | ||||||||||||
Net
(loss) / income applicable to common shareholders
|
$ | (9,644 | ) | $ | 257 | $ | (11,334 | ) | $ | 1,348 | ||||||
(Loss)
/ Earnings Per Common Share
|
||||||||||||||||
Basic
|
$ | (0.86 | ) | $ | 0.03 | $ | (1.19 | ) | $ | 0.17 | ||||||
Diluted
|
$ | (0.86 | ) | $ | 0.03 | $ | (1.19 | ) | $ | 0.17 |
See notes
to condensed consolidated financial statements.
Heritage
Oaks Bancorp | - 7 -
|
Heritage Oaks Bancorp
|
||||||||||||||||||||||||||||||||
and Subsidiaries
|
||||||||||||||||||||||||||||||||
Consolidated Statements of Stockholders' Equity
|
||||||||||||||||||||||||||||||||
Accumulated
|
||||||||||||||||||||||||||||||||
Common Stock
|
Additional
|
Other
|
Total
|
|||||||||||||||||||||||||||||
Preferred
|
Number of
|
Paid-In
|
Comprehensive
|
Retained
|
Comprehensive
|
Stockholders'
|
||||||||||||||||||||||||||
(dollars in thousands)
|
Stock
|
Shares
|
Amount
|
Capital
|
Income
|
Earnings
|
Income/(loss)
|
Equity
|
||||||||||||||||||||||||
Balance,
December 31, 2009
|
$ | 19,431 | 7,771,952 | $ | 48,747 | $ | 3,242 | $ | 13,407 | $ | (1,076 | ) | $ | 83,751 | ||||||||||||||||||
Issuance
of 56,160 shares of Series B preferred stock
|
52,408 | 52,408 | ||||||||||||||||||||||||||||||
Discount
on Series B preferred stock
|
(3,456 | ) | 3,456 | - | ||||||||||||||||||||||||||||
Conversion
of Series B preferred stock to common stock
|
(52,408 | ) | 17,279,995 | 52,408 | - | |||||||||||||||||||||||||||
Issuance
of 1,189,538 shares of Series C preferred stock
|
3,608 | 3,608 | ||||||||||||||||||||||||||||||
Accretion
on Series A preferred stock
|
179 | (179 | ) | - | ||||||||||||||||||||||||||||
Accretion
on Series B preferred stock
|
3,456 | (3,456 | ) | - | ||||||||||||||||||||||||||||
Dividends
paid on preferred stock
|
(262 | ) | (262 | ) | ||||||||||||||||||||||||||||
Accrued
dividends on preferred stock
|
(263 | ) | (263 | ) | ||||||||||||||||||||||||||||
Exercise
of stock options
|
11,260 | 42 | 42 | |||||||||||||||||||||||||||||
Share-based
compensation expense
|
188 | 188 | ||||||||||||||||||||||||||||||
Retirement
of restricted share awards
|
(525 | ) | ||||||||||||||||||||||||||||||
Comprehensive
income:
|
||||||||||||||||||||||||||||||||
Net
loss
|
$ | (7,174 | ) | (7,174 | ) | (7,174 | ) | |||||||||||||||||||||||||
Unrealized
security holding gains (net of $695 tax)
|
995 | 995 | 995 | |||||||||||||||||||||||||||||
Realized
loss on sale of securities (net of $40 tax benefit)
|
57 | 57 | 57 | |||||||||||||||||||||||||||||
Total
comprehensive loss
|
$ | (6,122 | ) | |||||||||||||||||||||||||||||
Balance,
June 30, 2010
|
$ | 23,218 | 25,062,682 | $ | 101,197 | $ | 6,886 | $ | 2,073 | $ | (24 | ) | $ | 133,350 | ||||||||||||||||||
Balance,
December 31, 2008
|
$ | - | 7,753,078 | $ | 48,649 | $ | 1,055 | $ | 21,420 | $ | (1,092 | ) | $ | 70,032 | ||||||||||||||||||
Issuance
of 21,000 shares of Series A Senior preferred stock and common stock
warrant
|
19,152 | 1,848 | 21,000 | |||||||||||||||||||||||||||||
Accretion
on Series A preferred stock
|
101 | (101 | ) | - | ||||||||||||||||||||||||||||
Dividends
paid on preferred stock
|
(160 | ) | (160 | ) | ||||||||||||||||||||||||||||
Exercise
of stock options (including $9 excess tax benefit from exercise of stock
options)
|
10,050 | 46 | 46 | |||||||||||||||||||||||||||||
Share-based
compensation expense
|
184 | 184 | ||||||||||||||||||||||||||||||
Retirement
of restricted share awards
|
(1,575 | ) | ||||||||||||||||||||||||||||||
Comprehensive
income:
|
||||||||||||||||||||||||||||||||
Net
income
|
$ | 1,609 | 1,609 | 1,609 | ||||||||||||||||||||||||||||
Unrealized
security holding losses (net of $1,027 tax benefit)
|
(1,469 | ) | (1,469 | ) | (1,469 | ) | ||||||||||||||||||||||||||
Realized
gains on sale of securities (net of $50 tax)
|
72 | 72 | 72 | |||||||||||||||||||||||||||||
Total
comprehensive income
|
$ | 212 | ||||||||||||||||||||||||||||||
Balance,
June 30, 2009
|
$ | 19,253 | 7,761,553 | $ | 48,695 | $ | 3,087 | $ | 22,768 | $ | (2,489 | ) | $ | 91,314 |
See notes
to condensed consolidated financial statements.
Heritage
Oaks Bancorp | - 8 -
|
Heritage Oaks Bancorp
|
||||||||
and Subsidiaries
|
||||||||
Consolidated Statements of Cash Flows
|
||||||||
For the six month periods
|
||||||||
ended June 30,
|
||||||||
(dollars in thousands)
|
2010
|
2009
|
||||||
Cash
flows from operating activities:
|
||||||||
Net
(loss) / income
|
$ | (7,174 | ) | $ | 1,609 | |||
Adjustments
to reconcile net income to net cash provided / (used) by operating
activities:
|
||||||||
Depreciation
and amortization
|
638 | 547 | ||||||
Provision
for possible loan losses
|
21,300 | 4,810 | ||||||
Amortization
of premiums / discounts on investment securities, net
|
591 | 29 | ||||||
Amortization
of intangible assets
|
257 | 525 | ||||||
Share-based
compensation expense
|
188 | 184 | ||||||
Loss
/ (gain) on sale of available for sale securities
|
97 | (122 | ) | |||||
Gain
on extinguishment of debt
|
(1,700 | ) | - | |||||
Decrease
/ (increase) in loans held for sale
|
58 | (3,753 | ) | |||||
Net
increase in bank owned life insurance
|
(262 | ) | (212 | ) | ||||
(Increase)
/ decrease in deferred tax asset
|
(9,356 | ) | 12 | |||||
(Gain)
/ loss on sale of other real estate owned
|
(62 | ) | 73 | |||||
Write-downs
on other real estate owned
|
205 | 131 | ||||||
Increase
in other assets
|
(4,464 | ) | (7,799 | ) | ||||
Increase
in other liabilities
|
270 | 822 | ||||||
Excess
tax benefit related to share-based compensation expense
|
- | (9 | ) | |||||
NET
CASH PROVIDED / (USED) IN OPERATING ACTIVITIES
|
586 | (3,153 | ) | |||||
Cash
flows from investing activities:
|
||||||||
Purchase
of securities, available for sale
|
(83,443 | ) | (38,553 | ) | ||||
Sale
of available for sale securities
|
2,197 | 4,762 | ||||||
Maturities
and calls of available for sale securities
|
338 | 1,136 | ||||||
Proceeds
from principal reductions and maturities of available for sale
securities
|
10,283 | 5,410 | ||||||
Purchase
of Federal Home Loan Bank stock
|
- | (705 | ) | |||||
Redemption
of Federal Home Loan Bank stock
|
217 | - | ||||||
Decrease
/ (increase) in loans, net
|
16,198 | (21,991 | ) | |||||
Allowance
for loan and lease loss recoveries
|
1,640 | 22 | ||||||
Purchase
of property, premises and equipment, net
|
(269 | ) | (578 | ) | ||||
Proceeds
from sale of other real estate owned
|
837 | 2,863 | ||||||
NET
CASH USED IN INVESTING ACTIVITIES
|
(52,002 | ) | (47,634 | ) | ||||
Cash
flows from financing activities:
|
||||||||
Increase
in deposits, net
|
20,368 | 100,468 | ||||||
Proceeds
from Federal Home Loan Bank borrowing
|
- | 75,000 | ||||||
Repayments
of Federal Home Loan Bank borrowing
|
- | (119,000 | ) | |||||
Decrease
in repurchase agreements
|
- | (2,796 | ) | |||||
Decrease
in junior subordinated debentures
|
(3,455 | ) | - | |||||
Excess
tax benefit related to share-based compensation expense
|
- | 9 | ||||||
Proceeds
from exercise of stock options
|
42 | 37 | ||||||
Cash
dividends paid
|
(262 | ) | (160 | ) | ||||
Proceeds
from issuance of preferred stock and common stock warrants,
net
|
56,016 | 21,000 | ||||||
NET
CASH PROVIDED BY FINANCING ACTIVITIES
|
72,709 | 74,558 | ||||||
Net
increase in cash and cash equivalents
|
21,293 | 23,771 | ||||||
Cash
and cash equivalents, beginning of period
|
40,738 | 24,571 | ||||||
Cash
and cash equivalents, end of period
|
$ | 62,031 | $ | 48,342 | ||||
Supplemental
Cash Flow Disclosures:
|
||||||||
Cash
Flow information
|
||||||||
Interest
paid
|
$ | 4,692 | $ | 4,836 | ||||
Income
taxes paid
|
$ | 3,125 | $ | 220 | ||||
Non-Cash
Flow Information
|
||||||||
Change
in other valuation allowance for investment securities
|
$ | 1,787 | $ | (2,374 | ) | |||
Loans
transferred to OREO or foreclosed collateral
|
$ | 4,987 | $ | 8,403 | ||||
Preferred
stock dividends declared not paid
|
$ | 263 | $ | - | ||||
Accretion
of preferred stock discount
|
$ | 3,635 | $ | - | ||||
Conversion
of preferred stock to common stock
|
$ | 52,408 | $ | - |
See notes
to condensed consolidated financial statements.
Heritage
Oaks Bancorp | - 9 -
|
Notes
to Consolidated Financial
Statements
|
Note
1. Consolidated Financial Statements
The
accompanying un-audited condensed consolidated financial statements of Heritage
Oaks Bancorp and subsidiaries (the “Company”) have been prepared in accordance
with the instructions to Form 10-Q and Article 10 of Regulation S-X.
Accordingly, certain information and notes required by accounting principles
generally accepted in the United States of America (“U.S. GAAP”) for annual
financial statements are not included herein. In the opinion of Management, all
adjustments (which consist solely of normal recurring accruals) considered
necessary for a fair presentation of results for the interim periods presented
have been included. These interim condensed consolidated financial statements
should be read in conjunction with the financial statements and related notes
contained in the Company’s 2009 Annual Report filed on Form 10-K.
The
condensed consolidated financial statements include the accounts of the Company
and its wholly-owned financial subsidiary, Heritage Oaks Bank (“the
Bank”). All significant inter-company balances and transactions have
been eliminated. Heritage Oaks Capital Trust II is an unconsolidated subsidiary
formed solely for the purpose of issuing trust preferred securities. Operating
results for the three and six months ended June 30, 2010 are not necessarily
indicative of the results that may be expected for the year ending December 31,
2010. Certain amounts in the consolidated financial statements for the year
ended December 31, 2009 and for the three and six months ended June 30, 2009 may
have been reclassified to conform to the presentation of the consolidated
financial statements in 2010.
The
preparation of consolidated financial statements in conformity with U.S. GAAP
requires Management to make estimates and assumptions. These
estimates and assumptions affect the reported amounts of assets and liabilities
at the date of the consolidated financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results
could differ from these estimates.
Events or
transactions that provided evidence about conditions that did not exist at June
30, 2010, but arose before the financial statements were available to be issued
have not been recognized in the financial statements as of and for the periods
ended June 30, 2010. Based on all currently available information,
the Company is not aware of any such events. Events or transactions
that were deemed to be of a material nature and provide evidence about
conditions that did exist at June 30, 2010 have been recognized in these
consolidated financial statements.
Note
2. Investment Securities
In
accordance with U.S. GAAP, investment securities are classified in three
categories and accounted for as follows: debt and mortgage-backed securities
that the Company has the positive intent and ability to hold to maturity are
classified as held-to-maturity and are measured at amortized cost; debt and
equity securities bought and held principally for the purpose of selling in the
near term are classified as trading securities and are measured at fair value,
with the unrealized gains and losses included in earnings; debt and equity
securities not classified as either held-to-maturity or trading securities are
deemed as available-for-sale and are measured at fair value, with the unrealized
gains and losses, net of applicable taxes, reported in a separate component of
stockholders’ equity. Any gains and losses on sales of investments are computed
on a specific identification basis. Premiums and discounts are
amortized or accreted using the interest method over the lives of the related
securities.
Heritage
Oaks Bancorp | - 10 -
|
Notes
to Consolidated Financial
Statements
|
The
following table sets forth the amortized cost and fair values of investment
securities available for sale at June 30, 2010 and December 31,
2009:
(dollars in thousands)
|
Gross
|
Gross
|
||||||||||||||
Amortized
|
Unrealized
|
Unrealized
|
Fair
|
|||||||||||||
As of June 30, 2010
|
Cost
|
Gains
|
Losses
|
Value
|
||||||||||||
Obligations
of U.S. government agencies and corporations
|
$ | 104 | $ | - | $ | (4 | ) | $ | 100 | |||||||
Mortgage
backed securities
|
||||||||||||||||
Agency
|
146,080 | 1,330 | (444 | ) | 146,966 | |||||||||||
Non-agency
|
19,095 | 909 | (2,271 | ) | 17,733 | |||||||||||
Obligations
of state and political subdivisions
|
27,557 | 576 | (137 | ) | 27,996 | |||||||||||
Other
securities
|
109 | - | - | 109 | ||||||||||||
Total
|
$ | 192,945 | $ | 2,815 | $ | (2,856 | ) | $ | 192,904 | |||||||
As
of December 31, 2009
|
||||||||||||||||
Obligations
of U.S. government agencies
|
$ | 108 | $ | - | $ | (4 | ) | $ | 104 | |||||||
Mortgage-backed
securities
|
||||||||||||||||
Agency
|
78,203 | 619 | (872 | ) | 77,950 | |||||||||||
Non-agency
|
21,935 | 1,184 | (2,966 | ) | 20,153 | |||||||||||
Obligations
of state and political subdivisions
|
22,653 | 421 | (210 | ) | 22,864 | |||||||||||
Other
securities
|
109 | - | - | 109 | ||||||||||||
Total
|
$ | 123,008 | $ | 2,224 | $ | (4,052 | ) | $ | 121,180 |
During
the six months ended June 30, 2010 the Bank purchased approximately $83.4
million in investment securities. Sales of investments totaled
approximately $2.2 million. In connection with these sales, the Bank
recognized an aggregate pre-tax loss of $0.1 million. Sales of
investment securities during the first six months of 2009 totaled approximately
$4.8 million. Gains recognized in connection with those sales totaled
approximately $0.1 million. Principal pay-downs on mortgage related
securities totaled approximately $10.3 million during the first six months of
2010.
Other
than Temporary Impairment
Management
periodically evaluates investments in the portfolio for other than temporary
impairment and more specifically when conditions warrant such an
evaluation. When evaluating whether impairment is other than
temporary, Management considers, among other things, the following: (1) the
length of time the security has been in an unrealized loss position, (2) the
extent to which the security’s fair value is less than its cost, (3) the
financial condition of the issuer, (4) any adverse changes in ratings issued by
various rating agencies, (5) the intent and ability of the Bank to hold such
securities for a period of time sufficient to allow for any anticipated recovery
in fair value and (6) in the case of mortgage related securities, credit
enhancements, loan-to-values, credit scores, delinquency and default rates, cash
flows and the extent to which those cash flows are within Management’s initial
expectations based on pre-purchase analyses.
During
the fourth quarter of 2009 the Company performed an analysis, with the
assistance of an independent third party, on several non-agency whole loan
collateralized mortgage obligations (“CMOs”) in the investment portfolio for
other than temporary impairment (“OTTI”). These securities were in a
net unrealized loss position for more than 12 months, were downgraded to below
investment grade status, and had been experiencing increases in delinquency and
default rates for a period of at least 12 months. The Company’s
review of these securities was performed under FASB ASC 320, which includes new
guidance the Company was required to adopt on January 1, 2009 in evaluating
investments for other than temporary impairment. OTTI is considered
to have occurred: (1) if the Company intends to sell the related
securities; (2) if it is “more likely than not” the Company will be
required to sell the securities before recovery of its amortized cost basis; or
(3) the present value of expected future cash flows is not sufficient to
recover the entire amortized cost basis of the securities.
Under
FASB ASC 320, an OTTI loss must be fully recognized in earnings if an investor
has the intent to sell the security or if it is more likely than not the
investor will be required to sell the security before the recovery of its
amortized cost. However, if an investor does not intend to sell the
security, it must still evaluate the expected future cash flows to be received
to determine if a credit loss has occurred. In the event that a
credit loss has occurred, only the amount of impairment related to the credit
loss is recognized in earnings. OTTI amounts related to all other
factors, such as market conditions, are recorded as a component of accumulated
other comprehensive income.
Although
as of the date of evaluation the Company had the ability and intent to hold the
related securities it evaluated for OTTI for the foreseeable future, the results
of the analysis performed on these securities indicated that the present value
of the expected future cash flows on each security was not sufficient to recover
their entire amortized cost basis and thus indicating a credit loss had
occurred.
Heritage
Oaks Bancorp | - 11 -
|
Notes
to Consolidated Financial
Statements
|
The
results of the Company’s Q4 2009 evaluation of several non-agency whole loan
CMOs indicated there was OTTI on four holdings in the investment portfolio as of
December 31, 2009. The gross unrealized loss on these holdings at the
time impairment was determined was approximately $2.0 million. The
Company’s analysis indicated that approximately $0.4 million of these losses
were credit related, while approximately $1.6 million were related to all other
factors, including general market conditions. These amounts were
recorded in the Company’s consolidated financial statements during the fourth
quarter of 2009. As of June 30, 2010 the remaining book balance of
these securities was approximately $3.9 million, compared to the $5.4 million
reported at December 31, 2009. During the second quarter of 2010 the
Bank sold one of the four securities mentioned above in an effort to take
advantage of current, more favorable, market pricing during the second
quarter. The Bank recognized a loss of approximately $150 thousand on
the sale of this security. The Company will continue to engage an independent
third party to review these securities on a quarterly basis for the foreseeable
future.
The
Company’s evaluations of non-agency whole loan CMOs, with the assistance of an
independent third party, compile relevant collateral details and performance
statistics on a security-by-security basis. These evaluations also
include assumptions about prepayment rates, future delinquencies, and loss
severities based on the underlying collateral characteristics, and
vintage. Additionally, evaluations include consideration of actual
recent collateral performance, the structuring of the security, including the
Company’s position within that structure, and expectations of relevant market
and economic data as of the end of the reporting period. Assumptions
made concerning the items listed above allow the Company to then derive an
estimate for the net present value of each security’s expected future cash
flows. This amount is then compared to the amortized cost of each
security to determine the amount of any possible credit loss.
As of
June 30, 2010, net unrealized losses on non-agency CMOs within the Bank’s
investment portfolio totaled approximately $1.4 million compared to $1.8 million
reported at December 31, 2009 and were primarily attributable to market interest
rate volatility and a significant widening of interest rate spreads relating to
the continued uncertainty in financial markets, rather than to credit
risk. Current characteristics of each security owned, such as
delinquency rates, foreclosure levels, credit enhancements, and projected
losses, are reviewed periodically by Management. Accordingly,
it is expected that these securities would not be settled at a price less than
the amortized cost of the Company’s investment. Because the Company does not
have the intent to sell these investments and it is not more likely than not
that the Company will be required to sell these investments before anticipated
recovery of fair value, which may be at maturity, the Company did not consider
these investments to be other than temporarily impaired as of June 30,
2010. However, it is possible that the underlying loan collateral of
these securities will perform worse than is currently expected, which could lead
to adverse changes in cash flows on these securities and future OTTI
losses. Events that could trigger material unrecoverable declines in
fair values, and therefore potential OTTI losses for these securities in the
future, include, but are not limited to, further significantly weakened economic
conditions, deterioration of credit metrics, significantly higher levels of
default, loss in value on the underlying collateral, deteriorating credit
enhancement, and further uncertainty and illiquidity in the financial
markets.
As of
June 30, 2010, the Company believes that unrealized losses on all other mortgage
related securities such as agency securities, including those issued by the
Federal Home Loan Mortgage Corporation (“FHLMC”), the Federal National Mortgage
Association (“FNMA”) and the Government National Mortgage Association (“GNMA”)
are not attributable to credit quality, but rather fluctuations in market prices
for these types of investments. Additionally, these securities have
maturity dates that range from 1 to 30 years and have contractual cash flows
guaranteed by agencies of the U.S. Government. As of June 30, 2010,
the Company does not believe unrealized losses related to these securities are
other than temporary.
The
following table provides a roll forward as of June 30, 2010 of investment
securities credit losses recorded in earnings. The beginning balance represents
the credit loss component for which OTTI occurred on debt securities in prior
periods. Additions represent the first time a debt security was credit impaired
or when subsequent credit impairments have occurred on securities for which OTTI
credit losses have been previously recognized. The Company did not record any
OTTI on investment securities during the three and six months ended June 30,
2010.
OTTI Related to
|
||||||||||||
OTTI Related
|
All Other
|
Total
|
||||||||||
(dollar amounts in thousands)
|
to Credit Loss
|
Factors
|
OTTI
|
|||||||||
Balance,
December 31, 2009
|
$ | 372 | $ | 1,584 | $ | 1,956 | ||||||
Charges
on securities for which OTTI was not previously recognized
|
- | - | - | |||||||||
Realized
losses for securities sold
|
(45 | ) | (70 | ) | (115 | ) | ||||||
Balance,
June 30, 2010
|
$ | 327 | $ | 1,514 | $ | 1,841 |
Heritage
Oaks Bancorp | - 12 -
|
Notes
to Consolidated Financial
Statements
|
The
following table provides a summary of investment securities in an unrealized
loss position as of June 30, 2010 and December 31, 2009:
Securities In A Loss Position
|
||||||||||||||||||||||||
For Less Than 12 Months
|
For 12 Months or More
|
Total
|
||||||||||||||||||||||
(dollars in thousands)
|
Fair
|
Unrealized
|
Fair
|
Unrealized
|
Fair
|
Unrealized
|
||||||||||||||||||
As of June 30, 2010
|
Value
|
Loss
|
Value
|
Loss
|
Value
|
Loss
|
||||||||||||||||||
Obligations
of U.S. government agencies and corporations
|
$ | - | $ | - | $ | 100 | $ | (4 | ) | $ | 100 | $ | (4 | ) | ||||||||||
Mortgage-backed
securities
|
||||||||||||||||||||||||
Agency
|
60,479 | (444 | ) | 76 | - | 60,555 | (444 | ) | ||||||||||||||||
Non-agency
|
- | - | 10,054 | (2,271 | ) | 10,054 | (2,271 | ) | ||||||||||||||||
Obligations
of state and political subdivisions
|
5,902 | (124 | ) | 139 | (13 | ) | 6,041 | (137 | ) | |||||||||||||||
Total
|
$ | 66,381 | $ | (568 | ) | $ | 10,369 | $ | (2,288 | ) | $ | 76,750 | $ | (2,856 | ) | |||||||||
As
of December 31, 2009
|
||||||||||||||||||||||||
Obligations
of U.S. government agencies
|
$ | - | $ | - | $ | 104 | $ | (4 | ) | $ | 104 | $ | (4 | ) | ||||||||||
Mortgage
backed securities
|
||||||||||||||||||||||||
Agency
|
38,625 | (870 | ) | 357 | (2 | ) | 38,982 | (872 | ) | |||||||||||||||
Non-agency
|
- | - | 11,618 | (2,966 | ) | 11,618 | (2,966 | ) | ||||||||||||||||
Obligations
of state and political subdivisions
|
6,012 | (210 | ) | - | - | 6,012 | (210 | ) | ||||||||||||||||
Total
|
$ | 44,637 | $ | (1,080 | ) | $ | 12,079 | $ | (2,972 | ) | $ | 56,716 | $ | (4,052 | ) |
At June
30, 2010, the Bank owned ten Whole Loan Private Label Mortgage Backed Securities
(“PMBS”) with a remaining principal balance of approximately $19.1
million. PMBS do not carry a government guarantee (explicit or
implicit) and require much more detailed due diligence in the form of pre and
post purchase analysis. All PMBS bonds were rated AAA by one or more
of the major rating agencies at the time of purchase. Due to the
severe and prolonged downturn in the economy PMBS bonds along with other asset
classes have seen deterioration in price, credit quality, and
liquidity. Rating agencies have been reassessing all ratings
associated with bonds starting with lower tranche or subordinate pieces (which
have increased loss exposure) then moving on to senior and super senior bonds
which is what the Bank owns with the exception of one mezzanine bond
(subordinate). At June 30, 2010, six bonds with an aggregate fair
value of $9.8 million are deemed to be non-investment grade. All six of these
bonds are in senior or super senior tranche positions of their respective bond
structures, meaning the Bank has priority in cash flows and has subordinate
tranches below its position providing credit support.
The Bank
continues to perform regular extensive analyses, quarterly, on PMBS bonds in the
portfolio including but not limited to updates on: credit enhancements,
loan-to-values, credit scores, delinquency rates and default rates. These
investment securities continue to demonstrate cash flows as expected, based on
pre-purchase analyses. As of June 30, 2010, Management does not
believe that losses on PMBS in the portfolio, other than those previously
discussed, are other than temporary.
Heritage
Oaks Bancorp | - 13 -
|
Notes
to Consolidated Financial
Statements
|
Note
3. Loans and the Allowance for Loan Losses
The
following table provides a summary of outstanding loan balances as of June 30,
2010 compared to December 31, 2009:
June 30,
|
December 31,
|
|||||||
(dollars in thousands)
|
2010
|
2009
|
||||||
Real
Estate Secured
|
||||||||
Multi-family
residential
|
$ | 18,911 | $ | 20,631 | ||||
Residential
1 to 4 family
|
29,476 | 25,483 | ||||||
Home
equity lines of credit
|
30,541 | 29,780 | ||||||
Commercial
|
351,598 | 337,940 | ||||||
Farmland
|
13,032 | 13,079 | ||||||
Commercial
|
||||||||
Commercial
and industrial
|
144,928 | 157,270 | ||||||
Agriculture
|
16,071 | 17,698 | ||||||
Other
|
246 | 238 | ||||||
Construction
|
||||||||
Single
family residential
|
9,501 | 15,538 | ||||||
Single
family residential - Spec.
|
2,750 | 3,400 | ||||||
Tract
|
- | 2,215 | ||||||
Multi-family
|
1,883 | 2,300 | ||||||
Hospitality
|
- | 14,306 | ||||||
Commercial
|
31,398 | 27,128 | ||||||
Land
|
39,356 | 52,793 | ||||||
Installment
loans to individuals
|
7,232 | 8,327 | ||||||
All
other loans (including overdrafts)
|
253 | 553 | ||||||
Total
loans, gross
|
697,176 | 728,679 | ||||||
Deferred
loan fees
|
1,698 | 1,825 | ||||||
Allowance
for loan losses
|
22,134 | 14,372 | ||||||
Total
loans, net
|
$ | 673,344 | $ | 712,482 | ||||
Loans
held for sale
|
$ | 9,429 | $ | 9,487 |
Concentration
of Credit Risk
At June
30, 2010, approximately $528.4 million or 75.8% of the Bank’s loan portfolio was
collateralized by various forms of real estate, this represents a decrease of
approximately $16.1 million when compared to that reported at December 31, 2009.
Such loans are generally made to borrowers located in San Luis Obispo and Santa
Barbara Counties. The Bank attempts to reduce its concentration of credit risk
by making loans which are diversified by industry and project
type. While Management believes that the collateral presently
securing this portfolio is adequate, there can be no assurances that further
significant deterioration in the California real estate market would not expose
the Bank to significantly greater credit risk.
At June
30, 2010, the Bank was contingently liable for letters of credit accommodations
made to its customers totaling approximately $15.7 million and un-disbursed loan
commitments in the approximate amount of $119.2 million. The Bank makes
commitments to extend credit in the normal course of business to meet the
financing needs of its customers. Commitments to extend credit are agreements to
lend to a customer as long as there is no violation of any condition established
in the contract. Commitments generally have fixed expiration dates or
other termination clauses and may require payment of a fee. Since
many of the commitments are expected to expire without being drawn upon, the
total outstanding commitment amount does not necessarily represent future cash
requirements. Standby letters of credit written are conditional commitments
issued by the Bank to guarantee the performance of a customer to a third party.
The credit risk involved in issuing letters of credit is essentially the same as
those involved in extending loan facilities to customers. The Bank currently
anticipates no losses as a result of such transactions. For more
detailed information on concentrations of credit risk, please refer to “Loans”
of “Financial Condition” under “Management’s Discussion and Analysis of Results
and Operations” contained within this document.
Heritage
Oaks Bancorp | - 14 -
|
Notes
to Consolidated Financial
Statements
|
Loans
Serviced for Others
Loans
serviced for others are not included in the accompanying balance
sheets. The unpaid principal balance of loans serviced for others,
exclusive of Small Business Administration (“SBA”) loans was $15.1 million and
$16.3 million at June 30, 2010 and December 31, 2009, respectively.
The Bank
originates SBA loans for sale to governmental agencies and institutional
investors. At June 30, 2010 and December 31, 2009, the unpaid
principal balance of SBA loans serviced for others totaled $6.6 million and $4.4
million, respectively. In accordance with ASC 860, the Bank
recognized approximately $0.2 million in gains on the sale of SBA loans for the
three and six months ended June 30, 2010. The Bank also recorded
approximately $31 thousand and $79 thousand in servicing assets related to the
sale of SBA loans during the three and six months ended June 30,
2010. These servicing assets are recoded initially at fair value and
will be amortized in proportion to and over the period of estimated net
servicing income associated with each SBA loan for which the Bank provides
servicing.
The
following table provides a reconciliation of the change in net SBA servicing
assets for the three and six months ended June 30, 2010:
For the three months ended
|
For the six months ended
|
|||||||||||||||
June 30,
|
June 30,
|
|||||||||||||||
(dollar amounts in thousands)
|
2010
|
2009
|
2010
|
2009
|
||||||||||||
Beginning
balance
|
$ | 29 | $ | (18 | ) | $ | (19 | ) | $ | (18 | ) | |||||
Additions
|
31 | - | 79 | - | ||||||||||||
Disposals
|
- | - | - | - | ||||||||||||
Amortization
|
(1 | ) | - | (1 | ) | - | ||||||||||
Ending
balance
|
$ | 59 | $ | (18 | ) | $ | 59 | $ | (18 | ) |
U.S. GAAP
requires that the Company record the transfer of a portion of a financial asset
(such as SBA loans) as secured borrowing in its consolidated financial
statements until such time that the transfer of a portion of the financial asset
represents a participating interest and the transfer of the participating
interest has met the conditions for surrender of control, as defined in ASC
860.
The
following summarizes the conditions that must be met to qualify as a
participating interest:
|
·
|
The
portions of a financial asset must represent a proportionate ownership
interest in an entire financial
asset.
|
|
·
|
From
the date of transfer, all cash flows received from the entire financial
asset must be divided proportionately among the participating interest
holders in an amount equal to their share of
ownership.
|
|
·
|
The
transfer of the financial asset shall involve no recourse (other than
standard representation and warranties) to, or subordination by, any
participating interest holder.
|
|
·
|
No
party has the right to pledge or exchange the entire financial
asset.
|
If the
participating interest or surrender of control criteria are not met the transfer
of the financial asset is not accounted for as a sale and de-recognition of the
asset is not appropriate and the Bank would continue to account for the transfer
as secured borrowing.
The
accounting guidance provided under ASC 860 has impacted the way the Bank
accounts for the sale of SBA loans. The terms contained in certain
participation and loan sale agreements, specifically those that relate to the
sale of SBA loans, are outside the control of the Company. These
sales agreements contain recourse provisions (generally 90 days) that initially
require the Bank to account for the transfer of a portion of these financial
assets as secured borrowing, until such time that the recourse provision
expires. Once the recourse provision expires, transfers of a portion
of these financial assets are re-evaluated to determine if they meet the
participating interest definition and subsequently accounted for as a
sale. As a result, the Bank will report SBA transfers as secured
borrowings over the period for which recourse provisions exist, which will
result in the deferral of any potential gain on sale from these transactions,
assuming all other sales criteria for each transaction are met.
Heritage
Oaks Bancorp | - 15 -
|
Notes
to Consolidated Financial
Statements
|
Impaired
Loans
The
following provides a summary of the Bank’s investment in impaired loans, the
corresponding valuation allowance for such loans, and income recognized thereon
as of June 30, 2010 and 2009:
June 30,
|
December 31,
|
|||||||
(dollar amounts in thousands)
|
2010
|
2009
|
||||||
Non-accruing
loans
|
$ | 35,066 | $ | 38,170 | ||||
Loans
90 days or more past due and still accruing
|
- | 151 | ||||||
Troubled
debt restructurings
|
10,731 | 9,703 | ||||||
Total
impaired loans
|
$ | 45,797 | $ | 48,024 | ||||
Impaired
loans with a valuation allowance
|
$ | 7,482 | $ | 6,155 | ||||
Valuation
allowance related to impaired loans
|
$ | 2,408 | $ | 852 | ||||
Impaired
loans without a valuation allowance
|
$ | 38,315 | $ | 41,869 | ||||
Average
recorded investment in impaired loans
|
$ | 51,450 | $ | 32,781 | ||||
Cash
receipts applied to reduce principal balance
|
$ | 9,772 | $ | 7,042 |
The
provisions of U.S. GAAP permit the valuation allowances reported above to be
determined on a loan-by-loan basis or by aggregating loans with similar risk
characteristics. Because all of the loans currently identified as
impaired have unique risk characteristics, valuation allowances the Bank has
recorded were determined on a loan-by-loan basis.
Loans the
Company considers to be impaired totaled approximately $45.8 million and $48.0
million at June 30, 2010 and December 31, 2009, respectively. The
Company classifies all non-accruing loans, loans 90 days or more past due and
still accruing as well as loans classified as troubled debt restructures as
impaired. If interest on non-accruing loans had been recognized at
the original interest rates stipulated in the respective loan agreements,
interest income would have been approximately $1.0 million and $1.6 million
higher during the three and six months ended June 30, 2010 compared to that
reported for the same periods ended a year earlier. The Company
recognized approximately $0.2 million and $0.3 million in interest income on
certain loans classified as impaired for the three and six months ended June 30,
2010. This compares to $4 thousand and $8 thousand in interest income
recognized on impaired loans for the same periods ended a year
earlier. Interest income recognition on impaired loans related
exclusively to troubled debt restructurings (“TDRs”) that were performing under
the modified terms of their respective loan agreements. It should be noted that
a significant portion of the Company’s impaired loans were carried at fair value
as of June 30, 2010, resulting in large part from the charge-off of loan
balances following the receipt of appraisal information on the underlying
collateral.
At June
30, 2010, approximately $14.7 million in loans were classified as TDRs of which
approximately $4.0 million were non-accruing. As of June 30, 2010
substantially all TDRs were evaluated based on the underlying collateral of the
respective loans. In a majority of cases, the Company has granted
concessions regarding interest rates, payment structure and
maturity. Foregone interest related to TDRs totaled approximately $35
thousand and $77 thousand for the three and six months ended June 30,
2010. This compares to the $7 thousand and $9 thousand reported in
the same three and six month periods ended a year earlier.
Allowance
for Loan Losses
An
allowance for loan losses has been established by Management to provide for
those loans that may not be repaid in their entirety for a variety of
reasons. The allowance is maintained at a level considered by
Management to be adequate to provide for probable incurred
losses. The allowance is increased by provisions charged to earnings
and is reduced by charge-offs, net of recoveries. The provision for loan losses
is based upon past loan loss experience and Management’s evaluation of the loan
portfolio under current economic conditions. Loans are charged to the
allowance for loan losses when, and to the extent, they are deemed by Management
to be uncollectible.
Heritage
Oaks Bancorp | - 16 -
|
Notes
to Consolidated Financial
Statements
|
The
following table provides a summary for the activity in the allowance for loan
losses during the periods indicated:
For the three months ended
|
For the six months ended
|
For the year ended
|
||||||||||||||||||
June 30,
|
June 30,
|
December 31,
|
||||||||||||||||||
(dollars in thousands)
|
2010
|
2009
|
2010
|
2009
|
2009
|
|||||||||||||||
Balance
at beginning of period
|
$ | 18,559 | $ | 10,429 | $ | 14,372 | $ | 10,412 | $ | 10,412 | ||||||||||
Provision
expense
|
16,100 | 2,700 | 21,300 | 4,810 | 24,066 | |||||||||||||||
Loans
charged-off
|
||||||||||||||||||||
Commercial
real estate
|
2,583 | - | 2,583 | - | 339 | |||||||||||||||
Farmland
|
235 | - | 235 | - | - | |||||||||||||||
Residential
1-4 family
|
282 | - | 282 | - | 558 | |||||||||||||||
Commercial
and industrial
|
7,869 | 942 | 8,818 | 1,225 | 5,816 | |||||||||||||||
Agriculture
|
1,209 | - | 1,209 | - | 2,224 | |||||||||||||||
Construction
|
525 | 415 | 988 | 1,821 | 2,218 | |||||||||||||||
Land
|
956 | 681 | 956 | 991 | 8,886 | |||||||||||||||
Other
|
9 | 4 | 107 | 101 | 163 | |||||||||||||||
Total
charge-offs
|
13,668 | 2,042 | 15,178 | 4,138 | 20,204 | |||||||||||||||
Recoveries
of loans previously charged off
|
1,143 | 19 | 1,640 | 22 | 98 | |||||||||||||||
Balance
at end of period
|
$ | 22,134 | $ | 11,106 | $ | 22,134 | $ | 11,106 | $ | 14,372 |
During
the three and six months ended June 30, 2010, the Company made provisions for
loan losses in the amount of $16.1 million and $21.3 million, respectively. This
when compared to the $2.7 million and $4.8 million reported for the same periods
ended a year earlier, represents an increase of approximately $13.4 million and
$16.5 million, respectively. Elevated provision expenses are
reflective of, among other things, additional loan balances charged-off during
the six months of 2010, continued weakness in local, state and national economic
conditions, the number and dollar volume of loans placed on non-accruing status
when compared to historical periods and the downgrade of certain credits within
the loan portfolio.
Note
4. Other Real Estate Owned (“OREO”)
The
following table provides a summary of the change in the balance of OREO for the
periods indicated below:
For the three months ended
|
For the six months ended
|
For the year ended
|
||||||||||||||||||
June 30,
|
June 30,
|
December 31,
|
||||||||||||||||||
(dollar amounts in
thousands)
|
2010
|
2009
|
2010
|
2009
|
2009
|
|||||||||||||||
Beginning
balance
|
$ | 741 | $ | 2,893 | $ | 946 | $ | 1,337 | $ | 1,337 | ||||||||||
Additions
|
4,987 | 6,655 | 4,987 | 8,403 | 9,595 | |||||||||||||||
Dispositions
|
(775 | ) | (2,879 | ) | (775 | ) | (2,998 | ) | (8,521 | ) | ||||||||||
Write-downs
|
- | - | (205 | ) | (73 | ) | (1,465 | ) | ||||||||||||
Ending
balance
|
$ | 4,953 | $ | 6,669 | $ | 4,953 | $ | 6,669 | $ | 946 |
Note
5. Deferred Tax Assets
The
Company is permitted to recognize deferred tax assets (“DTA”) only to the extent
that they are expected to be used to reduce amounts that have been paid or will
be paid to tax authorities. The determination of the amount of DTA
which is more likely than not to be realized is primarily dependent on
projections of future earnings, which are subject to uncertainty and estimates
that may change given economic conditions and other factors. The
realization of the DTA is assessed by the Company periodically. If
the Company determines that there is not sufficient positive evidence to support
the realization of its DTA beyond what it can realize from the carry-back of
operating losses a valuation allowance is established for all or a portion of
the DTA it expects will not be realized.
Heritage
Oaks Bancorp | - 17 -
|
Notes
to Consolidated Financial
Statements
|
In the
fourth quarter of 2009, the Company performed an in depth analysis of its DTA to
determine if the current carrying value of the DTA would be realized in future
periods. Based on the Company’s analysis and all currently available
information, the Company believes that as of June 30, 2010 the carrying value of
the DTA can be supported and that a valuation allowance is not necessary at this
time.
Companies
are subject to a change in ownership test under Section 382 of the Internal
Revenue Code, that if met, would limit the annual utilization of pre-change of
ownership carry-forward as well as the ability to use certain unrealized
built-in losses (as determined by Section 382 testing). As a result
of the Company’s March 2010 private placement, a change of ownership was deemed
to have occurred under Section 382. Under Section 382, the yearly
limitation on our ability to utilize such deductions will be equal to the
product of the applicable long-term tax exempt rate and the sum of the values of
our common stock and our TARP preferred stock immediately before the ownership
change. Our ability to utilize deductions related to credit losses
during the twelve month period following the deemed ownership change would also
be limited under Section 382, together with net operating loss carry-forwards,
to the extent that such deductions reflect a net loss that was “built-in” to our
assets immediately prior to the ownership change.
Because
the amount of equity issued in the Company’s March 2010 private placement
triggered an ownership change under Section 382, our ability to use the net
operating loss carry-forwards and certain “built-in” losses existing at the time
of the deemed change in ownership to offset future income may be substantially
limited. Therefore, the Company may incur higher than anticipated
income tax expense in future periods and / or may not fully realize portions of
its DTA subject to the Section 382 limitation.
Note
6. Earnings / (Loss) Per Share
Basic
earnings / (loss) per common share are computed by dividing net income available
to common shareholders by the weighted-average number of common shares
outstanding for the reporting period. Diluted earnings / (loss) per
common share are computed by dividing net income available to common
shareholders by the weighted-average number of common shares outstanding over
the reporting period, adjusted to include the effect of potentially dilutive
common shares. Potentially dilutive common shares are calculated
using the Treasury Stock Method and include incremental shares issuable upon
exercise of outstanding stock options, other share-based compensation awards and
any other security in which its conversion / exercise may result in the issuance
of common stock, such as the warrant the Company issued to the U.S. Treasury
during 2009. U.S. GAAP prohibits the computation of diluted earnings
/ (loss) per share from assuming exercise or issuance of securities that would
have an anti-dilutive effect on earnings per share. As a result, the
outstanding shares from the potential exercise of share-based compensation
awards and the warrant issued to the U.S. Treasury were not included in the
calculation of diluted earnings / (loss) per share for the three and six months
ended June 30, 2010.
The
following table sets forth the number of shares used in the calculation of both
basic and diluted earnings / (loss) per share for the three and six months ended
June 30, 2010 and 2009:
For the three months
ending,
|
||||||||||||||||
June 30, 2010
|
June 30, 2009
|
|||||||||||||||
Net
|
Net
|
|||||||||||||||
(dollar amounts in thousands except per share
data)
|
Income
|
Shares
|
Income
|
Shares
|
||||||||||||
Net
(loss) / income
|
$ | (5,835 | ) | $ | 507 | |||||||||||
Dividends
and accretion on preferred stock
|
(3,809 | ) | (250 | ) | ||||||||||||
Net
(loss) / income applicable to common shareholders
|
$ | (9,644 | ) | $ | 257 | |||||||||||
Weighted
average shares outstanding
|
11,250,989 | 7,696,027 | ||||||||||||||
Basic
(loss) / earnings per common share
|
$ | (0.86 | ) | $ | 0.03 | |||||||||||
Dilutive
effect of share-based compensation awards
|
- | 94,681 | ||||||||||||||
Dilutive
effect of common stock warrant
|
- | 76,254 | ||||||||||||||
Dilutive
effect of mandatorily convertible preferred stock
|
- | - | ||||||||||||||
Weighted
average diluted shares outstanding
|
11,250,989 | 7,866,962 | ||||||||||||||
Diluted
(loss) / earnings per common share
|
$ | (0.86 | ) | $ | 0.03 |
Heritage
Oaks Bancorp | - 18 -
|
Notes
to Consolidated Financial
Statements
|
For the six months ending,
|
||||||||||||||||
June 30, 2010
|
June 30, 2009
|
|||||||||||||||
Net
|
Net
|
|||||||||||||||
(dollar amounts in thousands except per share
data)
|
Income
|
Shares
|
Income
|
Shares
|
||||||||||||
Net
(loss) / income
|
$ | (7,174 | ) | $ | 1,609 | |||||||||||
Dividends
and accretion on preferred stock
|
(4,160 | ) | (261 | ) | ||||||||||||
Net
(loss) / income applicable to common shareholders
|
$ | (11,334 | ) | $ | 1,348 | |||||||||||
Weighted
average shares outstanding
|
9,492,421 | 7,692,765 | ||||||||||||||
Basic
(loss) / earnings per common share
|
$ | (1.19 | ) | $ | 0.17 | |||||||||||
Dilutive
effect of share-based compensation awards
|
- | 85,606 | ||||||||||||||
Dilutive
effect of common stock warrant
|
- | - | ||||||||||||||
Dilutive
effect of mandatorily convertible preferred stock
|
- | - | ||||||||||||||
Weighted
average diluted shares outstanding
|
9,492,421 | 7,778,371 | ||||||||||||||
Diluted
(loss) / earnings per common share
|
$ | (1.19 | ) | $ | 0.17 |
Note
7. Recent Accounting Pronouncements
On
July 21, 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting
Standards Update (“ASU”) No. 2010-20, “Receivables (Topic 310): Disclosures
about the Credit Quality of Financing Receivables and the Allowance for Credit
Losses.” The new disclosures will require significantly more information
about credit quality in a financial institution’s loan portfolio. This statement
addresses only disclosures and does change recognition or measurement of the
allowance for loan losses. The provisions under this statement are effective for
interim and annual reporting periods beginning after December 15,
2010.
In April
2010, the FASB issued ASU No. 2010-18, “Effect of a Loan Modification When
the Loan Is Part of a Pool That Is Accounted for as a Single
Asset.” ASU No. 2010-18 provides guidance on accounting for
acquired loans that have evidence of credit deterioration upon acquisition,
specifically those loans acquired and accounted for in the aggregate as a pool.
As a result of the amendments in this Update, modifications of loans that are
accounted for within a pool under Subtopic 310-30 do not result in the removal
of those loans from the pool even if the modification of those loans would
otherwise be considered a troubled debt restructuring. An entity will continue
to be required to consider whether the pool of assets in which the loan is
included is impaired if expected cash flows for the pool change. The
Company is required to adopt the provisions of this ASU in its first interim
period beginning after July 15, 2010. The Company does not currently
believe the adoption of this ASU will have a material impact on its consolidated
financial statements.
In
February 2010, the Financial FASB issued ASU No. 2010-09, “Subsequent Events (Topic
855) Amendments to Certain Recognition and disclosure
Requirements.” The amendments remove the requirement for an
SEC registrant to disclose the date through which subsequent events were
evaluated. Removal of the disclosure requirement did not have an
effect on the nature or timing of subsequent events evaluations performed by the
Company. ASU 2010-09 became effective upon issuance.
In
January 2010, the FASB issued ASU No. 2010-06, “Fair Value Measurements and
Disclosures (Topic 820): Improving Disclosures about Fair Value
Measurements.” ASU 2010-06 revises two disclosure requirements
concerning fair value measurements and clarifies two others. It
requires separate presentation of significant transfers into and out of Levels 1
and 2 of the fair value hierarchy and disclosure of the reasons for such
transfers. It will also require the presentation of purchases, sales,
issuances, and settlements within Level 3 on a gross basis rather than a net
basis. The amendments also clarify that disclosures should be
disaggregated by class of asset or liability and that disclosures about inputs
and valuation techniques should be provided for both recurring and non-recurring
fair value measurements. These new disclosure requirements were
effective for the period ended March 31, 2010, except for the requirement
concerning gross presentation of Level 3 activity, which is effective for fiscal
years beginning after December 15, 2010. The adoption of this ASU did
not have a material impact on the Company’s consolidated financial
statements.
Heritage
Oaks Bancorp | - 19 -
|
Notes
to Consolidated Financial
Statements
|
In
December 2009, FASB issued an accounting standard incorporated into Accounting
Standards Codification (“ASC”) 860. This update codifies SFAS
No. 166, “Accounting for
Transfers of Financial Assets—an Amendment of FASB Statement
No. 140,” which was previously issued by the FASB in June 2009 but
was not included in the original codification. This update to ASC 860
creates more stringent conditions for reporting a transfer of a portion of a
financial asset as a sale, clarifies other sale-accounting criteria, and changes
the initial measurement of a transferor’s interest in transferred financial
assets. This statement is effective for all annual and interim reporting periods
beginning after November 15, 2009. Under this standard, in order
to recognize the transfer of a portion of a financial asset as a sale, the
transferred portion and any portion that continues to be held by the transferor
must represent a participating interest, and the transfer of the participating
interest must meet the conditions for surrender of control. To qualify as a
participating interest: (i) the portions of a financial asset must
represent a proportionate ownership interest in an entire financial asset,
(ii) from the date of transfer, all cash flows received from the entire
financial asset must be divided proportionately among the participating interest
holders in an amount equal to their share of ownership, (iii) involve no
recourse (other than standard representation and warranties) to, or
subordination by, any participating interest holder, and (iv) no party has
the right to pledge or exchange the entire financial asset. If the participating
interest or surrender of control criteria are not met the transfer is not
accounted for as a sale and de-recognition of the asset is not
appropriate. Rather the transaction is accounted for as a secured
borrowing arrangement. The impact to certain transactions such as the sale of
SBA loans or certain participations being reported as secured borrowings rather
than derecognizing a portion of a financial asset would increase total assets
(loans) and liabilities (other borrowings). The terms contained in
certain participation and loan sale agreements are outside the control of the
Company and largely relate to Small Business Administration (“SBA”) loan
sales. These sales agreements contain recourse provisions (generally
90 days) that will initially preclude sale accounting. However, once
the recourse provision expires, transfers of portions of financial assets may be
reevaluated to determine if they meet the participating interest definition and
subsequently accounted for as a sale. As a result, The Company will
report SBA transfers as secured borrowings over the period for which recourse
provisions exist, which will result in the deferral of any potential gain on
sale from these transactions, assuming all other sales criteria for each
transaction are met. The Company does not believe it has or will have a
significant amount of participations subject to recourse provisions or other
features that would preclude de-recognition of the assets
transferred. The Company adopted this accounting standard on January
1, 2010 and does not currently believe the impact of adoption will have a
material impact on the Company’s consolidated financial statements.
In June
2009, the FASB issued an accounting standard, incorporated into ASC topic 810
“Consolidation,” that seeks to improve financial reporting by companies involved
with variable interest entities. Also addressed under this standard are concerns
about the application of certain key provisions, including those in which the
accounting and disclosures do not always provide timely and useful information
about a company’s involvement in a variable interest entity. The
standard requires a company to perform analyses to determine if its variable
interest(s) give it a controlling financial interest in a variable interest
entity. These analyses identify the primary beneficiary of the
variable interest entity as the company that has both of the following
characteristics: (a) the power to direct the activities of a variable interest
entity that most significantly impact the company’s economic performance; and
(b) the obligation to absorb losses of the entity that could potentially be
significant to the variable interest entity or the right to receive benefits
from the entity that could potentially be significant to the variable interest
entity. This standard is effective for all annual and interim
reporting periods beginning after November 15, 2009 with earlier application
prohibited. The adoption of this standard did not have a material
impact on the Company’s financial statements.
In June
2009, the FASB issued an accounting standard which was incorporated into ASC
topic 860 “Transfers and Servicing.” This standard seeks to improve the
relevance, representational faithfulness and comparability of the information
that a reporting entity provides in its financial statements about a transfer of
financial assets; the effects of a transfer on its financial position, financial
performance, and cash flows; and a transferor’s continuing involvement, if any,
in transferred financial assets. The Company adopted this accounting
standard on January 1, 2010 and the adoption did not have a material impact on
the Company’s financial statements.
In
December 2008, the FASB issued an accounting standard which was subsequently
incorporated into ASC topic 715 “Compensation – Retirement
Benefits.” This standard seeks to provide users of financial
statements with an understanding of: how investment allocation decisions are
made, the major categories of plan assets, the inputs and valuations techniques
used to measure the fair value of those assets, the effect of fair value
measurements using unobservable inputs on changes in plan assets during a
reporting period, and significant concentrations of risk within plan
assets. The Company is adopted this accounting standard on January 1,
2010. The adoption of this standard did not have a material impact on
its financial statements.
Heritage
Oaks Bancorp | - 20 -
|
Notes
to Consolidated Financial
Statements
|
Note
8. Share-Based Compensation
As of
June 30, 2010, the Company had two share-based employee compensation plans,
which are more fully described in Note 15 of the consolidated financial
statements in the Company's Annual Report filed on Form 10-K for the year ended
December 31, 2009. These plans include the “1997 Stock Option Plan” and the
“2005 Equity Based Compensation Plan.” Share-based compensation
expense for all share-based compensation awards granted after January 1, 2006,
is based on the grant-date fair value. For all awards except stock option
awards, the grant date fair value is either the fair market value per share or
book value per share (corresponding to the type of stock awarded) as of the
grant date. For stock option awards, the grant date fair value is
estimated using the Black-Scholes option pricing model. For all awards, the
Company recognizes these compensation costs only for those shares expected to
vest on a straight-line basis over the requisite service period of the award,
for which we use the related vesting term. The Company estimates
forfeiture rates based on historical employee option exercise and employee
termination experience.
The
share-based compensation expense recognized in the consolidated statements of
income for the three and six months ended June 30, 2010 and 2009 is based on
awards ultimately expected to vest, and accordingly has been adjusted by the
amount of estimated forfeitures. U.S. GAAP requires forfeitures to be
estimated at the time of grant and revised, if necessary, in subsequent periods
if actual forfeitures differ from those estimates.
The
following table provides a summary of the expenses the Company has recognized
related to share-based compensation as well as the impact those expenses have
had on diluted earnings per share for the periods indicated below:
For the three months ended
|
For the six months ended
|
|||||||||||||||
June 30,
|
June 30,
|
|||||||||||||||
(dollars in thousands except share and per share
data)
|
2010
|
2009
|
2010
|
2009
|
||||||||||||
Share-based
compensation expense:
|
||||||||||||||||
Stock
option expense
|
$ | 45 | $ | 42 | $ | 92 | $ | 86 | ||||||||
Restricted
stock expense
|
44 | 52 | 96 | 98 | ||||||||||||
Total
share-based compensation expense
|
89 | $ | 94 | 188 | $ | 184 | ||||||||||
Total
share-based compensation expense, net of tax
|
$ | 56 | $ | 57 | $ | 119 | $ | 113 | ||||||||
Diluted
shares outstanding
|
11,250,989 | 7,866,962 | 9,492,421 | 7,778,371 | ||||||||||||
Impact
on diluted earnings per share
|
$ | - | $ | 0.007 | $ | - | $ | 0.015 | ||||||||
Unrecognized
compensation expense:
|
||||||||||||||||
Stock
option expense
|
$ | 158 | $ | 258 | ||||||||||||
Restricted
stock expense
|
133 | 368 | ||||||||||||||
Total
unrecognized share-based compensation expense
|
$ | 291 | $ | 626 | ||||||||||||
Total
unrecognized share-based compensation expense, net of tax
|
$ | 203 | $ | 380 |
At June
30, 2010, there was a total of $158 thousand of unrecognized compensation
expense related to non-vested stock option awards. That expense is expected to
be recognized over a weighted-average period of 1.5 years.
The
Company grants restricted share awards periodically for the benefit of
employees. These restricted shares generally “cliff vest” after five years of
issuance. Recipients of restricted shares have the right to vote all shares
subject to such grant, and receive all dividends with respect to such shares,
whether or not the shares have vested. Recipients do not pay any cash
consideration for the shares. The total unrecognized compensation
expense related to restricted share awards at June 30, 2010 was $133 thousand.
That expense is expected to be recognized over the next 0.7 years.
The
aggregate intrinsic value in the table below represents the total pretax
intrinsic value (the difference between the Company’s closing stock price on the
last trading day of the second quarter of 2010 and the exercise price,
multiplied by the number of in-the-money options that would have been received
by the option holders had all option holders exercised their options on June 30,
2010). The aggregate pretax intrinsic value is subject to change
based on the fair market value of the Company's stock. There was no
aggregate intrinsic value associated with options that were exercised during
2010. The pretax intrinsic value associated with options
exercised in the second quarter of 2009 was approximately $22
thousand.
Heritage
Oaks Bancorp | - 21 -
|
Notes
to Consolidated Financial
Statements
|
The
following table provides a summary of the aggregate intrinsic value of options
outstanding and exercisable as well as options granted, exercised, and forfeited
during the year-to-date periods ended June 30, 2010 and 2009:
Average
|
||||||||||||||||
Weighted
|
Remaining
|
Total
|
||||||||||||||
Average
|
Contractual
|
Intrinsic
|
||||||||||||||
Number of
|
Exercise
|
Term
|
Value
|
|||||||||||||
Shares
|
Price
|
(in years)
|
(in 000's)
|
|||||||||||||
Options
outstanding, January 1, 2010
|
440,738 | $ | 9.15 | |||||||||||||
Granted
|
- | - | ||||||||||||||
Exercised
|
(11,260 | ) | 3.73 | |||||||||||||
Forfeited
|
- | - | ||||||||||||||
Options
outstanding, June 30, 2010
|
429,478 | $ | 9.29 | 3.95 | $ | 980 | ||||||||||
Exercisable
at June 30, 2010
|
356,290 | $ | 9.54 | 3.02 | $ | 980 | ||||||||||
Options
outstanding, January 1, 2009
|
408,830 | $ | 9.34 | |||||||||||||
Granted
|
30,324 | 4.81 | ||||||||||||||
Exercised
|
(10,050 | ) | 3.73 | |||||||||||||
Forfeited
|
- | - | ||||||||||||||
Options
outstanding, June 30, 2009
|
429,104 | $ | 9.15 | 4.34 | $ | 288 | ||||||||||
Exercisable
at June 30, 2009
|
347,172 | $ | 8.92 | 3.28 | $ | 245 |
The
Company did not grant any options during the three and six months ended June 30,
2010. During the first quarter of 2009 the Company granted 25,000
options to various non-management members of the Company’s Board of
Directors. The Company also granted 5,324 options to one other
individual during the second quarter of 2009. The following table
presents the assumptions used in the calculation of the weighted average fair
value of options granted during the first six months of 2009:
2009
|
||||
Expected
volatility
|
42.26 | % | ||
Expected
term (years)
|
10 | |||
Dividend
yield
|
0.00 | % | ||
Risk
free rate
|
2.84 | % | ||
Weighted-average
grant date fair value
|
$ | 2.74 |
The table
above presents the assumptions used to estimate the fair value of stock options
granted on the date of grant using the Black-Scholes pricing
model. The Black-Scholes model incorporates a range of assumptions
for inputs that are disclosed in the table above. Expected
volatilities are based on the daily historical stock price over the expected
life of the option. The expected term of options granted is derived
from the output of the model and represents the period of time that options
granted are expected to be outstanding. Dividend yields are estimated
based on the dividend yield on the Company’s common stock at the time of
grant. The risk-free rate for periods within the contractual life of
the stock option is based on the U.S. Treasury yield curve in effect at the time
of grant.
Estimates
of fair value derived from the Company’s use of the Black-Scholes pricing model
are theoretical values for stock options and changes in the assumptions used in
the models could result in different fair value estimates. The actual
value of the stock options granted will depend on the market value of the
Company’s common stock when the options are exercised.
Heritage
Oaks Bancorp | - 22 -
|
Notes to Consolidated Financial
Statements
|
Note
9. Fair Value Disclosures
The
Company determines the fair market values of certain financial instruments based
on the fair value hierarchy established in U.S. GAAP which requires an entity to
maximize the use of observable inputs and minimize the use of unobservable
inputs when measuring fair value and describes three levels of inputs that may
be used to measure fair value.
The
following provides a summary of the hierarchical levels used to measure fair
value:
Level 1 -
Quoted prices in active markets for identical assets or liabilities that the
reporting entity has the ability to access at the measurement date. Level 1
assets and liabilities may include debt and equity securities that are traded in
an active exchange market and that are highly liquid and are actively traded in
over-the-counter markets.
Level 2 -
Observable inputs other than Level 1 prices, such as quoted prices for similar
assets or liabilities; quoted prices in markets that are not active; or other
inputs that are observable or can be corroborated by observable market data for
substantially the full term of the assets or liabilities. Level 2 assets and
liabilities may include debt securities with quoted prices that are traded less
frequently than exchange-traded instruments and other instruments whose value is
determined using a pricing model with inputs that are observable in the market
or can be derived principally from or corroborated by observable market data.
This category generally includes U.S. Government and agency mortgage-backed debt
securities, corporate debt securities, derivative contracts, residential
mortgage and loans held-for-sale.
Level 3 -
Unobservable inputs that are supported by little or no market activity and that
are significant to the fair value of the assets or liabilities. Level 3 assets
and liabilities include financial instruments whose value is determined using
pricing models, discounted cash flow methodologies, or similar techniques, as
well as instruments for which the determination of fair value requires
significant management judgment or estimation. This category generally includes
certain private equity investments, retained residual interests in
securitizations, residential MSRs, asset-backed securities (“ABS”), highly
structured or long-term derivative contracts and certain collateralized debt
obligations (“CDOs”) where independent pricing information was not able to be
obtained for a significant portion of the underlying assets.
Fair
Value Measurements
The
Company used the following methods and significant assumptions to estimate fair
value:
Securities
The fair
value of securities available-for-sale are determined by obtaining quoted prices
on nationally recognized exchanges or matrix pricing which is a mathematical
technique used widely in the industry to value debt securities without relying
exclusively on quoted prices for the specific securities but rather relying on
the security’s relationship to other benchmark quoted securities.
Loans
Held For Sale
The fair
value of loans held for sale is determined, when possible, using quoted
secondary market prices. If no such quoted price exists, the fair value of the
loan is determined using quoted prices for a similar asset or assets, adjusted
for the specific attributes of that loan.
Impaired
Loans
A loan is
considered impaired when it is probable that payment of interest and principal
will not be made in accordance with the contractual terms of the loan
agreement. Impairment is measured based on the fair value of the
underlying collateral or the discounted expected future cash
flows. The Company measures impairment on all non-accrual loans for
which it has established specific reserves as part of the specific credit
allocation component of the allowance for loan losses. As such, the
Company records impaired loans as non-recurring Level 2 when the fair value of
the underlying collateral is based on an observable market price or current
appraised value. When current market prices are not available or the
Company determines that the fair value of the underlying collateral is further
impaired below appraised values, the Company records impaired loans as
non-recurring Level 3. At June 30, 2010, a significant majority of
the Company’s impaired loans were evaluated based on the fair value of their
underlying collateral based upon the most recent appraisal available to
Management.
|
Heritage
Oaks Bancorp | - 23 -
|
Notes to Consolidated
Financial Statements
|
Other
Real Estate Owned and Foreclosed Collateral
Other
real estate owned and foreclosed collateral are adjusted to fair value, less any
estimated costs to sell, at the time the loans are transferred into this
category. The fair value of these assets is based on independent
appraisals, observable market prices for similar assets, or Management’s
estimation of value. When the fair value is based on independent
appraisals or observable market prices for similar assets, the Company records
other real estate owned or foreclosed collateral as non-recurring Level 2
assets. When appraised values are not available, there is no
observable market price for similar assets, or Management determines the fair
value of the asset is further impaired below appraised values or observable
market prices, the Company records other real estate owned or foreclosed
collateral as non-recurring Level 3 assets.
The
following table provides a summary of the financial instruments the Company
measures at fair value on a recurring basis as of June 30, 2010:
Fair Value Measurements Using
|
||||||||||||||||
Quoted Prices in
|
Significant Other
|
Significant
|
||||||||||||||
Active Markets for
|
Observable
|
Unobservable
|
||||||||||||||
(dollars in thousands)
|
Identical Assets
|
Inputs
|
Inputs
|
Assets At
|
||||||||||||
As of June 30, 2010
|
(Level 1)
|
(Level 2)
|
(Level 3)
|
Fair Value
|
||||||||||||
Assets
|
||||||||||||||||
Obligations
of U.S. government agencies
|
$ | - | $ | 100 | $ | - | $ | 100 | ||||||||
Mortgage
backed securities
|
||||||||||||||||
Agency
|
- | 146,966 | - | 146,966 | ||||||||||||
Non-agency
|
- | 17,733 | - | 17,733 | ||||||||||||
Obligations
of state and political subdivisions
|
- | 27,241 | 755 | 27,996 | ||||||||||||
Other securities
|
- | 109 | - | 109 | ||||||||||||
Total assets measured on a recurring
basis
|
$ | - | $ | 192,149 | $ | 755 | $ | 192,904 | ||||||||
As of December 31, 2009
|
||||||||||||||||
Assets
|
||||||||||||||||
Obligations
of U.S. government agencies
|
$ | - | $ | 104 | $ | - | $ | 104 | ||||||||
Mortgage
backed securities
|
||||||||||||||||
Agency
|
- | 77,950 | - | 77,950 | ||||||||||||
Non-agency
|
- | 20,153 | - | 20,153 | ||||||||||||
Obligations
of state and political subdivisions
|
- | 22,127 | 737 | 22,864 | ||||||||||||
Other securities
|
- | 109 | - | 109 | ||||||||||||
Total assets measured on a recurring
basis
|
$ | - | $ | 120,443 | $ | 737 | $ | 121,180 |
The
following table provides a summary of the changes in balance sheet carrying
values associated with Level 3 financial instruments during the six months ended
June 30, 2010:
Purchases,
|
||||||||||||||||
Balance as of
|
Gains / (Losses)
|
Issuances, and
|
Balance as of
|
|||||||||||||
(dollars in thousands)
|
December 31, 2009
|
Included in OCI (1)
|
Settlements
|
June 30, 2010
|
||||||||||||
Obligations
of state and political subdivisions
|
$ | 737 | $ | 18 | $ | - | $ | 755 |
(1)
Realized or unrealized gains from the changes in values of Level 3 financial
instruments represent gains from changes in values of financial instruments only
for the period(s) in which the instruments were classified as Level
3.
The
assets presented under level 3 of the fair value hierarchy classified as
obligations of state and political subdivisions represent available for sale
investment securities in the form of certificates of participation where an
active market for such securities is not currently available.
|
Heritage
Oaks Bancorp | - 24 -
|
Notes to Consolidated Financial
Statements
|
The
following table provides a summary of the financial instruments the Company
measures at fair value on a non-recurring basis as of June 30,
2010:
Fair Value Measurements Using
|
||||||||||||||||||||
Quoted Prices in
|
Significant Other
|
Significant
|
||||||||||||||||||
Active Markets for
|
Observable
|
Unobservable
|
||||||||||||||||||
(dollars in thousands)
|
Identical Assets
|
Inputs
|
Inputs
|
Assets At
|
Total
|
|||||||||||||||
As of June 30, 2010
|
(Level 1)
|
(Level 2)
|
(Level 3)
|
Fair Value
|
Gains (Losses)
|
|||||||||||||||
Assets
|
||||||||||||||||||||
Impaired
loans
|
$ | - | $ | 43,389 | $ | - | $ | 43,389 | $ | (1,547 | ) | |||||||||
Loans
held for sale
|
- | 9,429 | - | 9,429 | - | |||||||||||||||
Other
real estate owned
|
- | 4,953 | - | 4,953 | (36 | ) | ||||||||||||||
Goodwill
|
- | - | 11,049 | 11,049 | - | |||||||||||||||
Total assets measured on a non-recurring
basis
|
$ | - | $ | 57,771 | $ | 11,049 | $ | 68,820 | $ | (1,583 | ) | |||||||||
As of December 31, 2009
|
||||||||||||||||||||
Assets
|
||||||||||||||||||||
Impaired
loans
|
$ | - | $ | 47,172 | $ | - | $ | 47,172 | $ | (20,204 | ) | |||||||||
Loans
held for sale
|
- | 9,487 | - | 9,487 | - | |||||||||||||||
Other
real estate owned
|
- | 946 | - | 946 | (1,496 | ) | ||||||||||||||
Goodwill
|
- | - | 11,049 | 11,049 | - | |||||||||||||||
Total assets measured on a non-recurring
basis
|
$ | - | $ | 57,605 | $ | 11,049 | $ | 68,654 | $ | (21,700 | ) |
Goodwill
assets are recorded at fair value initially and assessed for impairment
periodically thereafter under the provisions set forth in U.S.
GAAP. During the fiscal year ended December 31, 2009, the carrying
amount of goodwill assets were compared to their fair value. No
change in carrying amount resulted in accordance with the provisions set forth
in U.S. GAAP. Additionally, the Company has certain other loans that
are measured at fair value on a non-recurring basis such as loans that were
acquired in the acquisition of Business First National Bank.
Note
10. Fair Value of Financial Instruments
The fair
value of a financial instrument is the amount at which the asset or obligation
could be exchanged in a current transaction between willing parties, other than
a forced or liquidation sale. Fair value estimates are made at a
specific point in time based on relevant market information and information
about the financial instrument. These estimates do not reflect any
premium or discount that could result from offering for sale at one time the
entire holdings or a particular financial instrument. Because no
market value exists for a significant portion of the financial instruments, 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, involve uncertainties and matters of judgment and,
therefore, cannot be determined with precision. Changes in
assumptions could significantly affect these estimates.
Fair
value estimates are based on financial instruments both on and off the balance
sheet without attempting to estimate the value of anticipated future business
and the value of assets and liabilities that are not considered financial
instruments. Additionally, tax consequences related to the
realization of the unrealized gains and losses can have a potential effect on
fair value estimates and have not been considered in many of the
estimates.
|
Heritage
Oaks Bancorp | - 25 -
|
Notes to Consolidated Financial
Statements
|
The
following table provides a summary of the estimated fair value of financial
instruments at June 30, 2010 and December 31, 2009:
June 30, 2010
|
December 31, 2009
|
|||||||||||||||
Carrying
|
Carrying
|
|||||||||||||||
(dollars in thousands)
|
Amount
|
Fair Value
|
Amount
|
Fair Value
|
||||||||||||
Assets
|
||||||||||||||||
Cash
and cash equivalents
|
$ | 62,031 | $ | 62,031 | $ | 40,738 | $ | 40,738 | ||||||||
Interest
bearing deposits
|
119 | 119 | 119 | 119 | ||||||||||||
Investments
and mortgage-backed securities
|
192,904 | 192,904 | 121,180 | 121,180 | ||||||||||||
Federal
Home Loan Bank stock
|
5,611 | 5,611 | 5,828 | 5,828 | ||||||||||||
Loans
receivable, net of deferred fees and costs
|
695,478 | 692,214 | 726,854 | 731,045 | ||||||||||||
Loans
held for sale
|
9,429 | 9,429 | 9,487 | 9,487 | ||||||||||||
Bank
owned life insurance
|
12,811 | 12,811 | 12,549 | 12,549 | ||||||||||||
Accrued
interest receivable
|
3,701 | 3,701 | 3,639 | 3,639 | ||||||||||||
Liabilities
|
||||||||||||||||
Non-interest
bearing deposits
|
182,846 | 182,846 | 174,635 | 174,635 | ||||||||||||
Interest
bearing deposits
|
612,987 | 613,773 | 600,830 | 596,782 | ||||||||||||
Federal
Home Loan Bank advances
|
65,000 | 65,056 | 65,000 | 65,180 | ||||||||||||
Junior
subordinated debentures
|
8,248 | 7,660 | 13,403 | 12,390 | ||||||||||||
Accrued
interest payable
|
437 | 437 | 590 | 590 | ||||||||||||
Notional
|
Cost to Cede
|
Notional
|
Cost to Cede
|
|||||||||||||
Amount
|
or Assume
|
Amount
|
or Assume
|
|||||||||||||
Off-balance
sheet instruments, commitments to extend credit and standby letters of
credit
|
$ | 135,411 | $ | 1,354 | $ | 169,578 | $ | 1,696 |
The
following methods and assumptions were used by the Company in estimating fair
values of financial instruments:
Cash
and Cash Equivalents
The
carrying amounts reported in the balance sheet for cash and cash equivalents
approximate the fair values of those assets due to the short-term nature of the
assets.
Interest
Bearing Deposits at Other Financial Institutions
The
carrying amounts reported in the balance sheet for interest bearing deposits at
other financial institutions approximates the fair value of these assets due to
the short-term nature of the assets.
Investments
Including Federal Home Loan Bank Stock and Mortgage-Backed
Securities
Fair
values are based upon quoted market prices, where available. If quoted market
prices are not available, fair values are extrapolated from the quoted prices of
similar instruments or through the use of other observable data supporting a
valuation model. Fair values for holdings of Federal Home Loan Bank
stock is based on carrying amounts.
Loans,
Loans Held for Sale, and Accrued Interest Receivable
For
variable-rate loans that re-price frequently and with no significant change in
credit risk, fair values are based on carrying amounts. The fair
values for other loans (for example, fixed rate loans and loans that possess a
rate variable other than daily) are estimated using discounted cash flow
analysis, based on interest rates currently being offered for loans with similar
terms to borrowers of similar credit quality. Loan fair value
estimates include judgments regarding future expected loss experience and risk
characteristics.
The fair
value of loans held for sale is determined, when possible, using quoted
secondary market prices. If no such quoted price exists, the fair
value of the loan is determined using quoted prices for a similar asset or
assets, adjusted for the specific attributes of that loan. The
carrying amount of accrued interest receivable approximates its fair
value.
Bank
Owned Life Insurance
Fair
values are based on current cash surrender values at each reporting date
provided by the underlying insurers.
|
Heritage
Oaks Bancorp | - 26 -
|
Notes to Consolidated Financial
Statements
|
Federal
Home Loan Bank Advances
The fair
value disclosed for FHLB advances is determined by discounting contractual cash
flows at current market interest rates for similar instruments.
Interest
Bearing Deposits and Accrued Interest Payable
The fair
values disclosed for interest bearing deposits (for example, interest-bearing
checking accounts and passbook accounts) are, by definition, equal to the amount
payable on demand at the reporting date (that is, their carrying
amounts). The fair values for certificates of deposit are estimated
using a discounted cash flow analysis that applies interest rates currently
being offered on certificates to a schedule of aggregated contractual maturities
on such time deposits. The carrying amount of accrued interest
payable approximates its fair value.
Junior
Subordinated Debentures
The fair
value disclosed for junior subordinated debentures is based on contractual cash
flows at current market interest rates for similar instruments.
Off-Balance
Sheet Instruments
Fair
values of commitments to extend credit and standby letters of credit are based
upon fees currently charged to enter into similar agreements, taking into
account the remaining terms of the agreement and the counterparties' credit
standing.
Note
11. Preferred Stock
U.S
Treasury’s Capital Purchase Program (“CPP”)
Under its
Amended Articles of Incorporation, The Company is authorized to issue up to
5,000,000 shares of preferred stock, in one or more series, having such voting
powers, designations, preferences, rights, qualifications, limitations and
restrictions as determined by the Board of Directors.
On March
20, 2009, the Company issued 21,000 shares of Series A Senior Preferred Stock to
the U.S. Treasury under the terms of the CPP for $21.0 million with a
liquidation preference of $1,000 per share. The preferred stock
carries a coupon of 5% for five years and 9% thereafter. Senior
preferred stock issued to the U.S. Treasury is non-voting, cumulative, and
perpetual and may be redeemed at 100% of their liquidation preference plus
accrued and unpaid dividends following three years from the date of
issue. In addition, the Company issued a warrant to the U.S. Treasury
to purchase shares of the Company’s common stock in an amount equal to 15% of
the preferred equity issuance or approximately $3.2 million (611,650
shares). The warrant is exercisable immediately at a price of $5.15
per share, will expire after a period of 10 years from issuance and is
transferable by the U.S. Treasury. The warrant may be dilutive to
earnings per common share during reporting periods in which the warrant is not
anti-dilutive.
The U.S.
Treasury may transfer a portion or portions of the warrant, and/or exercise the
warrant at any time. The U.S. Treasury has agreed not to exercise
voting power with respect to any common shares issued to it upon exercise of the
warrant. At June 30, 2010, there had been no changes to the
number of common shares covered by the warrant nor had the U.S. Treasury
exercised any portion of the warrant.
The
proceeds received from the U.S. Treasury were allocated to the Series A Senior
Preferred Stock and the warrant based on their relative fair
values. The fair value of the Series A Senior Preferred Stock was
determined through a discounted future cash flow model at a discount rate of
10%. The fair value of the warrant was calculated using the
Black-Scholes option pricing model, which includes assumptions regarding the
Company’s dividend yield, stock price volatility, and the risk-free interest
rate. As a result the Company recorded the Series A Senior Preferred
Stock and the warrant at approximately $19.2 million and $1.8 million,
respectively. The Company will accrete the discount on the Series A
Senior Preferred Stock over a period of five years with corresponding charges to
retained earnings.
It is
also important to note that net income available to common shareholders will be
impacted to the extent the Company charges retained earnings for the accretion
of the discount on the Series A Senior Preferred Stock and any dividends accrued
and paid from retained earnings on the Series A Senior Preferred
Stock. For the three and six months ended June 30, 2010, dividends
and accretion on the Series A Senior Preferred Stock totaled approximately $0.7
million. Additionally, the Company is subject to certain limitations
during its participation in the CPP including:
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The
requirement to obtain consent from the U.S. Treasury for any proposed
increases in common stock dividends prior to the third anniversary date of
the preferred equity
issuance.
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Heritage
Oaks Bancorp | - 27 -
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Notes to Consolidated Financial
Statements
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The
Series A Senior Preferred Stock cannot be redeemed for three years unless
the Company obtains proceeds to replace the Series A Senior Preferred
Stock through a qualified equity
offering.
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The
U.S. Treasury must consent to any buy back of our common
stock.
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The
Company must adhere to restrictions placed on the amount of and type of
compensation paid to its executives while participating in the CPP, pursuant to
section 111 of the Emergency Economic Stabilization Act of 2008, as amended
(“EESA”).
In the
second quarter of 2010 the Company was required to defer dividend payments on
its Series A Senior Preferred Stock to comply with the terms of the Written
Agreement entered into between the Company and the Federal Reserve Bank of San
Francisco. As a result the Company accrued for but did not pay
approximately $0.3 million in dividends on its Series A Senior Preferred
Stock. If the Company fails to pay dividends on Series A Senior
Preferred Stock for a total of six quarters, whether or not consecutive, the
U.S. Treasury will have the right to elect two members of the Company’s Board of
Directors, voting together with any other holders of preferred shares ranking
pari passu with the
Series A Senior Preferred Stock. These directors would serve on the Company’s
Board of Directors until such time as the Company has paid in full all dividends
not previously paid, at which time these directors’ terms of office would
immediately terminate.
For more
information concerning the Written Agreement, please refer to Note 12.
Regulatory Order and Written Agreement of these consolidated financial
statements.
Private
Placement and Preferred Stock Conversion
On March
12, 2010 the Company announced that it completed a private placement of 52,088
shares of its Series B Mandatorily Convertible Adjustable Cumulative Perpetual
Preferred Stock ("Series B Preferred Stock") and 1,189,538 shares of its Series
C Convertible Perpetual Preferred Stock, raising gross proceeds of approximately
$56.0 million. In addition, approximately $4.0 million was placed in escrow for
a second closing of 4,072 shares of Series B Preferred Stock, which then closed
during the second quarter of 2010. Total gross proceeds raised in the
private placement were approximately $60.0 million.
In June
2010, the Company received shareholder approval to convert all outstanding
shares of Series B Preferred Stock to common stock and as a result the Company
issued 17,279,995 shares of common stock in June 2010.
The
Series B Preferred Stock was mandatorily convertible into common stock, upon the
approval by shareholders of the Company’s common stock at a conversion price of
$3.25 per common share. As indicated above, shareholder approval
occurred during the second quarter of 2010. The conversion price of
$3.25 per common share was less than the fair market value of the Company’s
common stock on March 10, 2010, (the “commitment date”) the date the Company
made a firm commitment to issue the Series B Preferred Stock. The
fair market value of the Company’s common stock on the commitment date was $3.45
per share. Therefore, the Series B Preferred Stock was issued with a
contingent beneficial conversion feature that had an intrinsic value equal to
the $0.20 per share difference between the share price on the commitment date
and the conversion price of the Series B Preferred Stock. The
intrinsic value of the beneficial conversion feature related to the entire
Series B Preferred Stock issuance was $3.5 million. The recognition
of the beneficial conversion feature was contingent upon the approval of the
Company’s shareholders of the conversion of the Series B Preferred Stock to
common stock and thus was recognized in June 2010 when such approval was
received at the Company’s annual meeting of shareholders.
Upon
conversion of the Series B Preferred Stock the related beneficial conversion
feature was recorded in conjunction with the establishment of a discount on the
Series B Preferred Stock and a corresponding increase in additional paid in
capital. The immediate accretion of the entire Series B Preferred
Stock discount occurred through a charge to retained earnings on June 11, 2010,
the date the Company converted the outstanding Series B Preferred Stock to
common stock.
Series C
Preferred Stock is a non-voting class of stock substantially similar in priority
to the common stock of the Company, except for a liquidation preference over the
Company’s common stock. The Series C Preferred Stock will convert to
shares of common stock on a one share for one share basis if the original holder
of such shares transfers them to an unaffiliated third party. The Series C
Preferred Stock will not be redeemable by either the Company or by the
holders. Holders of the Series C Preferred Stock do not have any
voting rights, including the right to elect any directors, other than the
customary limited voting rights with respect to matters significantly and
adversely affecting the rights and privileges of the Series C Preferred
Stock.
It should
be noted that two investors in the Company’s March 2010 private placement have
Board observation rights, while one of the two investors also has Board
nomination rights.
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Heritage
Oaks Bancorp | - 28 -
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Notes to Consolidated Financial
Statements
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As is the
case with the Series B Preferred Stock, the fair market value of the Company’s
common stock was higher than the conversion price of $3.25 per share of the
Series C Preferred Stock on the date the Company made a firm commitment to issue
the Series C Preferred Stock. Therefore, the Series C Preferred Stock
also has a contingent beneficial conversion feature associated with
it. However, since the conversion of the Series C Preferred Stock
remains contingent upon the holder’s transfer of the securities to an
unaffiliated third party with no specified date for its conversion to common
stock, the Company will record the contingent beneficial conversion feature as
an initial discount on Series C Preferred Stock and additional paid in capital,
with a concurrent immediate accretion of the established discount and
corresponding charge to retained earnings on the date the Series C Preferred
Stock converts to common stock. The amount of the contingent
beneficial conversion feature is approximately $0.2 million and will be recorded
as described upon the original holder’s transfer of Series C Preferred Stock to
an unaffiliated third party.
Note
12. Regulatory Order and Written Agreement
On March
4, 2010, the FDIC and the DFI issued a Consent Order (the "Order") to the Bank
that requires, among other things, the Bank to increase its capital ratios,
reduce its classified assets and increase Board oversight of Management. The
Board and Management are aggressively responding to the Order to ensure full
compliance and have taken actions necessary to comply with the Order within the
required time frames. Such actions include the completion of the capital raise
discussed above which, following a contribution of a portion of the proceeds to
the Bank, brought the Bank into compliance with the capital requirements of the
Order. Additionally, a Written Agreement was entered into between the
Company and the Federal Reserve Bank of San Francisco on March 4,
2010.
The
following provides a summary of certain provisions in the Order as well as the
Written Agreement. Please also refer to the Company’s current reports
filed on Form 8-K with the SEC on March 10, 2010 and March 8, 2010, for a more
complete description of the provisions of the Order and Written Agreement,
respectively.
Consent
Order
On
February 26, 2010, the Bank stipulated to the issuance of the Order by the FDIC,
its principal federal banking regulator, and the California Department of
Financial Institutions (“DFI”) which requires the Bank to take certain measures
to improve its safety and soundness. The Order was subsequently
issued by the FDIC and DFI on March 4, 2010. The Bank’s stipulation
to the issuance by the FDIC and the DFI of the Order resulted from certain
findings in a report of examination resulting from an examination of the Bank
conducted in September 2009 based upon financial and lending data measured as of
June 30, 2009. In entering into the stipulation to entry of the Order, the Bank
did not concede the findings or admit to any of the assertions in the report of
examination (“ROE”).
Under the
Order, the Bank is required to take certain measures as more fully discussed
below. At June 30, 2010, the Bank believes it is in compliance with
all components of the Order.
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Among
the corrective actions required are for the Bank to develop and adopt a
plan to maintain the minimum capital requirements for a “well-capitalized”
bank, and to reach and maintain a Tier 1 leverage ratio of at least 10%
and a total risked based capital ratio of 11.5% at the Bank level
beginning 90 days from the issuance of the Order. Following the
Company’s March 2010 private placement, $48.0 million was down-streamed to
the Bank in the form of Tier I capital, bringing the Bank’s regulatory
capital ratios above the required minimums set forth in the
Order.
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Pursuant
to the Order, the Bank must retain qualified management, must notify the
FDIC and the DFI in writing when it proposes to add any individual to its
Board of Directors or to employ any new senior executive officer, and must
conduct an independent study of management and personnel structure of the
Bank. A consultant was retained to complete the required management study.
The Bank is in compliance with the Order’s timelines for completion of
such study and implementation by the Board of a plan to address the
findings of such study. As part of the capital raise, the
Company and Bank received regulatory approval to add as a director of both
the Bank and Company one of the principals of the investor in the
transaction that owns approximately 14.4% of the outstanding voting shares
of the Company. The addition of a director to the
Company’s Board of Directors required an amendment to the
Company’s bylaws to increase the range of the size of the
board. The Company’s shareholders approved such an amendment at
the June 10, 2010 Shareholder Meeting and the director was added to the
Company’s Board effective June 23, 2010.
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Heritage
Oaks Bancorp | - 29 -
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Notes to Consolidated
Financial Statements
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Under
the Order the Bank’s Board of Directors must also increase its
participation in the affairs of the Bank, assuming full responsibility for
the approval of sound policies and objectives and for the supervision of
all the Bank’s activities. The Board of Directors believes it has always
provided appropriate oversight of the Bank, but has recently taken steps
to reevaluate such oversight and enhance where appropriate the frequency
and duration and the scope and depth of matters covered at its Board
meetings in response to the current economic environment and concerns
raised in the ROE. In direct response to the ROE, a new joint regulatory
compliance committee was formed at both the Bank and Company levels to
oversee the Bank’s and Company’s response to all regulatory matters,
including the Order and the Written Agreement, discussed
below. Detailed tracking of the Order’s requirements, and the
Bank’s progress in responding thereto, is reviewed and reported at all
such committee meetings, with regular reports then being provided by the
committee to the full Board. Further, and prior to the issuance
of the Order, the Board directed its Chairman, Michael Morris, to
significantly increase his direct oversight of Management and involvement
in Bank and Company affairs to ensure an appropriate response at both the
Bank and Company to the concerns raised in the recent examination of the
Bank.
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The
Order further requires the Bank to increase its Allowance for Loan Losses
(“ALLL”), as of the date of the ROE, by $3.5 million and to review and
revise its ALLL methodology. The Bank subsequently made
provisions of approximately $19.3 million in the third and fourth quarters
of 2009 and increased the ALLL by a net $4.2 million in the first quarter
of 2010. The Bank has revised its policy for determining the
adequacy of the ALLL to include an assessment of market conditions and
other qualitative factors. The Bank’s policy otherwise continues to
provide for a comprehensive determination of the adequacy of its ALLL
which is to be reviewed promptly and regularly at least once each calendar
quarter and be properly reported, and any deficiency in the allowance must
be remedied in the calendar quarter it is discovered, by a charge to
current operating
earnings.
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With
respect to classified assets as of the date of the ROE, the Order also
requires the Bank to charge-off or collect all assets classified as “Loss”
and one-half of the assets classified as “Doubtful,” and within 180 days
of the Order to reduce its level of assets classified as “Substandard” to
no more than the greater of $50.0 million or 50% of Tier 1 capital plus
the ALLL. As of December 31, 2009, the Bank met the requirement
to charge-off or collect all assets classified as “Loss” and one-half of
the assets classified as “Doubtful” as of the date of the
ROE. At June 30, 2010, the Bank has met the requirement to
reduce assets classified as “Substandard” as of the date of the ROE to no
more than the greater of $50.0 million or 50% of Tier 1 capital plus the
ALLL.
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The
Order requires that the Bank develop or revise, adopt and implement a
plan, which must be approved by the FDIC and DFI, to reduce the amount of
Commercial Real Estate loans extended, particularly focusing on reducing
loans for construction and land development. At June 30, 2010, the Bank
has reduced its concentrations for Commercial Real Estate and construction
and land development to within guidelines acceptable by the Order. In
addition, the Bank is to develop a plan for reducing the number of “watch
list” credits to an acceptable level, and develop or revise its written
lending and collection policies to provide more effective guidance and
control over the Bank’s lending function. At June 30, 2010, the
Bank has in place a plan to comply with this provision of the
Order.
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The
Order restricts the Bank from taking certain actions without the prior
written consent of the FDIC and the DFI, including paying cash dividends,
and from extending additional credit to certain types of borrowers. The
Bank has not paid cash dividends since the first quarter of 2008. In
addition, the Bank has put processes and controls in place to ensure
extensions of credit, directly or indirectly, are not granted to those who
are related to borrowers of loans charged-off or classified as “Loss”,
“Substandard” or “Doubtful” in the ROE. The Bank has also acknowledged
that neither the loan committee nor the Board of Directors will approve
any extension to a borrower classified “Substandard” or “Doubtful” in the
ROE without first collecting all past due interest in
cash.
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The
Order further requires the Bank to develop or revise, adopt and implement
a revised liquidity policy, and to adopt a contingency funding plan to
adequately address contingency funding sources and appropriately reduce
contingency funding reliance on off-balance sheet sources. The
Bank has revised its current liquidity policy and contingency funding
plan.
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The
Order also requires that the Bank prepare and submit a revised business
plan, that is to include a comprehensive budget, and a 3 year strategic
plan, and to further revise its investment policy. The Bank has
since prepared a comprehensive budget and revised the investment policy
and is in the process of developing a revised business plan and 3 year
strategic plan.
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Heritage
Oaks Bancorp | - 30 -
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Notes to Consolidated Financial
Statements
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Written
Agreement
On March
4, 2010, the Company entered into a written agreement with the FRB (the “Written
Agreement”), which requires the Company to take certain measures to improve its
safety and soundness. Under the Written Agreement, the Company is required to
develop and submit for approval, a plan to maintain sufficient capital at the
Company and the Bank within 60 days of the date of the Written Agreement. The
Written Agreement further provides, among other things, that the Company shall
not: declare or pay dividends without prior approval of the FRB, take dividends
from the Bank, make any distribution of interest, principal or other sums on
subordinated debt or trust preferred securities, incur, increase, or guarantee
any debt. The Company believes it is currently in compliance with all
requirements of the Written Agreement, including an update to its capital
plan. The Company has updated its cash flow projections for 2010 and
has provided that information to the FRB.
The
forgoing discussion of the Order and Written Agreement are qualified in their
entirety by reference to the complete text of the Order and Written Agreement,
which can be found on the Current Reports on Form 8-K filed March 10, 2010, and
March 8, 2010, respectively.
Note
13. Junior Subordinated Debentures
On June
8, 2010, the Company repurchased $5.0 million in face amount trust preferred
securities issued by Heritage Oaks Capital Trust III, and the related $5.2
million junior subordinated debentures issued by the Company. The
repurchase resulted in a pre-tax gain of approximately $1.7 million, recognized
during the three months ended June 30, 2010. The repurchase was made pursuant to
the non-objection of the Federal Reserve Bank of San Francisco and approval of
the United States Treasury Department.
In the
second quarter of 2010 the Company elected to defer interest payments on $8.2
million junior subordinated debentures to comply with the terms of the Written
Agreement entered into between the Company and the Federal Reserve Bank of San
Francisco. As a result the Company accrued for but did not pay approximately $42
thousand in interest payments on these debentures. For more information
concerning the Written Agreement, please refer to Note 12. Regulatory Order and
Written Agreement of these consolidated financial statements. For such time as
the Company continues to the deferral of interest, it will be prevented from,
among other things, paying dividends on its preferred and common
stock.
Note
14. Reclassifications
Certain
amounts in the 2009 financial statements have been reclassified to conform to
the 2010 presentation.
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Heritage
Oaks Bancorp | - 31 -
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Forward
Looking Statements
Certain
statements contained in this Quarterly Report on Form 10-Q/A (“Quarterly
Report”), including, without limitation, statements containing the words
“believes”, “anticipates”, “intends”, “expects”, and words of similar impact,
constitute “forward-looking statements” within the meaning of Section 27A of the
Securities Act of 1933 and Section 21E of the Securities and Exchange Act of
1934. Such forward-looking statements involve known and unknown risks,
uncertainties and other factors that may cause the actual results, performance
or achievements of the Company to be materially different from any future
results, performance or achievements expressed or implied by such
forward-looking statements. Such factors include, among others, the following:
the ongoing financial crisis in the United States, and the response of the
federal and state government and our regulators thereto, general economic
conditions in those areas in which the Company operates, the recent fluctuations
in U.S. markets resulting, in part, from problems related to sub-prime lending,
from the national recession and the recent downturn in the California real
estate market, general economic and business conditions in those areas in which
the Company operates, demographic changes, competition, fluctuations in interest
rates, changes in business strategy or development plans, changes in
governmental regulation, credit quality, the impact of the recent capital raise
to support the Company’s business, as well as economic, political and global
changes arising from the war on terrorism, increased profitability, continued
growth, the Bank’s beliefs as to the adequacy of its existing and anticipated
allowance for loan losses, beliefs and expectations about, and requirements to
comply with the terms of Consent Order and Written Agreement issued by
regulatory authorities having oversight of the Bank’s and Company’s operations,
financial policies of the United States government and continued weakness in the
real estate markets within which we operate. (Refer to the Company’s December
31, 2009 10-K, ITEM 1A. Risk Factors). The Company disclaims any obligation to
update any such factors or to publicly announce the results of any revisions to
any of the forward-looking statements contained herein to reflect future events
or developments.
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Heritage
Oaks Bancorp | - 32 -
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Item
2. Management’s Discussion and Analysis of Financial Condition and
Results of Operations
The
following is an analysis of the results of operations and financial condition of
the Company as of and for the three and six month periods ending June 30, 2010
and 2009. The analysis should be read in connection with the
consolidated financial statements and notes thereto appearing elsewhere in this
report.
The
Company
Heritage
Oaks Bancorp (the "Company") is a California corporation organized in 1994 to
act as a holding company of Heritage Oaks Bank ("Bank"), a 15 branch bank
serving San Luis Obispo and Santa Barbara Counties. In 1994, the
Company acquired all of the outstanding common stock of the Bank in a holding
company formation transaction.
In
October 2006, the Company formed Heritage Oaks Capital Trust II (“Trust II”).
Trust II is a statutory business trust formed under the laws of the State of
Delaware and is a wholly-owned, non-financial, non-consolidated subsidiary of
the Company.
In
September 2007, the Company formed Heritage Oaks Capital Trust III (“Trust
III”). Trust III is a statutory business trust formed under the laws of the
State of Delaware and is a wholly-owned, non-financial, non-consolidated
subsidiary of the Company. In June 2010 the Company re-purchased all
the outstanding securities related to Trust III and plans to dissolve Trust III
in the second half of 2010.
On
October 12, 2007, the Company acquired Business First National Bank (“Business
First”). Business First was merged with and into Heritage Oaks Bank,
a wholly owned subsidiary of the Company. In connection with the
acquisition, two additional branches were added to the Bank’s
network. For additional information regarding this acquisition,
please see Note 23 to the consolidated financial statements of the Company’s
2008 annual report, which was filed on Form 10-K.
Other
than holding the shares of the Bank, the Company conducts no significant
activities, although it is authorized, with the prior approval of the Board of
Governors of the Federal Reserve System (the "Federal Reserve Board"), the
Company's principal regulator, to engage in a variety of activities which are
deemed closely related to the business of banking. The Company has also caused
to be incorporated a subsidiary, CCMS Systems, Inc. which is currently inactive
and has not been capitalized. The Company has no present plans to activate the
proposed subsidiary.
Where
You Can Find More Information
Under the
Securities Exchange Act of 1934 Sections 13 and 15(d), periodic and current
reports must be filed with the SEC. The Company electronically files the
following reports with the SEC: Form 10-K (Annual Report), Form 10-Q (Quarterly
Report), Form 8-K (Current Report), and Form DEF 14A (Proxy Statement). The
Company may file additional forms. The SEC maintains an internet site,
www.sec.gov, in which all forms filed electronically may be accessed.
Additionally, all forms filed with the SEC and additional shareholder
information are available free of charge on the Company’s website:
www.heritageoaksbancorp.com.
The
Company posts these reports to its website as soon as reasonably practicable
after filing them with the SEC. None of the information on or
hyperlinked from the Company’s website is incorporated into this Quarterly
Report on Form 10-Q/A.
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Heritage
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Management’s
Discussion and Analysis
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Executive
Summary
For the
three and six months ended June 30, 2010, the Company reported a net loss
applicable to common shareholders of approximately $9.6 million and $11.3
million, respectively. In the same periods ended a year earlier, the
Company reported net income available to common shareholders of approximately
$0.3 million and $1.3 million, respectively. Net loss per diluted
common share was ($0.86) for the second quarter of 2010, compared to net income
of $0.03 per diluted common share in the same period ended a year
earlier. For the first six months of 2010, the net loss per diluted
common share was ($1.19) compared to net income per diluted common share of
$0.17 for the same period ended a year earlier. Operating results for
the second quarter and first six months of 2010 were negatively impacted by
significantly higher provisions for loan losses when compared to that reported
in the same periods a year earlier as well as increased non-interest
expenses. Increased provisions for loan losses can be attributed to
several large write-downs incurred within the Bank’s commercial and industrial
loan portfolio as well as the downgrade of certain large
credits. Higher non-interest expenses for the quarter and year to
date periods ended June 30, 2010 are attributable to increases in salaries and
benefits, occupancy costs, and FDIC insurance premiums. Increases in
salaries and benefits are attributable to the expansion of the Bank’s management
team and special assets department. Higher occupancy costs can be
attributed to annual increases in rental costs as well as a reduction in
sublease rental income associated with the relocation of one branch
office. Contributing further to the year over year decline in net
income available to common shareholders was the recording of the beneficial
conversion feature related to the conversion of the Company’s Series B Preferred
Stock to common stock during the second quarter of 2010. Since the
fair market value of the Company’s common stock was higher than the conversion
price of the Series B Preferred Stock on the date the Company made a firm
commitment to issue the Series B Preferred Stock, a contingent
beneficial conversion feature related to the Series B Preferred Stock existed
with a value of approximately $3.5 million. The recognition of the
beneficial conversion feature was contingent upon the Company’s receipt of
shareholder approval to convert the Series B Preferred Stock to common
stock. Upon shareholder approval to convert the Series B Preferred
Stock to common stock in June 2010, the Company recorded the beneficial
conversion feature and corresponding Series B Preferred Stock discount of
approximately $3.5 million. The Company simultaneously recorded the
immediate accretion of the Series B Preferred Stock discount. The
accretion of the Series B Preferred Stock discount is recorded as
reduction of retained earnings, and therefore represents a reduction of net
income available to common shareholders. Offsetting the negative
impact of the items mentioned above was a $1.7 million pre-tax gain the Company
recognized from the extinguishment of $5.0 million in junior subordinated
debentures in June 2010.
As
mentioned above, during the second quarter of 2010 the Company’s shareholders
approved the conversion of 56,160 shares of Series B Mandatorily Convertible
Adjustable Cumulative Perpetual Preferred Stock (“Series B Preferred Stock”)
into 17,280,000 shares of the Company’s common stock. Series B
Preferred Stock was issued in the Company’s March 2010 private placement, where
the Company also issued 1,189,538 shares of Series C Convertible Perpetual
Preferred Stock. Total gross proceeds from the offering were
approximately $60.0 million. The additional capital will allow the
Company to not only continue to work through asset quality issues, but will
allow the Bank to further focus on building its core franchise. For
additional information regarding the Company’s March 2010 private placement,
please see Note 11. Preferred Stock, of the consolidated financial statements
filed on this Form 10-Q/A.
Liquidity
remained relatively strong during the second quarter of 2010, with a liquidity
ratio, the ratio of liquid assets not pledged for collateral and other purposes
to deposits and other liabilities, of 30.83% compared to 30.94% and 20.50%
reported at March 31, 2010 and December 31, 2009, respectively. The
proceeds from the March 2010 private placement in conjunction with a $20.4
million or 2.6% year to date increase in total deposits contributed
significantly to the rise in on-balance sheet liquidity.
The
following provides a summary of operating results for the three and six month
periods ended June 30, 2010 and 2009:
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For
the three and six months ended June 30, 2010 interest income totaled
approximately $13.2 million and $25.6 million. This when
compared to the same three and six month periods ended a year earlier,
represents increases of approximately $0.9 million and $1.5 million,
respectively. Although the average balance of the loan
portfolio increased by approximately $18.0 million and $27.2 million as of
June 30, 2010 when compared to that reported for the same three and six
month periods ended a year earlier, interest reversals associated with
non-performing loans as well as the re-pricing and pay-down of certain
higher yielding credits worked to offset any increase in the level of
interest and fees earned on loans resulting from year over year growth in
the loan portfolio. Interest and fees on loans totaled
approximately $11.4 million and $22.6 million for the three and six months
ended June 30, 2010, essentially unchanged from that reported a year
earlier. Mitigating the impact that interest reversals had in
interest income was an approximate $0.9 million and $1.5 million increase
in interest earned on investments. Increases within this
category can be attributed in large part to the investment of excess
liquidity stemming from significant year over year deposit growth as well
as funds received in the Company’s March 2010 private
placement.
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Heritage
Oaks Bancorp | - 34 -
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Management’s
Discussion and Analysis
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For
the three and six months ended June 30, 2010, interest expense totaled
approximately $2.0 million and $4.5 million, respectively. This
when compared to the same three and six month periods ended a year
earlier, interest expense declined approximately $0.4 million and $0.2
million, respectively. Management’s continued focus of bringing
down funding costs contributed significantly to the year over year
declines within this category. The cost of interest bearing
deposits declined 40 and 27 basis points for the three and six month
periods ended June 30, 2010 when compared to that reported for the same
three and six month periods ended a year
earlier.
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Net
interest income for the three and six months ended June 30, 2010 totaled
approximately $11.1 million and $21.1 million. Net interest
income increased approximately $1.3 million and $1.7 million from that
reported during the same three and six month periods ended a year
earlier. Year over year changes in net interest income can be
attributed in large part to the items mentioned in the preceding
paragraphs.
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Non-interest
income totaled approximately $3.6 million and $5.2 million for the three
and six month periods ended June 30, 2010, representing an increase of
approximately $2.1 million and $2.0 million, respectively when compared to
the same periods ended a year earlier. As previously mentioned,
the Company recognized a $1.7 million pre-tax gain on the extinguishment
of $5.0 million in junior subordinated debentures during the second
quarter of 2010, which was a primary driver behind the increase within
this category. Excluding the impact of the gain from the
extinguishment of debt, non-interest income increased approximately $0.4
million and $0.3 million for the three and six month periods ended June
30, 2010. Increases in debit card interchange income as well as
higher mortgage origination fees in conjunction with gains the Bank
recognized on the sale of OREO properties, certain fixed assets and SBA
loans helped to offset declines in service charge income. For
more information related to non-interest income, please see “Non-Interest
Income” of this Discussion and
Analysis.
|
|
·
|
Non-interest
expense totaled approximately $8.8 million and $17.7 million for the three
and six months ended June 30, 2010, respectively. This when
compared to that reported for the same three and six month periods ended a
year earlier represents an increase of approximately $0.8 million and $2.3
million, respectively. As previously mentioned, the year over
year rise in non-interest expenses can be attributed to higher salaries
and employee benefits associated with the expansion of the Bank’s
management team and special assets department. Increases within
this category can also be attributed to higher occupancy costs stemming
from annual increases in rental costs as well as a reduction in sublease
rental income associated with the relocation of one branch
office. Higher regulatory assessment costs associated with
higher FDIC deposit insurance premiums contributed further to the year
over year rise in non-interest expenses. Partially offsetting
these increases was an approximate $0.1 million and $0.3 million decline
in scheduled CDI amortization for the three and six month periods ended
June 30, 2010, respectively. For more information related to
non-interest expenses, please see “Non-Interest Expenses” of this
Discussion and Analysis.
|
|
·
|
For
the three and six months ended June 30, 2010 the Company’s efficiency
ratio was 68.86% and 72.65%, respectively. This compares to the
70.02% and 68.38% reported for the same periods ended a year earlier.
Management remains focused on cost controls in an effort to mitigate the
rise in non-interest expenses primarily resulting from asset quality
issues and the need to effectively manage them in the current
environment.
|
The
following provides a summary for significant year to date changes in financial
condition balances as of June 30, 2010:
|
·
|
At
June 30, 2010, gross loan balances were approximately $697.2 million,
approximately $31.5 million or 4.3% lower than that reported at December
31, 2009. Contributing to the year to date decline in loan
balances was the receipt of approximately $9.7 million in principal
payments on non-accruing loans, $5.0 million in transfers to OREO and
$15.2 million in charge-offs. The year to date decline in gross loans can
also be attributed to several large pay-downs during the first six months
of 2010 in conjunction with scheduled amortization of balances in the
absence of significant new loan originations. The lower volume of loan
originations relative to historical periods can be attributed in part to
lower demand for certain types of credit as well as the Bank becoming more
selective with respect to the types of loans it chooses to
originate. See also “Loans” under “Financial Condition” of this
Discussion and Analysis for additional information regarding the Bank’s
loan portfolio.
|
|
·
|
At
June 30, 2010, total deposits were approximately $795.8 million,
approximately $20.4 million or 2.6% higher than that reported at December
31, 2009. Deposits, exclusive of brokered deposits were
approximately $794.7 million or $30.5 million higher than that reported at
December 31, 2009. Increases in core deposit balances allowed
the Bank to rely less on brokered deposits for funding. At June
30, 2010 brokered deposit balances totaled approximately $1.1 million and
represented 0.1% of total deposits. This compares to $11.2
million or 1.5% at December 31, 2009. See also “Deposits and
Borrowed Funds” under “Financial Condition” of this Discussion and
Analysis for information regarding the Bank’s deposit
liabilities.
|
|
Heritage
Oaks Bancorp | - 35 -
|
Management’s
Discussion and Analysis
|
|
·
|
At
June 30, 2010, borrowings from the FHLB were $65.0 million, unchanged from
that reported at December 31, 2009. The average rate paid on
borrowings with the FHLB for the three and six months ended June 30, 2010
was 0.62% and 0.60%, respectively. This compares to the 0.83%
and 0.88% reported for the same three and six month periods ended a year
earlier.
|
|
·
|
Investment
securities totaled approximately $192.9 million, approximately $71.7
million greater than that reported at December 31, 2009. The
year to date increase in the portfolio can be attributed to purchases the
Bank made to maximize the yield on earning assets in the absence of
significant new loan originations. For additional
information on the Bank’s investment securities portfolio, please see
“Investment Securities and Other Earning Assets” of this Discussion and
Analysis.
|
|
·
|
Federal
Funds sold and interest bearing due from balances totaled approximately
$44.2 million at June 30, 2010, representing an increase of approximately
$22.8 million over that reported at December 31,
2009. Increased balances within this category are attributable
in large part to approximately $20.4 million in deposit growth experienced
during the first six months of 2010 as well as proceeds the Company
received related to its March 2010 private placement. See also
“Investment Securities and Other Earning Assets” of this Discussion and
Analysis for additional information regarding Federal Funds sold and
interest bearing due from
balances.
|
The
following provides an overview of asset quality as of June 30,
2010:
|
·
|
At
June 30, 2010, the balance of non-performing loans was approximately $35.1
million or $13.9 million and $3.3 million lower than that reported at
March 31, 2010 and December 31, 2009, respectively. As of June
30, 2010 the balance of non-performing loans as a percentage of total
gross loans was 5.03% compared to the 6.78% and 5.26% reported as of March
31, 2010 and December 31, 2009, respectively. Contributing to
the year to date variance in non-performing loans was the approximate
$30.4 million in loans placed on non-accruing status,
the receipt of approximately $9.7 million in principal payments
on non-accruing balances, transfers to OREO totaling $5.0 million and
charged-offs of approximately $15.2 million. Contributing
further to the year to date variance in non-accruing loans was the return
of approximately $3.7 million in balances to accruing status following the
Bank’s efforts to bring resolution to problem credits. Please
see “Non-Performing Assets” of this Discussion and Analysis for a more
complete discussion of the loans the Bank has placed on non-accrual
status.
|
|
·
|
At
June 30, 2010, the allowance for loan losses totaled approximately $22.1
million, representing 3.17% of total gross loans. This compares
to the $14.4 million or 1.97% of total gross loans reported at December
31, 2009. Provisions for loan losses during the three and six
months ended June 30, 2010 totaled approximately $16.1 million and $21.3
million, respectively. This represents an increase of
approximately $13.4 million and $16.5 million from that reported for the
same periods ended a year earlier. See also “Provision for Loan
Losses” of this Discussion and Analysis for a more complete discussion
regarding loan loss
provisions.
|
|
·
|
Charge-offs
during the three and six month periods ended June 30, 2010 totaled
approximately $13.7 million and $15.2 million,
respectively. Net charge-offs during the three and six month
periods ended June 30, 2010 totaled approximately $12.5 million and $13.5
million, respectively. Net charge-offs to average gross loans
were 1.73% and 1.86% for the three and six month periods ended June 30,
2010, respectively. This compares to 0.29% and 0.59% reported
for the same three and six month periods ended a year earlier. Please see
“Allowance for Loan Losses” of this Discussion and Analysis for additional
information related to the
charge-offs.
|
|
·
|
OREO
balances totaled approximately $5.0 million at June 30, 2010, an increase
of approximately $4.0 million from that reported at December 31,
2009. As previously mentioned, the Bank transferred
approximately $5.0 million to OREO in the first six months of
2010. OREO dispositions totaled approximately $0.8 million and
write-downs of OREO totaled $0.2 million in first six months of
2010.
|
Recent
Developments
Regulatory
Order and Written Agreement
On March
4, 2010, the FDIC and the DFI issued a joint Consent Order (the “Order”) to the
Bank that requires, among other things, the Bank to increase its capital ratios,
reduce its classified assets and increase Board oversight of Management. The
Board and Management are aggressively responding to the Order to ensure full
compliance and will continue to take all actions necessary to comply with the
Order within the required time frames. Such actions include the completion of
the capital raise discussed below which, following a contribution of a portion
of the proceeds to the Bank, the Bank was brought into compliance with the
capital requirements of the Order. Additionally, a Written Agreement
was entered into between the Company and the Federal Reserve Bank of San
Francisco on March 4, 2010. With the capital raise secured, the Company and Bank
believe compliance with both the Order and Written Agreement has been
achieved.
|
Heritage
Oaks Bancorp | - 36 -
|
Management’s
Discussion and Analysis
|
For
additional information concerning the Order and the Written Agreement, please
see Note 12. Regulatory Order and Written Agreement, of the consolidated
financial statements filed on this Form 10-Q/A. For the full text of
the Order and Written Agreement, please also refer to the Company's current
reports on Form 8-K regarding the Consent Order and Written Agreement which were
filed with the Securities and Exchange Commission on March 10, 2010 and March 8,
2010, respectively.
Private
Placement and Preferred Stock Conversion
On March
12, 2010 the Company announced that it completed a private placement of 52,088
shares of its Series B Mandatorily Convertible Adjustable Cumulative Perpetual
Preferred Stock ("Series B Preferred Stock") and 1,189,538 shares of its Series
C Convertible Perpetual Preferred Stock, raising gross proceeds of approximately
$56.0 million. On June 8, 2010 the Company announced it had closed escrow on the
sale of an additional $4.0 million in Series B Preferred Stock related to its
March 2010 private placement. Together with the proceeds raised from
the initial offering, the Company raised a total of $60.0 million in gross
proceeds. Following the receipt of shareholder approval at the
Company’s June 2010 annual meeting, the Company converted to common stock all
Series B Preferred shares issued in the private placement. The total
number of common shares issued in the conversion was 17,279,995. For additional
information regarding the Company’s private placement, please see Note 11.
Preferred Stock, of the consolidated financial statements filed on this Form
10-Q/A.
Repurchase
of Trust Preferred Securities
In June
2010 the Company announced it had used $3.3 million of the $4.0 million in
proceeds received from the second closing of its March 2010 private placement to
repurchase the $5.0 million in face amount trust preferred securities issued by
Heritage Oaks Capital Trust III, and the related junior subordinated debentures
issued by the Company. The repurchase resulted in a pre-tax gain of
approximately of $1.7 million. The repurchase was made pursuant to the
non-objection of the Federal Reserve Bank of San Francisco and approval of the
United States Treasury Department. The Company intends to dissolve Heritage Oaks
Capital Trust III in the second half of 2010.
Dividends
and Stock Repurchases
During
the first six months of 2010, the Company paid approximately $262 thousand in
dividends on its Series A Senior Preferred Stock issued to the U.S. Treasury
under the CPP. In the second quarter of 2010 the Company was required
to defer dividend payments on its Series A Senior Preferred Stock to comply with
the terms of the Written Agreement entered into between the Company and the
Federal Reserve Bank of San Francisco. See also Note 11. Preferred
Stock, of the consolidated financial statements filed on this form 10-Q/A for
additional information about dividends on the Company’s Series A Senior
Preferred Stock. For more information concerning the Written
Agreement, please refer to Note 12. Regulatory Order and Written Agreement of
the consolidated financial statements filed on this Form 10-Q/A.
The
Company paid no dividends on or made repurchases of its common stock during the
first six months of 2010 or all of 2009.
|
Heritage
Oaks Bancorp | - 37 -
|
Management’s
Discussion and Analysis
|
Selected
Financial Data
The table
below provides selected financial data that highlights the Company’s quarterly
performance results:
For the quarters ended,
|
||||||||||||||||||||||||||||||||
(dollars in thousands except per share data)
|
06/30/10
|
03/31/10
|
12/31/09
|
09/30/09
|
06/30/09
|
03/31/09
|
12/31/08
|
09/30/08
|
||||||||||||||||||||||||
Return
on average assets
|
-2.32 | % | -0.56 | % | -1.43 | % | -2.30 | % | 0.23 | % | 0.54 | % | -0.63 | % | 0.27 | % | ||||||||||||||||
Return
on average equity
|
-17.35 | % | -5.70 | % | -15.27 | % | -22.54 | % | 2.20 | % | 6.04 | % | -6.93 | % | 2.94 | % | ||||||||||||||||
Return
on average common equity
|
-55.46 | % | -10.93 | % | -22.05 | % | -31.14 | % | 1.44 | % | 6.21 | % | -6.93 | % | 2.94 | % | ||||||||||||||||
Average
equity to average assets
|
13.36 | % | 9.88 | % | 9.35 | % | 10.18 | % | 10.68 | % | 8.95 | % | 9.06 | % | 9.16 | % | ||||||||||||||||
Average
common equity to average assets
|
6.91 | % | 6.57 | % | 7.14 | % | 7.87 | % | 8.26 | % | 8.61 | % | 9.06 | % | 9.16 | % | ||||||||||||||||
Net
interest margin
|
4.69 | % | 4.43 | % | 4.81 | % | 4.34 | % | 4.91 | % | 5.03 | % | 5.04 | % | 5.18 | % | ||||||||||||||||
Efficiency
ratio*
|
68.86 | % | 76.88 | % | 70.84 | % | 95.12 | % | 70.02 | % | 66.71 | % | 66.43 | % | 64.40 | % | ||||||||||||||||
Average
loans to average deposits
|
91.82 | % | 93.67 | % | 93.45 | % | 98.20 | % | 103.58 | % | 112.39 | % | 109.95 | % | 111.54 | % | ||||||||||||||||
Net
(loss) / income
|
$ | (5,835 | ) | $ | (1,339 | ) | $ | (3,416 | ) | $ | (5,242 | ) | $ | 507 | $ | 1,102 | $ | (1,254 | ) | $ | 534 | |||||||||||
Net
(loss) / income available to common shareholders
|
$ | (9,644 | ) | $ | (1,690 | ) | $ | (3,767 | ) | $ | (5,594 | ) | $ | 257 | $ | 1,091 | $ | (1,254 | ) | $ | 534 | |||||||||||
(Loss)
/ Earnings Per Common Share:
|
||||||||||||||||||||||||||||||||
Basic
|
$ | (0.86 | ) | $ | (0.22 | ) | $ | (0.48 | ) | $ | (0.73 | ) | $ | 0.03 | $ | 0.14 | $ | (0.16 | ) | $ | 0.07 | |||||||||||
Diluted
|
$ | (0.86 | ) | $ | (0.22 | ) | $ | (0.48 | ) | $ | (0.73 | ) | $ | 0.03 | $ | 0.14 | $ | (0.16 | ) | $ | 0.07 | |||||||||||
Outstanding
Shares:
|
||||||||||||||||||||||||||||||||
Basic
|
11,250,989 | 7,717,194 | 7,704,060 | 7,699,377 | 7,696,027 | 7,689,317 | 7,660,342 | 7,709,600 | ||||||||||||||||||||||||
Diluted
|
11,250,989 | 7,717,194 | 7,704,060 | 7,699,377 | 7,866,962 | 7,824,377 | 7,660,342 | 7,798,321 |
* The
efficiency ratio is defined as total non-interest expense as a percent of the
combined net interest income plus non-interest income, exclusive of gains and
losses on the sale of investment securities, other real estate owned, SBA loans
and extinguishment of debt.
Local
Economy
The
economy in the Company’s primary market area (San Luis Obispo and Santa Barbara
Counties) is based primarily on agriculture, tourism, light industry, oil and
retail trade. Services supporting these industries have also developed in the
areas of medical, financial and educational services. The population
of San Luis Obispo County, the City of Santa Maria (in Northern Santa Barbara
County), and the City of Santa Barbara totaled approximately 267,000, 85,000,
and 86,000 respectively, according to the most recent economic data provided by
the U.S. Census Bureau. The moderate climate allows a year round
growing season in the local economy’s agricultural sector. Vineyards
and cattle ranches also contribute largely to the local economy. The
Central Coast’s leading agricultural industry is the production of wine grapes
and production of premium quality wines. Vineyards in production have grown
significantly over the past several years throughout the Company’s service
area. Access to numerous recreational activities and destinations
including lakes, mountains and beaches, provide a relatively stable tourist
industry from many areas including the Los Angeles/Orange County basin, the San
Francisco Bay area and the San Joaquin Valley. The economy in the Company’s
primary markets of San Luis Obispo and Santa Barbara counties has not been
immune to the current downturn in national and state economic
conditions. Weakened economic conditions have resulted in, among
other things, increased unemployment, increased vacancy rates, and lower
occupancy rates in the hospitality industry within the Company’s primary
markets. However, the abundant tourism that has developed over the
past decade in our market area, especially in the wine industry and coastal
communities, has provided some support for our local economy in previous
economic downturns and has to some degree provided some support for the local
economy in the current economic environment.
|
Heritage
Oaks Bancorp | - 38 -
|
Management’s
Discussion and Analysis
|
The last
two years have proven to be challenging not only on the national level, but
within the state of California and more specifically our primary market
area. As the U.S. housing market continued to wane throughout 2009
and economic growth remained weak, the ability of borrowers to satisfy their
obligations to the financial sector has languished. These among other
factors placed severe stress on the U.S. financial system, leading to a downturn
in economic growth and unprecedented volatility in the U.S. equity and credit
markets. As mentioned, the Bank’s primary market area has
historically witnessed a more stable level of economic activity; however the
Bank believes these more macro level concerns have started to become more
evident within our market area. Recent indications show the
unemployment rate within California to be approximately 12.3%. Within
the Company’s primary market area, recent indications show the unemployment rate
within San Luis Obispo and Santa Barbara major metropolitan areas to be
approximately 9.5% and 8.3%, respectively. Additionally, according to
the most recent data available to the Company in regard to hotel occupancy
rates, published by Smith Travel Research in June 2010, hotel occupancy rates
showed a year over year decline of 3.9% and 0.1% for Paso Robles/San Luis Obispo
and Santa Barbara/Santa Maria, respectively. For the State of California, hotel
occupancy rates showed a year over year increase of 5.7%.
Housing
prices have fallen significantly in California and within the Bank’s market area
from the highs seen during 2006 and 2007. Recent information provided
by DataQuick Information Systems indicates that housing prices in San Luis
Obispo and Santa Barbara counties have declined in excess of 38% from the highs
seen in 2006 and 2007. However, the Company’s market area has seen
increases in home sales over the last year, with San Luis Obispo and Santa
Barbara counties showing sales increases of approximately 8% and 12%,
respectively for 2009 when compared to that reported for
2008. Increased sales can be attributed in part to sales of
distressed assets and the work through of any additional supply added to the
market in recent years during the economic downturn. Although
the level of sales in the Company’s market area has increased on a year over
year basis, recent information provided by DataQuick indicates home prices
declined in 2009 compared to that reported for December 2008. Prices
in some of the largest cities in our market area such as: San Luis Obispo, Paso
Robles, Santa Barbara, and Santa Maria have shown year over year declines of
approximately 16%, 13%, 16% and 7%, respectively as of December
2009. It should be noted that although changes in local median home
prices typically indicate home price appreciation and depreciation, price
changes may also reflect shifts in the composition of housing market activity.
Therefore, some of the variations in median home prices as of December 2009 may
be impacted by compositional changes in housing demand.
Although
prices in the Company’s market area remain well below the highs witnessed in
2006 and 2007, a lack of oversupply in the Company’s market relative to other
areas of California, desirable climate, and close proximity to popular tourist
destinations, for both San Luis Obispo and Santa Barbara Counties have resulted
in lower percentage declines in prices for the local real estate market,
relative to other areas of California.
Commercial
real estate prices in the Company’s primary markets have also come under some
pressure in the current economic downturn, although not to the extent witnessed
in some other areas of California. The most current data available to
the Company indicates vacancy rates in the retail, office and manufacturing
sectors of the Company’s primary market area to be 3.0%, 6.1% and 5.4%,
respectively as of the fourth quarter of 2009. This compares to
vacancy rates of 1.4%, 3.5% and 2.3% for the same respective categories in
2008.
Management
acknowledges that as economic conditions continue to wane, and as the level of
unemployment continues to rise, conditions within the Company’s primary market
may be negatively impacted above and beyond what the Company has seen thus
far. Additional job losses and any prolonged decline in economic
activity will no doubt impact the borrowers to whom the Bank has extended
credit, which may further impact our operating results and financial
condition.
Critical
Accounting Policies
The
Company’s significant accounting policies are set forth in the 2009 Annual
Report, Note 1 of the consolidated financial statements, which was filed on Form
10-K.
The
following is a brief description of the Company’s current accounting policies
involving significant Management valuation judgments.
Loans
and Interest on Loans
Loans
receivable that Management has the intent and ability to hold for the
foreseeable future or until maturity or payoff are reported at their outstanding
unpaid principal balances reduced by any charge-offs of specific valuation
allowances and net of any deferred fees or costs on originated loans, or
unamortized premiums or discounts on purchased loans.
|
Heritage
Oaks Bancorp | - 39 -
|
Management’s
Discussion and Analysis
|
Loan origination fees and certain
direct origination costs are capitalized and recognized as an adjustment in
yield over the life of the related loan.
Loans on
which the accrual of interest has been discontinued are designated as
non-accruing loans. The accrual of interest on loans is discontinued
when principal and/or interest is past due 90 days based on contractual terms of
the loan and/or when, in the opinion of Management, there is reasonable doubt as
to collectability unless such loans are well collateralized and in the process
of collection. When loans are placed on non-accrual status, all
interest previously accrued but not collected is reversed against current period
interest income. Interest income generally is not recognized on
specific non-accruing loans unless the likelihood of further loss is
remote. Interest payments received on such loans are applied as a
reduction to the loan principal balance. Interest accruals are
resumed on such loans only when they are brought current with respect to
interest and principal and when, in the judgment of Management, all remaining
principal and interest is estimated to be fully collectible, there has been at
least six months of sustained repayment performance since the loan was placed on
non-accrual and/or Management believes, based on current information, that such
loan is no longer impaired.
The
Company considers a loan to be impaired when, based on current information and
events, it is probable that the Bank will be unable to collect all amounts due
according to the contractual terms of the loan agreement. Measurement
of impairment is based on the expected future cash flows of an impaired loan
which are discounted at the loan’s original effective interest rate, or measured
by reference to an observable market value, if one exists, or the fair value of
the collateral for a collateral-dependent loan. The Company selects
the measurement method on a loan-by-loan basis except that collateral-dependent
loans for which foreclosure is probable are measured at the fair value of the
collateral. The Bank recognizes interest income on impaired loans
based on its existing methods of recognizing interest income on non-accrual
loans. All loans are generally charged-off at such time that it is
highly certain a loss has been realized.
Allowance
for Loan Losses
The
allowance for loan losses is maintained at a level which, in Management's
judgment, is adequate to absorb credit losses inherent in the loan portfolio as
of the balance sheet date. The amount of the allowance is based on
Management's evaluation of the collectability of the loan portfolio, including
the nature and volume of the portfolio, credit concentrations, trends in
historical loss experience, the level of certain classified balances and
specific impaired loans, and economic conditions and the related impact on
specific borrowers and industry groups. The allowance is increased by
a provision for loan losses, which is charged to earnings and reduced by
charge-offs, net of recoveries. Changes in the allowance relating to
impaired loans are charged or credited to the provision for loan
losses. Because of uncertainties inherent in the estimation process,
Management’s estimate of credit losses inherent in the loan portfolio and the
related allowance may change.
As
mentioned, loans are considered impaired if, based on current information and
events, it is probable that the Bank will be unable to collect all amounts due
according to the contractual terms of the loan agreement. In certain
instances the Bank may work with the borrower to modify the terms of the loan
agreement or otherwise restructure the loan in a way that would allow the
borrower to continue to perform under the modified terms of the loan
agreement. Loans such as these are considered impaired and require
the Bank to measure the amount of impairment, if any, at the time the loan is
restructured. The measurement of impaired loans is generally based on
the present value of expected future cash flows discounted at the historical
effective interest rate stipulated in the loan agreement, except that all
collateral-dependent loans are measured for impairment based on the fair value
of the collateral. In measuring the fair value of the collateral,
Management uses assumptions and methodologies consistent with those that would
be utilized by unrelated third parties. Allowances for impaired loans
are generally determined based on collateral values or the present value of
estimated cash flows.
As
mentioned, changes in the financial condition of individual borrowers, economic
conditions, historical loss experience and the condition of the various markets
in which collateral may be sold may all affect the required level of the
allowance for loan losses and the associated provision for loan
losses.
Other
Real Estate Owned
Real
estate and other property acquired in full or partial settlement of loan
obligations is referred to as other real estate owned (“OREO”). OREO
is originally recorded in the Company’s financial statements at fair value less
any estimated costs to sell. When property is acquired through
foreclosure or surrendered in lieu of foreclosure, the Company measures the fair
value of the property acquired against its recorded investment in the
loan. If the fair value of the property at the time of acquisition is
less than the recorded investment in the loan, the difference is charged to the
allowance for loan losses. Any subsequent fluctuations in the fair
value of OREO are recorded against a valuation allowance for foreclosed assets,
established through a charge to non-interest expense. All related
operating or maintenance costs are charged to non-interest expense as
incurred. Any subsequent gains or losses on the sale of OREO are
recorded in other income or expense as incurred.
|
Heritage
Oaks Bancorp | - 40 -
|
Management’s
Discussion and Analysis
|
Appraisals
for Collateral Dependent Loans
Once a
loan has been funded, the Bank has a policy to perform an annual review of the
borrower’s financial condition and of any real estate securing the
loan. This review includes, among other things, a physical inspection
of the real estate securing the loan, an analysis of any related rent rolls, an
analysis of all borrower and guarantor tax returns and financial
statements. This information is used internally by the Bank to
validate all covenants and the risk grade assigned to the loan. If
during the review process the Bank learns of additional information that would
suggest that the value of the collateral may be impaired from the original
underwriting of the loan, or the most recent appraisal, an additional
independent appraisal of the collateral is requested. If based on the
updated appraisal information it is determined the value of the collateral is
impaired and the Bank no longer expects to collect all previously determined
amounts related to the loan as stipulated in the loan’s original agreement, the
Bank typically moves to establish a valuation allowance for such loans or
charge-off such differences. Once a loan is deemed to be impaired
and/or the loan was downgraded to substandard status, the loan becomes the
responsibility of the Bank’s Special Assets department, which provides more
diligent oversight of problem credits. This oversight includes, among
other things, a review of all previous appraisals of collateral securing such
loans and determining in the Bank’s best judgment if those appraisals still
represent the current fair value of the loan. Additional appraisals
may be ordered at this time if deemed necessary.
Securities
Available for Sale
In
accordance with U.S. GAAP, securities are classified in three
categories and accounted for as follows: debt and mortgage-backed
securities that the Company has the positive intent and ability to hold to
maturity are classified as held-to-maturity and are measured at amortized cost;
debt and equity securities bought and held principally for the purpose of
selling in the near term are classified as trading securities and are measured
at fair value, with unrealized gains and losses included in earnings; debt and
equity securities not classified as either held-to-maturity or trading
securities are deemed as available-for-sale and are measured at fair value, with
unrealized gains and losses, net of applicable taxes, reported in a separate
component of stockholders' equity. The fair value of most securities
that are designated available for sale are based on quoted market
prices. If quoted market prices are not available, fair values are
extrapolated from the quoted prices of similar instruments or through the use of
other observable data supporting a valuation model. Gains or losses
on sales of investment securities are determined on the specific identification
method. Premiums and discounts are amortized or accreted using the
interest method over the expected lives of the related securities.
Declines
in the fair value of individual held-to-maturity and available-for-sale
securities below their cost that are other than temporary result in write-downs
of individual securities to their fair value. The related write-downs
are included in earnings as realized losses. In estimating other-than-temporary
impairment losses, Management considers: (1) the length of time the security has
been in an unrealized loss position, (2) the extent to which the security’s fair
value is less than its cost, (3) the financial condition of the issuer, (4) any
adverse changes in ratings issued by various rating agencies, (5) the intent and
ability of the Bank to hold such securities for a period of time sufficient to
allow for any anticipated recovery in fair value and (6) in the case of mortgage
related securities, current cash flows, credit enhancements, loan-to-values,
credit scores, delinquency and default rates.
Goodwill
and Other Intangible Assets
As
discussed in the 2009 Annual Report, Note 1 of the consolidated financial
statements, which was filed on Form 10-K, the Company assess goodwill and other
intangible assets each year for impairment. The Company’s assessment
at December 31, 2009, pursuant to its Goodwill Impairment Testing Policy, was
performed with the assistance of an independent third party and resulted in no
impairment.
Deferred
Tax Assets
Deferred
income taxes reflect the tax effect of temporary differences between the
financial statement carrying amounts and the corresponding tax basis of assets
and liabilities. The Company uses an estimate of future earnings to
support its position that the benefit of its deferred tax assets will be
realized. If future income should prove non-existent or less than the
amount of the deferred tax assets within the tax years to which they may be
applied, the asset may not be realized and a valuation allowance may be
established and the Company’s net income will be reduced. In the
fourth quarter of 2009, the Company performed an in depth analysis of its
deferred tax asset to determine if the current carrying value of the deferred
tax asset would be realized in future periods. Based on the Company’s
analysis and all currently available information, the Company believes that as
of June 30, 2010 the carrying value of the deferred tax asset can be supported
and that a valuation allowance is not necessary at this time.
|
Heritage
Oaks Bancorp | - 41 -
|
Management’s
Discussion and Analysis
|
Results
of Operations
The
Company’s operating results for the three and six months ended June 30, 2010
when compared to the same periods ended a year earlier were impacted
considerably by higher provisions for loan losses. Provisions for
loan losses during the three and six months ended June 30, 2010 totaled
approximately $16.1 million and $21.3 million, representing increases of
approximately $13.4 million and $16.5 million from that reported in the same
periods ended a year earlier. Higher levels of charge-offs in the
second quarter and first six months of 2010 in conjunction with: elevated levels
of non-accruing loan balances, increases in the balance of loans the Bank
classifies as special mention and substandard, higher historical loan loss
rates, and continued weakness in economic conditions were drivers behind the
increased loan loss provisions during the three and six months ended June 30,
2010. Please see “Provision for Loan Losses” of this Discussion and
Analysis for additional information related to provision for loan
losses. Also impacting operating results during the three and six
month periods ended June 30, 2010 were interest reversals related to loans the
Bank placed on non-accrual of approximately $0.2 million and $0.4 million,
respectively. Total foregone interest related to impaired loans was
approximately $1.0 million and $1.6 million during the three and six months
ended June 30, 2010. Interest reversals and foregone interest on impaired loans
were factors that negatively impacted the net interest margin during the periods
mentioned.
The
Company’s earnings are highly influenced by changes in short term interest
rates. The nature of the Company’s balance sheet can be summarily
described as of short duration and net asset sensitive. The balance sheet is of
short duration because a large percentage of its interest sensitive assets and
liabilities re-price immediately with changes in Federal Funds and Prime
interest rates. Contributing significantly to an asset sensitive
balance sheet is a relatively large volume of non-interest bearing demand
deposit accounts which effectively never re-price. Therefore, an
upward movement in short term interest rates will generally result in higher net
interest margin and conversely, a reduction in short term interest rates will
result in reduced net interest margin.
However,
in the last two years interest rates have fallen to unprecedented levels and as
a result a significant portion of loans in the Bank’s loan portfolio are
currently at their floors. Given that current interest rates are
considerably lower than most floors in the loan portfolio, the Bank would need
to see a notable rise in interest rates before the overall yield on the
portfolio would begin to rise. Additionally, as a result of
promotions over the last two years designed to attract lower cost core deposits,
the Bank was able to significantly increase the level of floating rate
liabilities in the form of money market and short term certificate accounts,
bringing the balance sheet to a more neutral position regarding interest rate
sensitivity. This was instrumental in mitigating substantial year
over year declines in the net interest margin as a result of dramatic declines
in the overnight Federal Funds and Prime rates during 2008.
For the
three and six months ended June 30, 2010 and 2009, the net interest margin was
4.69%, 4.56%, 4.91%, 4.97%, respectively. This represents a decline
of 22 and 41 basis points when compared to that reported for the same periods
ended a year earlier. As mentioned, interest reversals and foregone
interest related to loans the Bank placed on non-accrual negatively impacted the
net interest margin in 2010. For the second quarter and first six months of 2010
interest reversals (related to loans placed on non-accrual during the period)
negatively impacted the net interest margin by approximately 6 and 8 basis
points. Total foregone interest negatively impacted the net interest
margin by approximately 42 and 34 basis points for the second quarter and the
first six months of 2010, respectively. Additionally, significantly
higher average balances of overnight liquidity in the form of federal funds sold
and interest bearing due from placed added pressure on the margin as these
investments yielded, on average, approximately 0.22% for the second quarter and
the first six months of 2010.
Historically,
the largest and most variable source of income for the Company is net interest
income. The results of operations for the three and six months ended June 30,
2010 and 2009 reflect the impact of historically low interest rates throughout
the last two years and a significantly weakened economy.
Net
Interest Income and Margin
Net
interest income, the primary component of the net earnings of a financial
institution, refers to the difference between the interest paid on deposits and
borrowings, and the interest earned on loans and investments. The net
interest margin is the amount of net interest income expressed as a percentage
of average earning assets. Factors considered in the analysis of net interest
income are the composition and volume of earning assets and interest-bearing
liabilities, the amount of non-interest bearing liabilities and non-accrual
loans, and changes in market interest rates.
|
Heritage
Oaks Bancorp | - 42 -
|
Management’s Discussion and
Analysis
|
The
tables below set forth average balance sheet information, interest income and
expense, average yields and rates and net interest income and margin for the
three and six months ended June 30, 2010 and 2009. The average
balance of non-accruing loans has been included in loan totals:
For the three months ending
|
For the three months ending
|
|||||||||||||||||||||||
June 30, 2010
|
June 30, 2009
|
|||||||||||||||||||||||
Yield/
|
Income/
|
Yield/
|
Income/
|
|||||||||||||||||||||
(dollars in thousands)
|
Balance
|
Rate (4)
|
Expense
|
Balance
|
Rate (4)
|
Expense
|
||||||||||||||||||
Interest
Earning Assets:
|
||||||||||||||||||||||||
Investments
with other banks
|
$ | 119 | 3.37 | % | $ | 1 | $ | 119 | 3.37 | % | $ | 1 | ||||||||||||
Interest
bearing due from banks
|
42,234 | 0.23 | % | 24 | - | 0.00 | % | - | ||||||||||||||||
Federal
funds sold
|
4,203 | 0.10 | % | 1 | 20,816 | 0.19 | % | 10 | ||||||||||||||||
Investment
securities taxable
|
157,181 | 3.66 | % | 1,434 | 57,746 | 4.40 | % | 634 | ||||||||||||||||
Investment
securities non taxable
|
26,181 | 4.40 | % | 287 | 19,412 | 4.30 | % | 208 | ||||||||||||||||
Loans
(1) (2)
|
723,800 | 6.33 | % | 11,429 | 705,779 | 6.49 | % | 11,416 | ||||||||||||||||
Total
interest earning assets
|
953,718 | 5.54 | % | 13,176 | 803,872 | 6.12 | % | 12,269 | ||||||||||||||||
Allowance
for possible loan losses
|
(21,869 | ) | (10,121 | ) | ||||||||||||||||||||
Other
assets
|
77,766 | 71,936 | ||||||||||||||||||||||
Total
assets
|
$ | 1,009,615 | $ | 865,687 | ||||||||||||||||||||
Interest
Bearing Liabilities:
|
||||||||||||||||||||||||
Interest
bearing demand
|
$ | 72,013 | 0.31 | % | $ | 56 | $ | 61,084 | 0.69 | % | $ | 105 | ||||||||||||
Savings
|
27,231 | 0.38 | % | 26 | 23,819 | 0.19 | % | 11 | ||||||||||||||||
Money
market
|
275,395 | 1.05 | % | 718 | 177,585 | 1.48 | % | 656 | ||||||||||||||||
Time
deposits
|
232,490 | 1.89 | % | 1,095 | 185,078 | 2.52 | % | 1,161 | ||||||||||||||||
Brokered
money market funds
|
1,000 | 0.80 | % | 2 | 32,893 | 0.82 | % | 67 | ||||||||||||||||
Brokered
time deposits
|
543 | 0.74 | % | 1 | 36,907 | 1.46 | % | 134 | ||||||||||||||||
Total
interest bearing deposits
|
608,672 | 1.25 | % | 1,898 | 517,366 | 1.65 | % | 2,134 | ||||||||||||||||
Federal
funds purchased
|
- | 0.00 | % | - | 109 | 1.10 | % | - | ||||||||||||||||
Other
secured borrowing
|
829 | 5.32 | % | 11 | - | 0.00 | % | - | ||||||||||||||||
Federal
Home Loan Bank borrowing
|
65,000 | 0.62 | % | 101 | 68,956 | 0.83 | % | 143 | ||||||||||||||||
Junior
subordinated debentures
|
12,100 | 0.86 | % | 26 | 13,403 | 4.49 | % | 150 | ||||||||||||||||
Total
borrowed funds
|
77,929 | 0.71 | % | 138 | 82,468 | 1.43 | % | 293 | ||||||||||||||||
Total
interest bearing liabilities
|
686,601 | 1.19 | % | 2,036 | 599,834 | 1.62 | % | 2,427 | ||||||||||||||||
Non
interest bearing demand
|
179,648 | 163,994 | ||||||||||||||||||||||
Total
funding
|
866,249 | 0.94 | % | 2,036 | 763,828 | 1.27 | % | 2,427 | ||||||||||||||||
Other
liabilities
|
8,506 | 9,372 | ||||||||||||||||||||||
Total
liabilities
|
$ | 874,755 | $ | 773,200 | ||||||||||||||||||||
Stockholders'
Equity:
|
||||||||||||||||||||||||
Preferred
stock
|
$ | 63,672 | $ | 19,197 | ||||||||||||||||||||
Common
stock
|
58,004 | 48,674 | ||||||||||||||||||||||
Additional
paid in capital
|
4,132 | 3,032 | ||||||||||||||||||||||
Retained
earnings
|
9,219 | 23,543 | ||||||||||||||||||||||
Valuation
allowance investments
|
(167 | ) | (1,959 | ) | ||||||||||||||||||||
Total
stockholders' equity
|
134,860 | 92,487 | ||||||||||||||||||||||
Total
liabilities and stockholders' equity
|
$ | 1,009,615 | $ | 865,687 | ||||||||||||||||||||
Net
interest income
|
$ | 11,140 | $ | 9,842 | ||||||||||||||||||||
Net
interest margin (3)
|
4.69 | % | 4.91 | % |
(1)
|
Nonaccrual
loans have been included in total
loans.
|
(2)
|
Loan
fees of $158 and $225 for the three months ending June 30, 2010 and 2009,
respectively have been included in interest income
computation.
|
(3)
|
Net
interest margin has been calculated by dividing the net interest income by
total average earning assets.
|
(4)
|
Yield
/ Rate is annualized using actual number of days in
period.
|
|
Heritage
Oaks Bancorp | - 43 -
|
Management’s Discussion and
Analysis
|
For the six months ending
|
For the six months ending
|
|||||||||||||||||||||||
June 30, 2010
|
June 30, 2009
|
|||||||||||||||||||||||
Yield/
|
Income/
|
Yield/
|
Income/
|
|||||||||||||||||||||
(dollars in thousands)
|
Balance
|
Rate (4)
|
Expense
|
Balance
|
Rate (4)
|
Expense
|
||||||||||||||||||
Interest
Earning Assets:
|
||||||||||||||||||||||||
Investments
with other banks
|
$ | 119 | 1.69 | % | $ | 1 | $ | 119 | 3.39 | % | $ | 2 | ||||||||||||
Interest
bearing due from banks
|
45,541 | 0.23 | % | 52 | - | 0.00 | % | - | ||||||||||||||||
Federal
funds sold
|
3,344 | 0.12 | % | 2 | 16,852 | 0.20 | % | 17 | ||||||||||||||||
Investment
securities taxable
|
130,496 | 3.80 | % | 2,457 | 51,507 | 4.66 | % | 1,189 | ||||||||||||||||
Investment
securities non taxable
|
24,579 | 4.46 | % | 544 | 18,293 | 4.34 | % | 394 | ||||||||||||||||
Loans
(1) (2)
|
728,001 | 6.25 | % | 22,570 | 700,804 | 6.49 | % | 22,563 | ||||||||||||||||
Total
interest earning assets
|
932,080 | 5.54 | % | 25,626 | 787,575 | 6.19 | % | 24,165 | ||||||||||||||||
Allowance
for possible loan losses
|
(19,624 | ) | (10,370 | ) | ||||||||||||||||||||
Other
assets
|
75,039 | 69,431 | ||||||||||||||||||||||
Total
assets
|
$ | 987,495 | $ | 846,636 | ||||||||||||||||||||
Interest
Bearing Liabilities:
|
||||||||||||||||||||||||
Interest
bearing demand
|
$ | 76,089 | 0.72 | % | $ | 270 | $ | 62,845 | 0.61 | % | $ | 189 | ||||||||||||
Savings
|
27,637 | 0.31 | % | 43 | 22,949 | 0.18 | % | 20 | ||||||||||||||||
Money
market
|
272,158 | 1.16 | % | 1,567 | 175,378 | 1.51 | % | 1,316 | ||||||||||||||||
Time
deposits
|
229,947 | 1.97 | % | 2,242 | 164,228 | 2.60 | % | 2,116 | ||||||||||||||||
Brokered
money market funds
|
1,000 | 0.81 | % | 4 | 36,854 | 0.72 | % | 131 | ||||||||||||||||
Brokered
time deposits
|
3,791 | 2.29 | % | 43 | 33,169 | 1.74 | % | 287 | ||||||||||||||||
Total
interest bearing deposits
|
610,622 | 1.38 | % | 4,169 | 495,423 | 1.65 | % | 4,059 | ||||||||||||||||
Federal
funds purchased
|
- | 0.00 | % | - | 378 | 1.07 | % | 2 | ||||||||||||||||
Securities
sold under agreement to repurchase
|
- | 0.00 | % | - | 1,312 | 0.31 | % | 2 | ||||||||||||||||
Other
secured borrowing
|
897 | 4.95 | % | 22 | - | 0.00 | % | - | ||||||||||||||||
Federal
Home Loan Bank borrowing
|
65,000 | 0.60 | % | 193 | 89,105 | 0.88 | % | 388 | ||||||||||||||||
Junior
subordinated debentures
|
12,748 | 2.45 | % | 155 | 13,403 | 4.59 | % | 305 | ||||||||||||||||
Total
borrowed funds
|
78,645 | 0.95 | % | 370 | 104,198 | 1.35 | % | 697 | ||||||||||||||||
Total
interest bearing liabilities
|
689,267 | 1.33 | % | 4,539 | 599,621 | 1.60 | % | 4,756 | ||||||||||||||||
Non
interest bearing demand
|
174,428 | 154,971 | ||||||||||||||||||||||
Total
funding
|
863,695 | 1.06 | % | 4,539 | 754,592 | 1.27 | % | 4,756 | ||||||||||||||||
Other
liabilities
|
8,586 | 8,733 | ||||||||||||||||||||||
Total
liabilities
|
$ | 872,281 | $ | 763,325 | ||||||||||||||||||||
Stockholders'
Equity:
|
||||||||||||||||||||||||
Preferred
stock
|
$ | 47,494 | $ | 10,921 | ||||||||||||||||||||
Common
stock
|
53,405 | 48,661 | ||||||||||||||||||||||
Additional
paid in capital
|
3,709 | 2,190 | ||||||||||||||||||||||
Retained
earnings
|
10,918 | 23,162 | ||||||||||||||||||||||
Valuation
allowance investments
|
(312 | ) | (1,623 | ) | ||||||||||||||||||||
Total
stockholders' equity
|
115,214 | 83,311 | ||||||||||||||||||||||
Total
liabilities and stockholders' equity
|
$ | 987,495 | $ | 846,636 | ||||||||||||||||||||
Net
interest income
|
$ | 21,087 | $ | 19,409 | ||||||||||||||||||||
Net
interest margin (3)
|
4.56 | % | 4.97 | % |
(1)
|
Nonaccrual
loans have been included in total
loans.
|
(2)
|
Loan
fees of $358 and $483 for the six months ending June 30, 2010 and 2009,
respectively have been included in interest income
computation.
|
(3)
|
Net
interest margin has been calculated by dividing the net interest income by
total average earning assets.
|
(4)
|
Yield
/ Rate is annualized using actual number of days in
period.
|
|
Heritage
Oaks Bancorp | - 44 -
|
Management’s Discussion and
Analysis
|
The
tables below set forth changes in average interest earning assets and their
respective yields for the three and six month periods ending June 30, 2010
compared to that reported during the same periods ended in 2009:
Average Balance
|
Average Yield
|
|||||||||||||||||||||||||||
for the three months ending
|
for the three months ending
|
|||||||||||||||||||||||||||
June 30,
|
Variance
|
June 30,
|
||||||||||||||||||||||||||
(dollars
in thousands)
|
2010
|
2009
|
dollar
|
percentage
|
2010
|
2009
|
Variance
|
|||||||||||||||||||||
Investments
with other banks
|
$ | 119 | $ | 119 | $ | - | 0.00 | % | 3.37 | % | 3.37 | % | 0.00 | % | ||||||||||||||
Interest
bearing due from banks
|
42,234 | - | 42,234 | 100.00 | % | 0.23 | % | 0.00 | % | 0.23 | % | |||||||||||||||||
Federal
funds sold
|
4,203 | 20,816 | (16,613 | ) | -79.81 | % | 0.10 | % | 0.19 | % | -0.09 | % | ||||||||||||||||
Investment
securities taxable
|
157,181 | 57,746 | 99,435 | 172.19 | % | 3.66 | % | 4.40 | % | -0.74 | % | |||||||||||||||||
Investment
securities non taxable
|
26,181 | 19,412 | 6,769 | 34.87 | % | 4.40 | % | 4.30 | % | 0.10 | % | |||||||||||||||||
Loans
(1) (2)
|
723,800 | 705,779 | 18,021 | 2.55 | % | 6.33 | % | 6.49 | % | -0.16 | % | |||||||||||||||||
Total
interest earning assets
|
$ | 953,718 | $ | 803,872 | $ | 149,846 | 18.64 | % | 5.54 | % | 6.12 | % | -0.58 | % |
(1)
|
Nonaccrual
loans have been included in total
loans.
|
(2)
|
Loan
fees of $158 and $225 for the three months ending June 30, 2010 and 2009,
respectively have been included in the interest income
computation.
|
Average Balance
|
Average Yield
|
|||||||||||||||||||||||||||
for the six months ending
|
for the six months ending
|
|||||||||||||||||||||||||||
June 30,
|
Variance
|
June 30,
|
||||||||||||||||||||||||||
(dollars
in thousands)
|
2010
|
2009
|
dollar
|
percentage
|
2010
|
2009
|
Variance
|
|||||||||||||||||||||
Investments
with other banks
|
$ | 119 | $ | 119 | $ | - | 0.00 | % | 1.69 | % | 3.39 | % | -1.70 | % | ||||||||||||||
Interest
bearing due from banks
|
45,541 | - | 45,541 | 100.00 | % | 0.23 | % | 0.00 | % | 0.23 | % | |||||||||||||||||
Federal
funds sold
|
3,344 | 16,852 | (13,508 | ) | -80.16 | % | 0.12 | % | 0.20 | % | -0.08 | % | ||||||||||||||||
Investment
securities taxable
|
130,496 | 51,507 | 78,989 | 153.36 | % | 3.80 | % | 4.66 | % | -0.86 | % | |||||||||||||||||
Investment
securities non taxable
|
24,579 | 18,293 | 6,286 | 34.36 | % | 4.46 | % | 4.34 | % | 0.12 | % | |||||||||||||||||
Loans
(1) (2)
|
728,001 | 700,804 | 27,197 | 3.88 | % | 6.25 | % | 6.49 | % | -0.24 | % | |||||||||||||||||
Total
interest earning assets
|
$ | 932,080 | $ | 787,575 | $ | 144,505 | 18.35 | % | 5.54 | % | 6.19 | % | -0.65 | % |
(1)
|
Nonaccrual
loans have been included in total
loans.
|
(2)
|
Loan
fees of $358 and $483 for the six months ending June 30, 2010 and 2009,
respectively have been included in the interest income
computation.
|
At June
30, 2010, average interest earning assets were approximately $149.8 million and
$144.5 million higher than that reported over the same three and six month
periods ended a year earlier. Organic loan growth, higher interest
bearing due from balances and investment securities are the primary factors
behind the increase. The significant increase in interest bearing due
from balances as well as investment securities is primarily the result of a
$91.8 million year over year increase in deposit balances in addition to
approximately $60.0 million in gross proceeds the Company raised in its March
2010 private placement. The yield on earning assets for the three and
six months ended June 30, 2010 was 5.54% compared to 6.12% and 6.19% for the
same periods ended a year earlier. The year over year decline in the
yield on earning assets can be attributed to several factors including the
impact of interest reversals and foregone interest on non-accruing loans as well
as a significant increase in the level of lower yielding short term investment
balances.
For the
three and six months ended June 30, 2010 the yield on the loan portfolio was
6.33% and 6.25% or 16 and 24 basis points lower than that reported for the same
periods ended a year earlier. Impacting the yield on the loan
portfolio were approximately $0.2 million and $0.4 million in interest reversals
related to additional loans the Bank placed on non-accrual during the second
quarter and the first six months of 2010, respectively. These
reversals negatively impacted the yield on the portfolio by approximately 8 and
10 basis points and the yield on earnings assets by approximately 6 and 8 basis
points for the three and six months ended June 30, 2010 when compared to that
reported for the same periods ended in 2009. For the three and six
months ended June 30, 2010 total foregone interest related to non-accruing loan
balances totaled approximately $1.0 million and $1.6 million, respectively and
negatively impacted the yield on the portfolio by approximately 56 and 44 basis
points and the yield on earning assets by approximately 42 and 34 basis points,
respectively.
Throughout
the last twelve months the Bank has sought to maintain considerable levels of
on-balance sheet liquidity through its continued focus on core deposit gathering
while operating in a challenging economic environment. While the
Bank’s liquidity position was enhanced markedly over the last twelve months as a
result of this initiative, it has placed some pressure on earning asset yields
as a significant portion of these funds have been invested overnight in the form
of interest bearing balances due from the Federal Reserve and federal funds
sold. These investments yield considerably less than what the Bank
might otherwise earn if those funds were invested in loans. Although
average loan balances increased approximately $18.0 million and $27.2 million
year over year for the three and six month periods ended June 30, 2010, the
level of deposit growth has significantly outpaced the level of new loan
originations. New loan originations have slowed due in part to a
decline in loan demand and fewer loans that meet the Bank’s underwriting
criteria in the current economic environment. As a result, in an
effort to maximize the yield on interest earning assets in the absence of
significant new loan originations, the Bank has been making selective purchases
of relatively short term, agency-backed, cash flow generating, mortgage
securities over the last twelve months. These purchases account for
the majority of the year over year increase in the average balance of the
investment portfolio and the decline in the overall yield of taxable investment
securities as they currently yield considerably less than other investments in
the portfolio. These relatively short term investments have allowed
the Bank to maximize yields on excess liquidity while ensuring adequate cash
flow to support potential loan growth in future periods.
|
Heritage
Oaks Bancorp | - 45 -
|
Management’s Discussion and
Analysis
|
The
tables below set forth changes in average interest bearing liabilities and their
respective rates for the three and six month periods ending June 30, 2010
compared to that reported during the same periods ended in 2009:
Average Balance
|
Average Rate
|
|||||||||||||||||||||||||||
for the three months ending
|
for the three months ending
|
|||||||||||||||||||||||||||
June 30,
|
Variance
|
June 30,
|
||||||||||||||||||||||||||
(dollars in thousands)
|
2010
|
2009
|
dollar
|
percentage
|
2010
|
2009
|
Variance
|
|||||||||||||||||||||
Interest
bearing demand
|
$ | 72,013 | $ | 61,084 | $ | 10,929 | 17.89 | % | 0.31 | % | 0.69 | % | -0.38 | % | ||||||||||||||
Savings
|
27,231 | 23,819 | 3,412 | 14.32 | % | 0.38 | % | 0.19 | % | 0.19 | % | |||||||||||||||||
Money
market
|
275,395 | 177,585 | 97,810 | 55.08 | % | 1.05 | % | 1.48 | % | -0.43 | % | |||||||||||||||||
Time
deposits
|
232,490 | 185,078 | 47,412 | 25.62 | % | 1.89 | % | 2.52 | % | -0.63 | % | |||||||||||||||||
Brokered
money market funds
|
1,000 | 32,893 | (31,893 | ) | -96.96 | % | 0.80 | % | 0.82 | % | -0.02 | % | ||||||||||||||||
Brokered
time deposits
|
543 | 36,907 | (36,364 | ) | -98.53 | % | 0.74 | % | 1.46 | % | -0.72 | % | ||||||||||||||||
Federal
funds purchased
|
- | 109 | (109 | ) | -100.00 | % | 0.00 | % | 1.10 | % | -1.10 | % | ||||||||||||||||
Other
secured borrowing
|
829 | - | 829 | 100.00 | % | 5.32 | % | 0.00 | % | 5.32 | % | |||||||||||||||||
Federal
Home Loan Bank borrowing
|
65,000 | 68,956 | (3,956 | ) | -5.74 | % | 0.62 | % | 0.83 | % | -0.21 | % | ||||||||||||||||
Junior
subordinated debentures
|
12,100 | 13,403 | (1,303 | ) | -9.72 | % | 0.86 | % | 4.49 | % | -3.63 | % | ||||||||||||||||
Total
interest bearing liabilities
|
$ | 686,601 | $ | 599,834 | $ | 86,767 | 14.47 | % | 1.19 | % | 1.62 | % | -0.43 | % |
Average Balance
|
Average Rate
|
|||||||||||||||||||||||||||
for the six months ending
|
for the six months ending
|
|||||||||||||||||||||||||||
June 30,
|
Variance
|
June 30,
|
||||||||||||||||||||||||||
(dollars in thousands)
|
2010
|
2009
|
dollar
|
percentage
|
2010
|
2009
|
Variance
|
|||||||||||||||||||||
Interest
bearing demand
|
$ | 76,089 | $ | 62,845 | $ | 13,244 | 21.07 | % | 0.72 | % | 0.61 | % | 0.11 | % | ||||||||||||||
Savings
|
27,637 | 22,949 | 4,688 | 20.43 | % | 0.31 | % | 0.18 | % | 0.13 | % | |||||||||||||||||
Money
market
|
272,158 | 175,378 | 96,780 | 55.18 | % | 1.16 | % | 1.51 | % | -0.35 | % | |||||||||||||||||
Time
deposits
|
229,947 | 164,228 | 65,719 | 40.02 | % | 1.97 | % | 2.60 | % | -0.63 | % | |||||||||||||||||
Brokered
money market funds
|
1,000 | 36,854 | (35,854 | ) | -97.29 | % | 0.81 | % | 0.72 | % | 0.09 | % | ||||||||||||||||
Brokered
time deposits
|
3,791 | 33,169 | (29,378 | ) | -88.57 | % | 2.29 | % | 1.74 | % | 0.55 | % | ||||||||||||||||
Federal
funds purchased
|
- | 378 | (378 | ) | -100.00 | % | 0.00 | % | 1.07 | % | -1.07 | % | ||||||||||||||||
Securities
sold under repurchase agreements
|
- | 1,312 | (1,312 | ) | -100.00 | % | 0.00 | % | 0.31 | % | -0.31 | % | ||||||||||||||||
Other
secured borrowing
|
897 | - | - | 100.00 | % | 4.95 | % | 0.00 | % | 4.95 | % | |||||||||||||||||
Federal
Home Loan Bank borrowing
|
65,000 | 89,105 | (24,105 | ) | -27.05 | % | 0.60 | % | 0.88 | % | -0.28 | % | ||||||||||||||||
Junior
subordinated debentures
|
12,748 | 13,403 | (655 | ) | -4.89 | % | 2.45 | % | 4.59 | % | -2.14 | % | ||||||||||||||||
Total
interest bearing liabilities
|
$ | 689,267 | $ | 599,621 | $ | 89,646 | 14.95 | % | 1.33 | % | 1.60 | % | -0.27 | % |
At June
30, 2010, the average balance of interest bearing liabilities was approximately
$86.8 million and $89.6 million higher than that reported over the same three
and six month periods ended a year earlier. Year over year increases
in the average balance of interest bearing liabilities can be attributed in
large part to higher money market, time deposits as well as interest bearing
demand. The Bank attributes strong year over year deposit growth
within these categories to several factors including promotional efforts to
attract and retain core deposits. This initiative allowed the Bank to
pay-down FHLB borrowings and approximately $68.3 million and $65.2 million in
average brokered deposits for the three and six month periods ended June 30,
2010, respectively, relying less on alternative funding sources.
The
significant increases in floating rate deposit balances over the last year and
the ability to re-price those funds as needed, as well as year over year
increases in non-interest bearing demand deposits assisted the Bank in keeping
its overall cost of funding down and mitigating the decline in the net interest
margin. At June 30, 2010 approximately $408.5 million or 59.5% of the
Company’s interest bearing liabilities possess a floating rate.
|
Heritage
Oaks Bancorp | - 46 -
|
Management’s Discussion and
Analysis
|
For the
three and six months ended June 30, 2010 the average rate paid on interest
bearing liabilities was 1.19% and 1.33%, respectively, down 43 and 27 basis
points from that reported for the same periods ended a year
earlier. The year over year decline can be attributed in part to
increases in lower cost core deposit balances, the absence of higher cost
brokered time deposits and the re-pricing of money market and time
deposits.
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 three and six month periods ended June 30,
2010 over the same periods ended in 2009, and the amount of such change
attributable to changes in average balances (volume) or changes in average
yields and rates:
For the three months ended
|
For the six months ended
|
|||||||||||||||||||||||
June 30, 2010 over 2009
|
June 30, 2010 over 2009
|
|||||||||||||||||||||||
(dollars in thousands)
|
Volume
|
Rate
|
Total
|
Volume
|
Rate
|
Total
|
||||||||||||||||||
Interest Income:
|
||||||||||||||||||||||||
Investments
with other banks
|
$ | - | $ | - | $ | - | $ | - | $ | (1 | ) | $ | (1 | ) | ||||||||||
Interest
bearing due from Federal Reserve
|
24 | - | 24 | 52 | - | 52 | ||||||||||||||||||
Federal
funds sold
|
(6 | ) | (3 | ) | (9 | ) | (10 | ) | (5 | ) | (15 | ) | ||||||||||||
Investment
securities taxable
|
924 | (124 | ) | 800 | 1,523 | (255 | ) | 1,268 | ||||||||||||||||
Investment
securities non-taxable (2)
|
112 | - | 112 | 210 | - | 210 | ||||||||||||||||||
Taxable
equivalent adjustment (2)
|
(38 | ) | 5 | (33 | ) | (71 | ) | 11 | (60 | ) | ||||||||||||||
Loans
(1)
|
288 | (275 | ) | 13 | 859 | (852 | ) | 7 | ||||||||||||||||
Net
increase / (decrease)
|
1,304 | (397 | ) | 907 | 2,563 | (1,102 | ) | 1,461 | ||||||||||||||||
Interest
expense
|
||||||||||||||||||||||||
Savings,
NOW, money market
|
274 | (246 | ) | 28 | 598 | (243 | ) | 355 | ||||||||||||||||
Time
deposits
|
259 | (325 | ) | (66 | ) | 719 | (593 | ) | 126 | |||||||||||||||
Brokered
funds
|
(149 | ) | (49 | ) | (198 | ) | (537 | ) | 166 | (371 | ) | |||||||||||||
Federal
funds purchased
|
- | - | - | (1 | ) | (1 | ) | (2 | ) | |||||||||||||||
Other
secured borrowings
|
11 | - | 11 | 22 | - | 22 | ||||||||||||||||||
Securities
sold under agreement to repurchase
|
- | - | - | (1 | ) | (1 | ) | (2 | ) | |||||||||||||||
Federal
Home Loan Bank borrowing
|
(8 | ) | (34 | ) | (42 | ) | (90 | ) | (105 | ) | (195 | ) | ||||||||||||
Long
term debt
|
(14 | ) | (110 | ) | (124 | ) | (14 | ) | (136 | ) | (150 | ) | ||||||||||||
Net
increase / (decrease)
|
373 | (764 | ) | (391 | ) | 696 | (913 | ) | (217 | ) | ||||||||||||||
Total
net increase / (decrease)
|
$ | 931 | $ | 367 | $ | 1,298 | $ | 1,867 | $ | (189 | ) | $ | 1,678 |
(1)
|
Includes
loan fees of $158 and $225 for the three months ending June 30, 2010 and
2009 and $358 and $483 for the six months ending June 30, 2010 and 2009,
respectively.
|
(2)
|
Adjusted
to a fully taxable equivalent basis using a tax rate of
34%.
|
Non-Interest
Income
The
tables below set forth changes in non-interest income for the three and six
month periods ended June 30, 2010 compared to the same periods ended in
2009:
For the three months ended
|
||||||||||||||||
June 30,
|
Variance
|
|||||||||||||||
(dollars in thousands)
|
2010
|
2009
|
dollar
|
percentage
|
||||||||||||
Service
charges on deposit accounts
|
$ | 614 | $ | 752 | $ | (138 | ) | -18.4 | % | |||||||
ATM/Debit
and credit card transaction/interchange fees
|
323 | 254 | 69 | 27.2 | % | |||||||||||
Bancard
|
48 | 55 | (7 | ) | -12.7 | % | ||||||||||
Mortgage
origination fees
|
461 | 336 | 125 | 37.2 | % | |||||||||||
Earnings
on bank owned life insurance
|
143 | 124 | 19 | 15.3 | % | |||||||||||
Other
commissions and fees
|
92 | 83 | 9 | 10.8 | % | |||||||||||
Gain
on extinguishment of debt
|
1,700 | - | 1,700 | 100.0 | % | |||||||||||
Loss
on sale of investment securities
|
(97 | ) | - | (97 | ) | -100.0 | % | |||||||||
Gain
/ (loss) on sale of OREO
|
62 | (104 | ) | 166 | 159.6 | % | ||||||||||
Gain
on sale of furniture fixtures and equipment
|
58 | - | 58 | 100.0 | % | |||||||||||
Gain on sale of SBA loans
|
209 | - | 209 | 100.0 | % | |||||||||||
Total non-interest income
|
$ | 3,613 | $ | 1,500 | $ | 2,113 | 140.9 | % |
|
Heritage
Oaks Bancorp | - 47 -
|
Management’s Discussion and
Analysis
|
For the six months ended
|
||||||||||||||||
June 30,
|
Variance
|
|||||||||||||||
(dollars in thousands)
|
2010
|
2009
|
dollar
|
percentage
|
||||||||||||
Service
charges on deposit accounts
|
$ | 1,239 | $ | 1,464 | $ | (225 | ) | -15.4 | % | |||||||
ATM/Debit
and credit card transaction/interchange fees
|
582 | 470 | 112 | 23.8 | % | |||||||||||
Bancard
|
84 | 92 | (8 | ) | -8.7 | % | ||||||||||
Mortgage
origination fees
|
801 | 665 | 136 | 20.5 | % | |||||||||||
Earnings
on bank owned life insurance
|
294 | 246 | 48 | 19.5 | % | |||||||||||
Other
commissions and fees
|
267 | 232 | 35 | 15.1 | % | |||||||||||
Gain
on extinguishment of debt
|
1,700 | - | 1,700 | 100.0 | % | |||||||||||
(Loss)
/ gain on sale of investment securities
|
(97 | ) | 122 | (219 | ) | -179.5 | % | |||||||||
Gain
/ (loss) on sale of OREO
|
62 | (131 | ) | 193 | 147.3 | % | ||||||||||
Gain
on sale of furniture fixtures and equipment
|
58 | - | 58 | 100.0 | % | |||||||||||
Gain
on sale of SBA loans
|
209 | - | 209 | 100.0 | % | |||||||||||
Total
non-interest income
|
$ | 5,199 | $ | 3,160 | $ | 2,039 | 64.5 | % |
Non-interest
income totaled approximately $3.6 million and $5.2 million for the three and six
month periods ended June 30, 2010, representing an increase of approximately
$2.1 million and $2.0 million, respectively when compared to the same periods
ended a year earlier. The primary driver behind the quarterly and
year over year increase can be attributed to a $1.7 million gain the Company
recognized from the extinguishment of $5.0 million in junior subordinated
debentures associated with Heritage Oaks Capital Trust III during the second
quarter of 2010 at a price of 66% of the face amount of the debentures.
Excluding the impact of the gain from the extinguishment of debt, non-interest
income increased approximately $0.4 million and $0.3 million for the three and
six month periods ended June 30, 2010. Increases in debit card
interchange income as well as higher mortgage origination fees in conjunction
with gains the Bank recognized on the sale of OREO properties, certain fixed
assets and SBA loans helped to offset declines in service charge income as well
as losses the Bank recognized on the sale of investment securities.
The
Company attributes the decline in service charge income to better cash
management practices of business clients in the current economic
environment. Higher transaction/interchange income is attributable to
greater focus on debit card usage in conjunction with additional core
relationships the Bank obtained over the last twelve months. The Bank
also saw an increase in earnings on bank owned life insurance which can be
attributed to additional policies the Bank purchased in the second half of 2009
for certain executive officers.
Mortgage
origination fees increased considerably during the second quarter and first six
months of 2010 from that reported a year earlier. This can be
attributed to a reduction in origination expenses the Bank realized during the
first six months of 2010.
The
tables below illustrate the change in the number and total dollar volume of
mortgage loans originated during the three and six months ended June 30, 2010
when compared to the same periods ended in 2009:
For the three months ended June 30,
|
||||||||||||
(dollars in thousands)
|
2010
|
2009
|
Variance
|
|||||||||
Dollar
volume
|
$ | 38,829 | $ | 46,622 | -16.7 | % | ||||||
Number
of loans
|
110 | 149 | -26.2 | % | ||||||||
For the six months ended June 30,
|
||||||||||||
(dollars in thousands)
|
2010
|
2009
|
Variance
|
|||||||||
Dollar
volume
|
$ | 68,515 | $ | 88,687 | -22.7 | % | ||||||
Number
of loans
|
199 | 278 | -28.4 | % |
|
Heritage
Oaks Bancorp | - 48 -
|
Management’s
Discussion and Analysis
|
Non-Interest
Expenses
The
tables below set forth changes in non-interest expenses for the three and six
month periods ended June 30, 2010 compared to the same periods ended in
2009:
For the three months ended
|
||||||||||||||||
June 30,
|
Variance
|
|||||||||||||||
(dollars in thousands)
|
2010
|
2009
|
dollar
|
percentage
|
||||||||||||
Salaries
and employee benefits
|
$ | 4,351 | $ | 3,745 | $ | 606 | 16.2 | % | ||||||||
Occupancy
|
941 | 826 | 115 | 13.9 | % | |||||||||||
Equipment
|
370 | 376 | (6 | ) | -1.6 | % | ||||||||||
Promotional
|
173 | 225 | (52 | ) | -23.1 | % | ||||||||||
Data
processing
|
680 | 691 | (11 | ) | -1.6 | % | ||||||||||
Stationery
and supplies
|
107 | 99 | 8 | 8.1 | % | |||||||||||
Regulatory
fees
|
690 | 537 | 153 | 28.5 | % | |||||||||||
Audit
and tax costs
|
142 | 147 | (5 | ) | -3.4 | % | ||||||||||
Amortization
of core deposit intangible
|
128 | 262 | (134 | ) | -51.1 | % | ||||||||||
Director
fees
|
128 | 80 | 48 | 60.0 | % | |||||||||||
Communications
|
79 | 61 | 18 | 29.5 | % | |||||||||||
Loan
department
|
308 | 290 | 18 | 6.2 | % | |||||||||||
Other
|
731 | 675 | 56 | 8.3 | % | |||||||||||
Total
non interest expense
|
$ | 8,828 | $ | 8,014 | $ | 814 | 10.2 | % |
For the six months ended
|
||||||||||||||||
June 30,
|
Variance
|
|||||||||||||||
(dollars in thousands)
|
2010
|
2009
|
dollar
|
percentage
|
||||||||||||
Salaries
and employee benefits
|
$ | 8,729 | $ | 7,548 | $ | 1,181 | 15.6 | % | ||||||||
Occupancy
|
1,874 | 1,678 | 196 | 11.7 | % | |||||||||||
Equipment
|
698 | 701 | (3 | ) | -0.4 | % | ||||||||||
Promotional
|
352 | 326 | 26 | 8.0 | % | |||||||||||
Data
processing
|
1,335 | 1,361 | (26 | ) | -1.9 | % | ||||||||||
Stationery
and supplies
|
229 | 203 | 26 | 12.8 | % | |||||||||||
Regulatory
fees
|
1,302 | 680 | 622 | 91.5 | % | |||||||||||
Audit
and tax costs
|
285 | 295 | (10 | ) | -3.4 | % | ||||||||||
Amortization
of core deposit intangible
|
257 | 525 | (268 | ) | -51.0 | % | ||||||||||
Director
fees
|
256 | 163 | 93 | 57.1 | % | |||||||||||
Communications
|
161 | 123 | 38 | 30.9 | % | |||||||||||
Loan
department
|
732 | 512 | 220 | 43.0 | % | |||||||||||
Other
|
1,484 | 1,324 | 160 | 12.1 | % | |||||||||||
Total
non interest expense
|
$ | 17,694 | $ | 15,439 | $ | 2,255 | 14.6 | % |
Salary
and Employee Benefits
Salaries
and employee related expenses increased approximately $0.6 million and $1.2
million during the three and six months ended June 30, 2010 when compared to
that reported in the same periods ended a year earlier. The expansion
of the Bank’s management team in conjunction with additions to the Bank’s
special assets department contributed to the year over year increase within this
category.
Occupancy
Expenses
Year over
year increases within this category are primarily attributable to annual
increases in rental expense as well as the absence of sublease rental income
associated with the relocation of one branch office.
Promotion
Expenses
Promotional
expenses declined slightly in the second quarter of 2010 from that reported in
the same period a year ago. The decline in the second quarter can be
attributed in part to Management’s efforts to contain costs within certain areas
of the Bank. Promotional costs increased slightly during the first six months of
2010, primarily the result of increased costs incurred during the first quarter
associated with promotional efforts designed to attract and retain core deposit
balances.
Heritage
Oaks Bancorp | - 49
-
|
Management’s
Discussion and Analysis
|
Regulatory
Fees
For the
three and six months ended June 30, 2010, regulatory fees totaled approximately
$0.7 million and $1.3 million, respectively. This represents
respective increases of approximately $0.2 million and $0.6 million over that
reported for the same three and six month periods ended in 2009. Increases
within this category can be attributed in large part to higher FDIC insurance
costs, primarily due to a change in the Bank’s risk ratings. The Bank
currently anticipates regulatory assessment costs to remain elevated throughout
2010.
Core
Deposit Intangible (“CDI”) Amortization
Upon the
acquisition of Business First, the Company booked a CDI in the approximate
amount of $3.8 million. The balance of this intangible is being
amortized over a six year period pursuant to a schedule provided in the initial
valuation process. For the three and six months ended June 30, 2010
CDI amortization was approximately $0.1 million and $0.3 million lower than that
reported for the same periods ended in 2009. Substantially all of the
year over year variance can be attributed to scheduled CDI amortization
associated with the Business First acquisition.
Loan
Department Costs
For the
three and six months ended June 30, 2010, loan department costs increased
approximately $18 thousand and $220 thousand from that reported in the same
periods ended a year earlier. The increase within this category
during the first six months of 2010 can be attributed in large part to a $0.1
million increase in write-downs on OREO as well as an increase in legal fees and
other costs associated with managing substandard and non-performing assets
during the first quarter of 2010.
Provision
for Income Taxes
For the
three and six month periods ended June 30, 2010 the Company recorded an income
tax benefit of approximately $4.3 million and $5.5 million,
respectively. This compares to the $0.1 million and $0.7 million in
income tax expense the Company recorded for the same periods ended in
2009. The year over year decline within this category can be
attributed in large part to substantial increases in provisions for loan losses
during 2010. Income tax benefits for the three and six month periods
ended June 30, 2010 were 42.7% and 43.5% of the Company’s pre-tax
loss. The effective tax rate for the same periods ended a year
earlier was 19.3% and 30.6%, respectively. The primary reason behind
the increase in the Company’s effective tax rate can be attributed in large part
to significant permanent differences such as non-taxable income on holdings of
municipal securities and bank owned life insurance comprising a smaller portion
of the Company’s pre-tax loss for the three and six months ended June 30, 2010
when compared to the same periods ended a year earlier. For the
second quarter and the first six months of 2010, net tax exempt income on
municipal securities and bank owned life insurance totaled approximately $0.4
million and $0.8 million, respectively.
Provision
for Loan Losses
An
allowance for loan losses has been established by Management to provide for
those loans that may not be repaid in their entirety for a variety of
reasons. The allowance is maintained at a level considered by
Management to be adequate to provide for probable incurred
losses. The allowance is increased by provisions charged to earnings
and is reduced by charge-offs, net of recoveries. The provision for
loan losses is based upon Management’s analysis of the adequacy of the allowance
for loan losses, which includes, among other things, an analysis of past loan
loss experience and Management’s evaluation of the loan portfolio under current
economic conditions.
The Bank
recognizes that credit losses will be experienced and the risk of loss will vary
with, among other things: general economic conditions; the type of loan being
made; the creditworthiness of the borrower over the term of the loan and in the
case of a collateralized loan, the quality of the collateral for such
loan. The allowance for loan losses represents the Bank’s best
estimate of the allowance necessary to provide for probable estimable losses in
the portfolio as of the balance sheet date. In making this determination, the
Bank analyzes the ultimate collectability of loans in the portfolio by
incorporating feedback provided by internal loan staff, Management’s findings
from internal loan reviews, findings from an independent semi-annual loan review
function, and information provided by examinations performed by regulatory
agencies. The Bank makes monthly evaluations as to the adequacy of
the allowance for loan losses and makes adjustments to the related provision for
loan losses accordingly.
Heritage
Oaks Bancorp | - 50
-
|
Management’s
Discussion and Analysis
|
The Bank
accounts for problem loans in accordance with accounting guidance provided under
U.S. GAAP. U.S. GAAP provides that when it is probable that a
creditor will be unable to collect all amounts due in accordance with the terms
of the loan that such loan is deemed impaired. Impaired loans are
accounted for differently in that the amount of the impairment is measured and
reflected in the records of the creditor. The allowance for loan
losses related to loans that are identified for evaluation in accordance with
accounting guidance under U.S. GAAP is based on discounted cash flows using the
loan’s historical effective interest rate stipulated in the loan agreement or
the fair value of the collateral for certain collateral dependent
loans. When the Bank determines a loan to be impaired, an analysis is
performed to determine the extent of the impairment and specific reserves may be
established for such loans, which in many cases requires the Bank to make
additional provisions for loan losses in addition to any provisions required
under Management’s monthly analysis of the adequacy of the allowance, exclusive
of the impact that such impaired loans may have on the required balance of the
allowance and the related provision for loan losses.
The
allowance for loan losses is based on estimates, and ultimate losses will vary
from current estimates. These estimates are reviewed monthly by the
Bank’s Directors, Loan Committee and full Board of Directors, and as
adjustments, either positive or negative, become necessary, a corresponding
increase or decrease is made in the provision for loan losses. The
methodology used to determine the adequacy of the allowance for loan losses and
any resulting provision for loan losses for the three and six months ended June
30, 2010 is consistent with prior periods.
The
Bank’s provision for loan losses was $16.1 million in the second quarter of 2010
and approximately $21.3 million for the first six months of
2010. This represents an increase of approximately $13.4 million and
$16.5 million over that reported for the same periods ended a year
earlier. Loan loss provisions increased in part due to continued
weakness in certain qualitative factors such as: economic conditions and the
level of substandard and non-performing loans when compared to historical
periods. Additionally, higher levels of charge-offs when compared to
historical periods have led the Bank to increase the allowance as required by
monthly analyses it conducts in determining its adequacy to cover potential
losses in the loan portfolio.
The Bank
also employs the use of a “watch list” and loan grading system to assist in
monitoring the quality of certain credits in the loan portfolio. As
loans on the watch list and any other loan within the portfolio experience
deterioration, the Bank typically moves to downgrade such loans, resulting in an
increase in the required allowance to cover any potential
losses. During 2009 and into the first six months of 2010, the Bank
further expanded the list of credits it has placed on the watch list in an
effort to add additional oversight and to more closely scrutinize certain groups
of loans that have experienced deterioration as a result of, among other things,
the continued weakened state of local, state and national economic
environments. Management believes the significant economic downturn
witnessed during the last two years has had a considerable impact on the ability
of certain borrowers to satisfy their obligations to the Bank, resulting in
continued watch list expansion, loan downgrades and corresponding increases in
loan loss provisions. At June 30, 2010 the balance of loans the Bank
has graded “substandard” totaled approximately $61.6 million of which
approximately $35.1 million were non-accruing. When compared to the
$75.4 million in substandard balances as December 31, 2009, substandard balances
declined approximately $13.8 million. The decline in substandard
balances can be attributed in part to charge-offs of certain non-accruing loans,
transfers to OREO status as well as credit upgrades following workouts with
various borrowers.
The Bank
also makes estimates as to the impact that certain economic factors will have on
various credits within the portfolio. Negative economic trends
witnessed during 2008 and 2009 have continued in 2010 and contributed
substantially to increases in the required allowance to cover potential losses
in the loan portfolio, resulting in year over year increases in loan loss
provisions.
Charge-offs
during the three and six months ended June 30, 2010 totaled approximately $13.7
million and $15.2 million, respectively. This represents an increase
of approximately $11.6 million and $11.0 million when compared to that reported
for the same periods ended a year earlier. Net charge-offs to average
loans were 1.73% and 1.86% for the three and six month periods ended June 30,
2010, compared to the 0.29% and 0.59% reported for the same periods ended a year
earlier. During 2009 the majority of charge-offs occurred in the
commercial and industrial, agriculture, construction and land segments of the
loan portfolio. The majority of charge-offs in the first six months
of 2010 continued in the categories of commercial and industrial as well as
construction and land. Losses within these segments in conjunction
with the downgrade of certain large credits contributed further to the
additional provisions the Bank made to the allowance for loan losses during the
first six months of 2010. Continued increases in the level of
charge-offs, elevated levels of substandard and non-performing loans in
conjunction with any further significant downturn in economic conditions in
future periods may result in further significant provisions to the allowance for
loan losses.
Looking
forward into the remainder of 2010, Management anticipates there to be continued
weakness in economic conditions on national, state and local levels compared to
historical periods. Many economic forecasts suggest unemployment
levels to remain elevated for some time, which will undoubtedly place continued
pressure on conditions within the Bank’s primary market
area. Continued economic pressures may negatively impact the
financial condition of borrowers to whom the Bank has extended credit and as a
result the Bank may be required to make further significant provisions to the
allowance for loan losses during 2010. That said, Management has and
will continue to be proactive in looking for signs of deterioration within the
loan portfolio in an effort to manage credit quality and work with borrowers
where possible to mitigate any further losses.
Heritage
Oaks Bancorp | - 51
-
|
Management’s
Discussion and Analysis
|
Financial
Condition
At June
30, 2010 total assets were approximately $1.0 billion. This
represents an increase of approximately $65.3 million or 6.9% over that reported
at December 31, 2009. The increase in total assets is primarily
attributable to higher interest bearing due from balances as well as higher
balances in the investments portfolio, resulting from the receipt of
approximately $60.0 million in gross proceeds from the Company’s March 2010
private placement and a $20.4 million year to date increase in total
deposits.
At June
30, 2010, total deposits were approximately $795.8 million or approximately
$20.4 million higher than that reported at December 31, 2009. Net of
a $10.1 million pay-down in brokered funds, total deposits increased
approximately $30.5 million. Deposit growth was across all categories with the
majority of the year to date increase attributable to increases in non-interest
bearing demand, money market balances and time deposits.
Loans
At June
30, 2010 total gross loan balances were $697.2 million. This
represents a decline of approximately $31.5 million or 4.3% from the $728.7
million reported at December 31, 2009. Pay-downs in the commercial
real estate, commercial and industrial and construction and land segments in
conjunction with the work through of certain problem credits contributed to the
year to date decline in loan balances.
The
following table provides a summary of year to date variances in the loan
portfolio as of June 30, 2010:
June 30,
|
December 31,
|
Variance
|
||||||||||||||
(dollars in thousands)
|
2010
|
2009
|
dollar
|
percentage
|
||||||||||||
Real
Estate Secured
|
||||||||||||||||
Multi-family
residential
|
$ | 18,911 | $ | 20,631 | $ | (1,720 | ) | -8.34 | % | |||||||
Residential
1 to 4 family
|
29,476 | 25,483 | 3,993 | 15.67 | % | |||||||||||
Home
equity line of credit
|
30,541 | 29,780 | 761 | 2.56 | % | |||||||||||
Commercial
|
351,598 | 337,940 | 13,658 | 4.04 | % | |||||||||||
Farmland
|
13,032 | 13,079 | (47 | ) | -0.36 | % | ||||||||||
Commercial
|
||||||||||||||||
Commercial
and industrial
|
144,928 | 157,270 | (12,342 | ) | -7.85 | % | ||||||||||
Agriculture
|
16,071 | 17,698 | (1,627 | ) | -9.19 | % | ||||||||||
Other
|
246 | 238 | 8 | 3.36 | % | |||||||||||
Construction
|
||||||||||||||||
Single
family residential
|
9,501 | 15,538 | (6,037 | ) | -38.85 | % | ||||||||||
Single
family residential - Spec.
|
2,750 | 3,400 | (650 | ) | -19.12 | % | ||||||||||
Tract
|
- | 2,215 | (2,215 | ) | -100.00 | % | ||||||||||
Multi-family
|
1,883 | 2,300 | (417 | ) | -18.13 | % | ||||||||||
Hospitality
|
- | 14,306 | (14,306 | ) | -100.00 | % | ||||||||||
Commercial
|
31,398 | 27,128 | 4,270 | 15.74 | % | |||||||||||
Land
|
39,356 | 52,793 | (13,437 | ) | -25.45 | % | ||||||||||
Installment
loans to individuals
|
7,232 | 8,327 | (1,095 | ) | -13.15 | % | ||||||||||
All
other loans (including overdrafts)
|
253 | 553 | (300 | ) | -54.25 | % | ||||||||||
Total
loans, gross
|
697,176 | 728,679 | (31,503 | ) | -4.32 | % | ||||||||||
Deferred
loan fees
|
1,698 | 1,825 | (127 | ) | -6.96 | % | ||||||||||
Reserve
for possible loan losses
|
22,134 | 14,372 | 7,762 | 54.01 | % | |||||||||||
Total
loans, net
|
$ | 673,344 | $ | 712,482 | $ | (39,138 | ) | -5.49 | % | |||||||
Loans
held for sale
|
$ | 9,429 | $ | 9,487 | $ | (58 | ) | -0.61 | % |
Heritage
Oaks Bancorp | - 52
-
|
Management’s
Discussion and Analysis
|
Real
Estate Secured
The
following table provides a break-down of the real estate secured segment of the
Bank’s loan portfolio as of June 30, 2010:
June 30, 2010
|
Percent of
|
Single
|
||||||||||||||||||||||||||
Undisbursed
|
Total Bank
|
Percent
|
Bank's Risk
|
Number
|
Largest
|
|||||||||||||||||||||||
(dollars in thousands)
|
Balance
|
Commitment
|
Exposure
|
Composition
|
Based Capital
|
of Loans
|
Loan
|
|||||||||||||||||||||
Retail
|
$ | 44,249 | $ | 2,308 | $ | 46,557 | 9.9 | % | 36.6 | % | 62 | $ | 5,000 | |||||||||||||||
Professional
|
77,053 | 144 | 77,197 | 16.5 | % | 63.7 | % | 96 | 10,000 | |||||||||||||||||||
Hospitality
|
91,855 | 220 | 92,075 | 19.7 | % | 75.9 | % | 48 | 10,692 | |||||||||||||||||||
Multi-family
|
18,911 | - | 18,911 | 4.0 | % | 15.6 | % | 18 | 4,066 | |||||||||||||||||||
Home
equity lines of credit
|
30,541 | 19,643 | 50,184 | 10.7 | % | 25.2 | % | 321 | 1,680 | |||||||||||||||||||
Residential
1 to 4 family
|
29,476 | 690 | 30,166 | 6.4 | % | 24.4 | % | 76 | 2,893 | |||||||||||||||||||
Farmland
|
13,032 | 502 | 13,534 | 2.9 | % | 10.8 | % | 25 | 1,937 | |||||||||||||||||||
Healthcare
/ medical
|
18,192 | 59 | 18,251 | 3.9 | % | 15.0 | % | 34 | 2,155 | |||||||||||||||||||
Restaurants
/ food establishments
|
7,419 | - | 7,419 | 1.6 | % | 6.1 | % | 14 | 2,541 | |||||||||||||||||||
Commercial
|
98,050 | 715 | 98,765 | 21.2 | % | 81.0 | % | 124 | 5,000 | |||||||||||||||||||
Other
|
14,780 | 247 | 15,027 | 3.2 | % | 12.2 | % | 27 | 2,100 | |||||||||||||||||||
Total
real estate secured
|
$ | 443,558 | $ | 24,528 | $ | 468,086 | 100.0 | % | 366.5 | % | 845 | $ | 48,064 |
As of
June 30, 2010, real estate secured balances represented approximately $443.6
million of total gross loans. This when compared to that reported at
December 31, 2009, represents an increase of approximately $16.6 million or
3.9%. The primary factor behind the year to date increase can be
attributed to the completion of several large hospitality construction projects
and their subsequent re-classification to commercial real estate.
At June
30, 2010, real estate secured balances represented 366.5% of the Bank’s total
risk-based capital, compared to the 524.1% reported at December 31,
2009. Total commitments as a percentage of the Bank’s total
risk-based capital were 386.7% at June 30, 2010, compared to 556.1% reported at
December 31, 2009. The significant decline in these ratios can be
attributed to the additional capital the Company raised in a private placement
during the first six months of 2010 and subsequent down-stream of $48.0 million
to the Bank.
At June
30, 2010, approximately $172.2 million or 38.8% of the real estate secured
segment of the loan portfolio was considered owner occupied.
Capitalization
rates, the rate at which a stream of cash flows are discounted to find their
present value, on commercial properties in our primary market area for the last
three years were as follows: 5.5% to 9.0% in 2009, 4.5% to 8.0% in 2008 and 6.0%
to 7.0% in 2007. An uptick in capitalization rates, as indicated
above, would indicate that we are seeing pressure on commercial real estate
prices within our market, primarily resulting from weakened economic
conditions.
In
September 2004, the Bank issued an $11.7 million irrevocable standby letter of
credit to guarantee the payment of taxable variable rate demand bonds that has
since been reduced to $11.4 million. The primary purpose of the bond
issue was to refinance existing debt and provide funds for capital improvement
and expansion of an assisted living facility. The project is 100%
complete and substantially leased. The letter of credit was renewed
in July 2009 and will expire in September 2010.
Heritage
Oaks Bancorp | - 53
-
|
Management’s
Discussion and Analysis
|
Commercial
The
following table provides a break-down of the commercial and industrial segment
of the Bank’s commercial loan portfolio as of June 30, 2010:
June 30, 2010
|
Percent of
|
Single
|
||||||||||||||||||||||||||
Undisbursed
|
Total Bank
|
Percent
|
Bank's Risk
|
Number
|
Largest
|
|||||||||||||||||||||||
(dollars in thousands)
|
Balance
|
Commitment
|
Exposure
|
Composition
|
Based Capital
|
of Loans
|
Loan
|
|||||||||||||||||||||
Agriculture
|
$ | 2,439 | $ | 3,516 | $ | 5,955 | 2.8 | % | 2.0 | % | 30 | $ | 2,000 | |||||||||||||||
Oil
/ Gas and Utilities
|
1,595 | 600 | 2,195 | 1.0 | % | 1.3 | % | 9 | 1,200 | |||||||||||||||||||
Construction
|
22,559 | 15,751 | 38,310 | 18.2 | % | 18.6 | % | 163 | 5,438 | |||||||||||||||||||
Manufacturing
|
8,407 | 10,464 | 18,871 | 8.9 | % | 6.9 | % | 91 | 1,675 | |||||||||||||||||||
Wholesale
and retail
|
13,517 | 5,909 | 19,426 | 9.2 | % | 11.2 | % | 114 | 1,250 | |||||||||||||||||||
Transportation
and warehousing
|
2,007 | 1,047 | 3,054 | 1.4 | % | 1.7 | % | 33 | 596 | |||||||||||||||||||
Media
& information services
|
7,553 | 1,999 | 9,552 | 4.5 | % | 6.2 | % | 22 | 4,500 | |||||||||||||||||||
Financial
services
|
7,319 | 2,323 | 9,642 | 4.6 | % | 6.0 | % | 43 | 1,500 | |||||||||||||||||||
Real-estate
/ rental and leasing
|
15,762 | 6,792 | 22,554 | 10.7 | % | 13.0 | % | 90 | 3,500 | |||||||||||||||||||
Professional
services
|
17,412 | 7,026 | 24,438 | 11.6 | % | 14.4 | % | 148 | 1,939 | |||||||||||||||||||
Healthcare
/ medical & social services
|
17,993 | 7,249 | 25,242 | 11.9 | % | 14.9 | % | 114 | 11,355 | |||||||||||||||||||
Restaurants
and hospitality
|
23,573 | 2,086 | 25,659 | 12.1 | % | 19.5 | % | 130 | 6,000 | |||||||||||||||||||
All
other
|
4,792 | 1,823 | 6,615 | 3.1 | % | 4.0 | % | 171 | 1,200 | |||||||||||||||||||
Commercial
and industrial
|
$ | 144,928 | $ | 66,585 | $ | 211,513 | 100.0 | % | 119.7 | % | 1,158 | $ | 42,153 |
At June
30, 2010, commercial and industrial loans represented approximately $144.9
million of total gross loan balances. This represents a decline of
approximately $12.3 million or 7.9%. The year to date decline can be
attributed to several large pay-downs of various business lines of
credit as well as charge-offs totaling approximately $8.8 million during the
first six months of 2010.
At June
30, 2010 total commercial and industrial balances represented 119.7% of the
Bank’s total risk-based capital, compared to the 193.1% reported at December 31,
2009. Total commercial and industrial commitments as a percentage of
the Bank’s total risk-based capital was 174.8%, compared to the 288.7% reported
at December 31, 2009. The significant decline in these ratios can be attributed
to the additional capital the Company raised in a private placement during the
first six months of 2010 and subsequent down-stream of $48.0 million to the
Bank.
At June
30, 2010 agriculture balances totaled approximately $16.1 million, which
represents an approximate $1.6 million decline when compared to that reported at
December 31, 2009. The year to date decline within this category can
be attributed in large part to the work-through of one problem loan during the
second quarter of 2010. The Bank received approximately $1.9 million
from the sale of collateral related to this particular loan and subsequently
charge-off the remaining balance of approximately $0.9 million. At
June 30, 2010 agriculture balances represented 13.3% of the Bank’s total
risk-based capital. This compares to 21.7% of the Bank’s total
risk-based capital as of December 31, 2009.
Heritage
Oaks Bancorp | - 54
-
|
Management’s
Discussion and Analysis
|
Construction
The
following table provides a break-down of the construction segment of the Bank’s
loan portfolio as of June 30, 2010:
June 30, 2010
|
Percent of
|
Single
|
||||||||||||||||||||||||||
Undisbursed
|
Total Bank
|
Percent
|
Bank's Risk
|
Number
|
Largest
|
|||||||||||||||||||||||
(dollars in thousands)
|
Balance
|
Commitment
|
Exposure
|
Composition
|
Based Capital
|
of Loans
|
Loan
|
|||||||||||||||||||||
Single
family residential
|
$ | 9,501 | $ | 5,159 | $ | 14,660 | 25.8 | % | 7.8 | % | 22 | $ | 3,325 | |||||||||||||||
Single
family residential - Spec.
|
2,750 | 557 | 3,307 | 5.8 | % | 2.3 | % | 3 | 1,750 | |||||||||||||||||||
Tract
|
- | - | - | 0.0 | % | 0.0 | % | - | - | |||||||||||||||||||
Multi-family
|
1,883 | - | 1,883 | 3.3 | % | 1.6 | % | 2 | 1,400 | |||||||||||||||||||
Commercial
|
31,398 | 5,549 | 36,947 | 65.1 | % | 25.9 | % | 16 | 6,720 | |||||||||||||||||||
Hospitality
|
- | - | - | 0.0 | % | 0.0 | % | - | - | |||||||||||||||||||
Total
construction
|
$ | 45,532 | $ | 11,265 | $ | 56,797 | 100.0 | % | 37.6 | % | 43 | $ | 13,195 |
At June
30, 2010, construction balances represented approximately $45.5 million or 6.5%
of total gross loan balances, compared to $64.9 million or 8.9% reported at
December 31, 2009. The decline in construction balances can be
attributed in large part to the re-classification of several large hospitality
construction loans to commercial real estate, following the completion of the
underlying projects. Contributing further to the year to date decline within
this category were charge-offs of approximately $1.0 million, payments received
on loans from the liquidation of underlying collateral totaling approximately
$1.6 million and transfers to OREO status totaling approximately $0.9
million.
At June
30, 2010 total construction balances represented approximately 37.6% of the
Bank’s total risk-based capital. This compares to the 79.7% reported
at December 31, 2009. Total construction commitments represented
46.9% of the Bank’s total risk-based capital at June 30, 2010. This
compares to the 103.8% reported at December 31, 2009. The significant
decline in these ratios can be attributed to the additional capital the Company
raised in a private placement during the first six months of 2010 and subsequent
down-stream of $48.0 million to the Bank.
Construction
loans are typically granted for a one year period and then, with income
properties, are amortized over a period not more than 30 years with 10 to 15
year maturities.
Land
The
following table provides a break-down of the land segment of the Bank’s loan
portfolio as of June 30, 2010:
June 30, 2010
|
Percent of
|
Single
|
||||||||||||||||||||||||||
Undisbursed
|
Total Bank
|
Percent
|
Bank's Risk
|
Number
|
Largest
|
|||||||||||||||||||||||
(dollars in thousands)
|
Balance
|
Commitment
|
Exposure
|
Composition
|
Based Capital
|
of Loans
|
Loan
|
|||||||||||||||||||||
Single
family residential
|
$ | 6,547 | $ | - | $ | 6,547 | 16.4 | % | 5.4 | % | 29 | $ | 1,000 | |||||||||||||||
Single
family residential - Spec.
|
1,447 | - | 1,447 | 3.6 | % | 1.2 | % | 6 | 618 | |||||||||||||||||||
Tract
|
18,453 | - | 18,453 | 46.1 | % | 15.2 | % | 8 | 5,236 | |||||||||||||||||||
Multi-family
|
- | - | - | 0.0 | % | 0.0 | % | - | - | |||||||||||||||||||
Commercial
|
10,110 | 650 | 10,760 | 26.9 | % | 8.4 | % | 19 | 1,500 | |||||||||||||||||||
Hospitality
|
2,799 | - | 2,799 | 7.0 | % | 2.3 | % | 3 | 2,340 | |||||||||||||||||||
Total
land
|
$ | 39,356 | $ | 650 | $ | 40,006 | 100.0 | % | 32.5 | % | 65 | $ | 10,694 |
At June
30, 2010, land balances represented approximately $39.4 million or 5.6% of total
gross loan balances. Land balances declined approximately $13.4
million when compared to the $52.8 million reported at December 31,
2009. The year to date decline can be attributed to several factors
including: charge-offs of approximately $1.0 million, transfers to OREO of
approximately $3.2 million and payments received from the sale of collateral of
problem loans in the amount of $2.7 million. Additionally, the Bank
created special purpose commercial and industrial financing related to the
largest loan within this category. The financing of that note
resulted in an approximate $5.4 million pay-down within this
category. Special purpose financing is related to a rock quarry
operation that has been developed on the site of the project in the absence of
meaningful demand for tract construction. Recent appraisals of the
underlying collateral indicate the loan is well secured and the borrower
continues to perform under the terms of the respective notes.
Heritage
Oaks Bancorp | - 55
-
|
Management’s
Discussion and Analysis
|
At June
30, 2010 total land loan balances represented 32.5% of the Bank’s total
risk-based capital compared to the 64.8% reported at December 31,
2009. Total land commitments represented approximately 33.1% of the
Bank’s total-risked based capital at June 30, 2010 compared to the 65.8%
reported at December 31, 2009. The significant decline in
these ratios can be attributed to the additional capital the Company raised in a
private placement during the first six months of 2010 and subsequent down-stream
of $48.0 million to the Bank.
Installment
At June
30, 2010, the installment loan balances were approximately $7.2 million compared
to the $8.3 million reported at December 31, 2009. Installment loans
include revolving credit plans, consumer loans, as well as credit card balances
obtained in the acquisition of Business First.
Loans
Held for Sale
Loans
held for sale consist of mortgage originations that have already been sold
pursuant to correspondent mortgage loan agreements. There is no interest rate
risk associated with these loans as the commitments are in place at the time the
Bank funds them. Settlement from the correspondents is typically within 30 to 45
days. At June 30, 2010 mortgage correspondent loans (loans held for
sale) totaled approximately $9.4 million, essentially unchanged from that
reported at December 31, 2009.
Foreign
Loans
At June
30, 2010 the Bank had no foreign loans outstanding.
Summary
of Market Condition
Prices of
single family homes have fallen significantly from market highs seen in 2006 and
2007 in the Company’s market area and California as a whole. Along
with other segments in the real estate sector, commercial real estate prices in
the Company’s market area experienced pressure during the last year and the
Company has begun to see increases in vacancy rates in certain retail,
industrial and office segments. The most recent data available to the
Company shows vacancy rates within retail, industrial and office segments to be
approximately 5.6%, 6.1% and 9.7%, respectively as of the third quarter of
2009. This compares to 3.0%, 5.4% and 6.1%, respectively as of the
third quarter of 2008. The Company realizes that any prolonged and
significant downturn in the national, state and local economies may further
impact the values of commercial real estate within its market footprint as well
as the borrowers to whom the Bank has extended such credit and as such vacancy
rates may increase in future periods. As such, Management continues
to closely monitor the credits within this segment of the loan portfolio for
potential signs of deterioration. Additionally, the Bank is aware
that as economic conditions worsen and levels of unemployment continue to rise,
borrowers to whom the Bank has extended commercial lines of credit may come
under additional pressure to satisfy their outstanding
obligations. That said, the Bank continues to employ stringent
lending standards and remains very selective with regard to any additional
commercial real estate, real estate construction, land and commercial loans it
chooses to originate in an effort to effectively manage risk in this difficult
credit environment.
As
previously mentioned, with the effects of a weakened economy placing more
pressure on borrowers, the ability of consumers to satisfy outstanding
obligations to the financial sector, as a whole, has been
impacted. We believe that within certain areas of our local economy
these more macro level concerns have become more evident. This has
had an impact on the level of and type of loans the Bank has placed on
non-accrual and charged-off during the last two years. Additionally,
the Company has devoted considerable resources to the monitoring of credits
within the loan portfolio in order to take any appropriate steps when and if
necessary to mitigate any material adverse impact the effects of weakened
economic conditions may have on the Bank overall.
As of
June 30, 2010, a substantial portion of loans the Bank originated within the
major categories of commercial real estate, construction, land, and commercial
and industrial were made to borrowers within our current market
footprint.
Heritage
Oaks Bancorp | - 56
-
|
Management’s
Discussion and Analysis
|
Credit
Quality
While the
Bank continues to adhere to prudent underwriting standards, the credit quality
of the Bank’s loan portfolio is impacted by numerous factors, including the
economic environment in the markets in which it operates and its impact on real
estate prices securing collateral dependent loans in the Bank’s loan
portfolio. Weakened economic conditions have had, and if continue to
persist, may further impact real estate used as collateral for certain loans the
Bank has made. Additionally, weak economic conditions have impacted
certain borrowers to whom the Bank has extended credit, making it difficult and
in some cases impossible for those borrowers to continue to make scheduled loan
payments. An inability of certain borrowers to continue to perform
under the original terms of their respective loan agreements in conjunction with
declines in collateral values has resulted in, and if such conditions continue,
may result in further, increases in provisions for loan losses and have an
adverse impact on the Company’s operating results.
In an
effort to manage credit quality the Bank monitors loans in the portfolio with
the assistance of a semi-annual independent loan review to identify and mitigate
any potential credit quality issues and losses in a proactive
manner. Management’s review in conjunction with the semi-annual
independent review focuses on non-watch related credits within certain pools of
loans that may be expected to experience stress due to economic
conditions. This process allows the Bank to validate credit ratings,
underwriting structure and the Bank’s estimated exposure in the current economic
environment and enhance communications with borrowers where necessary ultimately
in an effort to mitigate potential losses to the Bank. The Bank’s
next scheduled review is expected to occur within the third quarter of
2010.
The
current lending environment has proven to be difficult for the
Bank. Significantly weakened economic conditions have resulted in a
considerable increase in the number and dollar volume of past due loans as well
as loans the Bank has placed on non-accrual during the year. In
response to these conditions, the Bank formed a Special Assets department in
2008, which has subsequently been expanded. This area of the Bank not
only monitors loans that have been classified as non-performing and/or groups of
loans that have been downgraded in order to enhance communications with
borrowers, assist in the “work-out” of certain credits, more closely monitor
collateral, and determine the Bank’s exposure to such
relationships.
Allowance
for Loan Losses
The Bank
maintains an allowance for loan losses at a level considered by Management to be
adequate to provide for probable incurred losses as of the date of the balance
sheet. The allowance is comprised of three components: specific
credit allocation, general portfolio allocation, and subjectively determined
allocation. The allowance is increased by provisions for loan losses
charged to earnings and decreased by loan charge-offs, net of recovered
balances.
Specific
Credit Allocation
The
specific credit allocation of the allowance is determined through the
measurement of impairment on certain loans that have been identified during each
reporting period as impaired. A loan is considered impaired when,
based on current information and events, it is probable that the Bank will be
unable to collect all amounts due according to the contractual terms of the loan
agreement. The Bank may also consider a loan impaired when based on
certain information and events surrounding a borrower, it is determined that the
likelihood of the Bank receiving all scheduled payments, including interest,
when due is remote. Once a loan is classified as impaired, the Bank
places the loan under the supervision of its Special Assets
department. The Special Assets department is responsible for
performing comprehensive analyses of impaired loans, including obtaining updated
financial information regarding the borrower, obtaining updated appraisals on
any collateral securing such loans and ultimately determining the extent to
which such loans are impaired. Once the amount of impairment on
specific impaired loans has been determined, the Bank typically establishes a
corresponding valuation allowance, which then becomes a component of the Bank’s
specific credit allocation in the allowance for loan losses.
General
Portfolio Allocation
For
purposes of determining the general portfolio allocation of the allowance, the
loan portfolio is segmented into several pools of loans, exclusive of balances
individually evaluated for impairment, similar to the stratification presented
in Note 3. Loans and the Allowance for Loan Losses, of the consolidated
financial statements filed on this Form 10-Q/A. The loan portfolio is
then further segmented by an internal loan grading system that classifies loans
as: pass, special mention, substandard and doubtful. Estimated loss
rates are then applied to each segment of the loan portfolio according to loan
grade to determine the amount of the general portfolio
allocation. Estimated loss rates applied are determined through an
analysis of historical loss rates for each segment of the loan portfolio, based
on the Bank’s prior experience with such loans.
Heritage
Oaks Bancorp | - 57
-
|
Management’s
Discussion and Analysis
|
Subjectively
Determined Allocation
The
subjectively determined allocation of the allowance is determined by estimates
the Bank makes in regard to certain internal and external factors that may have
either a positive or negative impact on the overall credit quality of the loan
portfolio. Certain of these factors include: local, state and
national economic and business conditions, trends in the credit quality of the
loan portfolio, existence and the effects of concentrations, the nature and
volume of the loan portfolio, the quality of loan review as well as any other
factor determined by Management to possibly have an impact on the credit quality
of the loan portfolio.
Management
periodically monitors loans in the portfolio to identify certain credits that
may be impaired and/or experiencing deterioration and as such, makes appropriate
changes in the level of the allowance when necessary. Management
employs the use of, among other things, a watch list, loan grading system,
feedback provided by internal loan staff regarding specific credits,
Management’s findings from internal loan reviews, findings and analyses provided
from the Bank’s semi-annual independent loan review function and information
provided from examinations by regulatory agencies to manage credit risk and
address any necessary changes in the required level of the allowance for loan
losses in a timely manner.
The
determination of the amount of the allowance and any corresponding increase or
decrease in the level of provisions for loan losses is based on Management’s
best estimate of the current credit quality of the loan portfolio and any
probable inherent losses as of the balance sheet date. The nature of
the process in which Management determines the appropriate level of the
allowance involves the exercise of considerable judgment. While
Management utilizes its best judgment and all available information in
determining the adequacy of the allowance, the ultimate adequacy of the
allowance is dependent upon a variety of factors beyond the Bank’s control,
including but not limited to, the performance of the loan portfolio, changes in
current and future economic conditions and the view of regulatory agencies
regarding the level of classified assets. Continued weakness in
economic conditions and any other factor that may adversely affect credit
quality, result in higher levels of past due and non-accruing loans, defaults,
and additional loan charge-offs, which may require additional provisions for
loan losses in future periods and a higher balance in the Bank’s allowance for
loan losses.
The
allowance for loan losses increased in the second quarter of 2010 over that
reported at December 31, 2009, due to several factors including: continued
weakness in the economy, continued elevated levels in the number of and dollar
volume of non-performing and classified loans when compared to historical
periods and higher levels of charge-offs. At June 30, 2010 the
balance of classified loans was approximately $66.4 million. This
compares to the $75.4 million in classified loan balances reported at December
31, 2009. Although the balance of classified loans has declined
compared to that reported at December 31, 2009, classified balances remain at
elevated levels when compared to historical periods, which has resulted in
higher required balances in the general portfolio allocation under the Bank’s
methodology for determining an appropriate level for the allowance for loan
losses. Elevated charge-offs also contributed to the higher required
balances of the general portfolio allocation of the
allowance. Additionally, continued weakened economic conditions as
well as continued negative trends in overall credit quality resulted in higher
required balances of the subjectively determined allocation of the
allowance. As a result of the items mentioned the Bank made
provisions for loan losses in the amount of $16.1 million and $21.3 million for
the three and six months ended June 30, 2010, respectively. This
compares to provisions of approximately $2.7 million and $4.8 million during the
same periods ended a year earlier. As a result the allowance for loan
losses at June 30, 2010 was approximately $22.1 million compared to the $14.4
million reported at December 31, 2009, an increase of approximately $7.7 million
or 54.0% during the first six months of 2010.
Loans
charged-off during the three and six months ended June 30, 2010 totaled
approximately $13.7 million and $15.2 million, respectively. This
compares to charge-offs of approximately $2.0 million and $4.1 million reported
for the same periods ended a year earlier. Comprising the majority of
charge-offs for the second quarter of 2010 were charge-offs that eliminated
100.0% of the carrying value of certain loans from the Bank’s balance sheet
including: a) 26 C&I loans with total charged-off balances of
approximately $7.8 million; b) 4 commercial real estate loans with total
charged-off balances of $1.9 million; c) 2 agricultural loans with total
charged-off balances of $0.3 million; d) 1 single family 1-4 unit residential
loan with a total charged-off of $0.2 million; and e) 2 farmland loans with
total charged-off balances of $0.2 million. In addition to 100.0%
charge-offs recorded during the second quarter, $1.1 million of quarterly
charge-offs were related to the write-down of 11 loans to estimated fair value
prior to transfer to OREO. Net charge-offs to average loans for the
three and six months ended June 30, 2010 were 1.73% and 1.86%,
respectively. This compares to the 0.29% and 0.59% reported for the
same three and six month periods ended a year earlier. At June 30,
2010 the allowance for loan losses represented 3.17% of total gross loans
compared to the 1.97% reported at December 31, 2009.
As of
June 30, 2010 Management believes the allowance for loan losses was sufficient
to cover current estimable losses in the Bank’s loan portfolio.
Heritage
Oaks Bancorp | - 58
-
|
Management’s
Discussion and Analysis
|
The
following table provides an analysis of the allowance for loan losses for the
periods indicated:
For the six months
|
||||||||
ended June 30,
|
||||||||
(dollars amounts in thousands)
|
2010
|
2009
|
||||||
Balance,
beginning of period
|
$ | 14,372 | $ | 10,412 | ||||
Charge-offs
|
||||||||
Real
Estate Secured
|
||||||||
Multi-family
residential
|
- | - | ||||||
Residential
1 to 4 family
|
282 | - | ||||||
Home
equity line of credit
|
- | - | ||||||
Commercial
|
2,583 | - | ||||||
Farmland
|
235 | - | ||||||
Commercial
|
||||||||
Commercial
and industrial
|
8,818 | 1,225 | ||||||
Agriculture
|
1,209 | - | ||||||
Other
|
- | - | ||||||
Construction
|
988 | 1,821 | ||||||
Land
|
956 | 991 | ||||||
Installment
loans to individuals
|
49 | - | ||||||
All
other loans
|
58 | 101 | ||||||
Total
charge-offs
|
15,178 | 4,138 | ||||||
Recoveries
|
||||||||
Real
Estate Secured
|
||||||||
Multi-family
residential
|
- | - | ||||||
Residential
1 to 4 family
|
75 | 4 | ||||||
Home
equity line of credit
|
- | - | ||||||
Commercial
|
21 | - | ||||||
Farmland
|
- | - | ||||||
Commercial
|
||||||||
Commercial
and industrial
|
209 | 2 | ||||||
Agriculture
|
54 | - | ||||||
Other
|
- | - | ||||||
Construction
|
27 | 16 | ||||||
Land
|
1,245 | - | ||||||
Installment
loans to individuals
|
6 | - | ||||||
All
other loans
|
3 | - | ||||||
Total
recoveries
|
1,640 | 22 | ||||||
Net
charge-offs
|
13,538 | 4,116 | ||||||
Additions
to allowance charged to operations
|
21,300 | 4,810 | ||||||
Balance,
end of period
|
$ | 22,134 | $ | 11,106 | ||||
Gross
loans, end of period
|
$ | 697,176 | $ | 697,854 | ||||
Net
charge-offs to average loans
|
1.86 | % | 0.59 | % | ||||
Allowance
for loan losses to total gross loans
|
3.17 | % | 1.59 | % | ||||
Non-performing
loans to allowance for loan losses
|
158.43 | % | 110.19 | % |
Heritage
Oaks Bancorp | - 59
-
|
Management’s
Discussion and Analysis
|
For
reporting purposes, the Company allocates the allowance for loan losses across
product types within the loan portfolio. However, substantially all
of the allowance is available to absorb all credit losses without restriction,
unless specific reserves have been established. The following table
provides a summary of the allowance for loan losses and its allocation to each
major loan category of the loan portfolio as well as the percentage that each
major category of loans comprises as compared to total gross loan balances as of
the dates indicated below:
June 30,
|
December 31,
|
|||||||||||||||||||||||
2010
|
2009
|
2009
|
||||||||||||||||||||||
Percent
|
Percent
|
Percent
|
||||||||||||||||||||||
Amount
|
of Total
|
Amount
|
of Total
|
Amount
|
of Total
|
|||||||||||||||||||
(dollars amounts in thousands)
|
Allocated
|
Loans
|
Allocated
|
Loans
|
Allocated
|
Loans
|
||||||||||||||||||
Real
Estate Secured
|
||||||||||||||||||||||||
Multi-family
residential
|
$ | 140 | 2.7 | % | $ | 79 | 2.5 | % | $ | 119 | 2.8 | % | ||||||||||||
Residential
1 to 4 family
|
631 | 4.2 | % | 276 | 3.4 | % | 264 | 3.5 | % | |||||||||||||||
Home
equity line of credit
|
184 | 4.4 | % | 139 | 4.1 | % | 179 | 4.1 | % | |||||||||||||||
Commercial
|
9,509 | 50.4 | % | 4,402 | 43.4 | % | 6,081 | 46.5 | % | |||||||||||||||
Farmland
|
804 | 1.9 | % | 258 | 1.4 | % | 208 | 1.8 | % | |||||||||||||||
Commercial
|
||||||||||||||||||||||||
Commercial
and industrial
|
5,887 | 20.9 | % | 3,785 | 24.5 | % | 4,635 | 21.6 | % | |||||||||||||||
Agriculture
|
586 | 2.3 | % | 132 | 2.0 | % | 178 | 2.4 | % | |||||||||||||||
Other
|
1 | 0.0 | % | 4 | 0.1 | % | 1 | 0.0 | % | |||||||||||||||
Construction
|
||||||||||||||||||||||||
Single
family residential
|
140 | 1.4 | % | 290 | 2.1 | % | 304 | 2.1 | % | |||||||||||||||
Single
family residential - Spec.
|
64 | 0.4 | % | 161 | 1.5 | % | 46 | 0.5 | % | |||||||||||||||
Tract
|
- | 0.0 | % | 70 | 0.4 | % | 190 | 0.3 | % | |||||||||||||||
Multi-family
|
15 | 0.3 | % | 577 | 0.8 | % | 90 | 0.3 | % | |||||||||||||||
Hospitality
|
- | 0.0 | % | 76 | 1.8 | % | 107 | 2.0 | % | |||||||||||||||
Commercial
|
556 | 4.5 | % | 136 | 2.5 | % | 270 | 3.7 | % | |||||||||||||||
Land
|
3,512 | 5.6 | % | 682 | 8.2 | % | 1,644 | 7.2 | % | |||||||||||||||
Installment
loans to individuals
|
91 | 1.0 | % | 32 | 1.2 | % | 40 | 1.1 | % | |||||||||||||||
All
other loans (including overdrafts)
|
14 | 0.0 | % | 7 | 0.1 | % | 16 | 0.1 | % | |||||||||||||||
Total
allowance for loan losses
|
$ | 22,134 | 100.0 | % | $ | 11,106 | 100.0 | % | $ | 14,372 | 100.0 | % |
As of
June 30, 2010 the allocation of the allowance for loan losses to the real estate
secured segment of the loan portfolio has increased when compared to that
allocated to these categories in prior periods. This is due in large
part to higher balances of classified real estate loans, an increase in specific
credit reserves within this segment, increased levels of credit losses and the
continued weakness in local state and economic
conditions. Contributing further to the increase in the allocation to
the real estate secured segment of the portfolio was an increase in watch list
credits within this segment, specifically within commercial real
estate.
Increases
in the allocation to commercial and industrial and land balances can be
attributed to higher balances of watch list and classified credits within these
categories in conjunction with the continued weakened state of economic
conditions.
Continued
weakness in economic conditions and any further deterioration in the credit
quality of the segments mentioned above may result in further significant
provisions for loan losses and increases in the allocation of the allowance to
those categories.
Non-Performing
Assets
The
Bank’s Management is responsible for monitoring loan performance, which is done
through various methods, including a review of loan delinquencies and personal
knowledge of customers. Additionally, the Bank maintains both a
“watch” list of loans that, for a variety of reasons, Management believes
require regular review as well as an internal loan classification
process. Semi-annually, the loan portfolio is also reviewed by an
experienced, outside loan reviewer not affiliated with the Bank to augment
Management’s own internal review of loans in the portfolio. A list of
delinquencies, the watch list, internal loan classifications and internal and
external loan reviews are reviewed regularly by the Bank’s Board of
Directors.
Heritage
Oaks Bancorp | - 60
-
|
Management’s
Discussion and Analysis
|
The Bank
has a non-accrual policy that requires a loan greater than 90 days past due
and/or specifically determined to be impaired to be placed on non-accrual status
unless such loan is well-collateralized and in the process of
collection. When loans are placed on non-accrual status, all accrued
but uncollected interest income is reversed from earnings. Once on
non-accrual status payments received on such loans are applied as a reduction of
the loan principal balance. Interest on a loan is only recognized on
a cash basis and is generally not recognized on specific impaired loans unless
the likelihood of further loss is remote. Loans may be returned to
accrual status if Management believes that all remaining principal and interest
is fully collectible and there has been at least six months of sustained
repayment performance since the loan was placed on non-accrual.
Loans
typically move to non-accruing status from the Bank’s “substandard” risk
grade. When a loan is first classified as substandard, the Bank
obtains updated appraisal information on the underlying collateral. Once the
updated appraisal is obtained and analyzed by Management, a valuation allowance,
if necessary, is established against such loan or a loss is recognized by a
charge to the allowance for loan losses if Management believes that the full
amount of the Bank’s recorded investment in the loan is no longer
collectible. Therefore, at the time a loan moves into non-accruing
status, a valuation allowance typically has already been established or balances
on such loan have been charged-off. The Bank orders new appraisals on
underlying collateral in order to have the most current indication of fair
value, if appraisals obtained while the loan was classified as substandard are
deemed to be out dated.
If a
complete appraisal will take a significant amount of time to complete, while
waiting for an appraisal the Bank may also rely on a broker’s price opinion or
other meaningful market data, such as comparables, in order to derive its best
estimate of a property’s fair value at the time the decision to classify the
loan as substandard, or move the loan to non-accruing status, is
made. Once a loan is on non-accruing status an analysis of the
underlying collateral is performed at least quarterly.
If a
loan’s credit quality deteriorates to the point that collection of principal is
believed by Management to be doubtful and the value of collateral securing the
obligation is sufficient, the Bank generally takes steps to protect and
liquidate the collateral. Any loss resulting from the difference
between the loan balance and the fair market value of the collateral is
recognized by a charge to the allowance for loan losses. When
collateral is held for sale after foreclosure, it is subject to a periodic
appraisal. If the appraisal indicates that the collateral will sell
for less than its recorded value, the Bank recognizes the loss by a charge to
non-interest expense.
Negative
undertones associated with the economy and real estate markets have resulted in
the expansion of the Bank’s internal watch list as well as the number of and
dollar volume of non-accruing loans over the last year. While credit
quality is consistently monitored, Management has implemented additional
precautionary actions that include but are not limited to pro-actively
identifying credit weaknesses earlier in the collection cycle, increasing the
oversight frequency of watch list credits and devoting additional internal
resources to monitor those credits. Although the Bank believes these
actions will serve to potentially minimize any future losses the Bank may incur
related to problem loans, no guarantee can be made that the Bank will not
experience an increase in non-performing loans, given continued uncertainties
surrounding the local, state and national economic conditions.
As
evidenced in the table below summarizing the Bank’s non-performing assets, the
current economic downturn has had a significant impact in regard to loans
related to land, construction, commercial and industrial and commercial real
estate.
Heritage
Oaks Bancorp | - 61
-
|
Management’s
Discussion and Analysis
|
The
following table provides a summary of non-accruing loans as of June 30, 2010 and
December 31, 2009:
June 30,
|
December 31,
|
Variance
|
||||||||||||||
(dollars in thousands)
|
2010
|
2009
|
Dollar
|
Percent
|
||||||||||||
Loans
delinquent 90 days or more and still accruing
|
$ | - | $ | 151 | $ | (151 | ) | -100.00 | % | |||||||
Non-Accruing
Loans
|
||||||||||||||||
Commercial
real estate
|
$ | 14,160 | $ | 11,035 | $ | 3,125 | 28.32 | % | ||||||||
Residential
1-4 family
|
1,310 | 1,147 | 163 | 14.21 | % | |||||||||||
Home
equity lines of credit
|
320 | 320 | - | 0.00 | % | |||||||||||
Farmland
|
2,936 | - | 2,936 | 100.00 | % | |||||||||||
Commercial
and industrial
|
4,610 | 8,429 | (3,819 | ) | -45.31 | % | ||||||||||
Agriculture
|
706 | 3,172 | (2,466 | ) | -77.74 | % | ||||||||||
Construction
|
2,454 | 3,838 | (1,384 | ) | -36.06 | % | ||||||||||
Land
|
8,284 | 10,182 | (1,898 | ) | -18.64 | % | ||||||||||
Installment
|
286 | 47 | 239 | 508.51 | % | |||||||||||
Total
non-accruing loans
|
$ | 35,066 | $ | 38,170 | $ | (3,104 | ) | -8.13 | % | |||||||
Other
real estate owned
|
$ | 4,953 | $ | 946 | $ | 4,007 | 423.57 | % | ||||||||
Total
non-performing assets
|
$ | 40,019 | $ | 39,267 | $ | 752 | 1.92 | % | ||||||||
Ratio
of allowance for credit losses to total gross loans
|
3.17 | % | 1.97 | % | ||||||||||||
Ratio
of allowance for credit losses to total non-performing
loans
|
63.12 | % | 37.50 | % | ||||||||||||
Ratio
of non-performing loans to total gross loans
|
5.03 | % | 5.26 | % | ||||||||||||
Ratio
of non-performing assets to total assets
|
3.96 | % | 4.15 | % |
At June
30, 2010 the balance of non-accruing loans was approximately $35.1 million or
$3.1 million lower than that reported at December 31, 2009. Year to
date changes in non-accruing balances can be attributed in part to Management’s
work-through of problem credits during 2010. While a significant
portion of these balances were charged-off, the Bank saw approximately $3.7
million in balances return to accruing status following the Bank’s efforts to
work with certain borrowers to bring resolution to problem
credits. Additionally, the Bank transferred approximately $5.0
million to OREO status and is actively marketing such assets for eventual
sale. The Bank also received approximately $9.7 million in principal
payments on non-accruing loans during the first six months of 2010, primarily
the result of collateral liquidations.
Non-performing
assets totaled approximately $40.0 million at June 30, 2010, approximately $0.8
million higher than that reported at December 31, 2009.
Heritage
Oaks Bancorp | - 62
-
|
Management’s
Discussion and Analysis
|
The
following table reconciles the change in non-accruing balances for the six
months ended June 30, 2010:
Balance
|
Additions to
|
Transfers
|
Returns to
|
Balance
|
||||||||||||||||||||||||
December 31,
|
Non-Accruing
|
Net
|
to Foreclosed
|
Preforming
|
June 30,
|
|||||||||||||||||||||||
(dollars in thousands)
|
2009
|
Balances
|
Paydowns
|
Collateral
|
Status
|
Charge-offs
|
2010
|
|||||||||||||||||||||
Real
Estate Secured
|
||||||||||||||||||||||||||||
Multi-family
residential
|
$ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | ||||||||||||||
Residential
1 to 4 family
|
1,147 | 458 | (11 | ) | - | - | (284 | ) | 1,310 | |||||||||||||||||||
Home
equity line of credit
|
320 | - | - | - | - | - | 320 | |||||||||||||||||||||
Commercial
|
11,035 | 11,806 | (2,555 | ) | (234 | ) | (3,305 | ) | (2,587 | ) | 14,160 | |||||||||||||||||
Farmland
|
- | 3,810 | (62 | ) | (577 | ) | - | (235 | ) | 2,936 | ||||||||||||||||||
Commercial
|
||||||||||||||||||||||||||||
Commercial
and industrial
|
8,429 | 6,020 | (629 | ) | (10 | ) | (381 | ) | (8,819 | ) | 4,610 | |||||||||||||||||
Agriculture
|
3,172 | 825 | (2,082 | ) | - | - | (1,209 | ) | 706 | |||||||||||||||||||
Other
|
- | - | - | - | - | - | - | |||||||||||||||||||||
Construction
|
||||||||||||||||||||||||||||
Single
family residential
|
940 | - | - | - | - | (219 | ) | 721 | ||||||||||||||||||||
Single
family residential - Spec.
|
683 | 1,250 | - | (538 | ) | - | (145 | ) | 1,250 | |||||||||||||||||||
Tract
|
2,215 | - | (1,646 | ) | (363 | ) | - | (206 | ) | - | ||||||||||||||||||
Multi-family
|
- | 900 | - | - | - | (417 | ) | 483 | ||||||||||||||||||||
Hospitality
|
- | - | - | - | - | - | - | |||||||||||||||||||||
Commercial
|
- | - | - | - | - | - | - | |||||||||||||||||||||
Land
|
10,182 | 4,949 | (2,661 | ) | (3,226 | ) | - | (960 | ) | 8,284 | ||||||||||||||||||
Installment
loans to individuals
|
47 | 387 | (5 | ) | (35 | ) | - | (108 | ) | 286 | ||||||||||||||||||
All
other loans
|
- | - | - | - | - | - | - | |||||||||||||||||||||
Totals
|
$ | 38,170 | $ | 30,405 | $ | (9,651 | ) | $ | (4,983 | ) | $ | (3,686 | ) | $ | (15,189 | ) | $ | 35,066 |
The
following provides additional information regarding non-accruing loan balances
as of June 30, 2010:
Real
Estate Secured – Commercial (“CRE”)
The
majority of balances within this category can be attributed to nine loans to
eight borrowers, totaling approximately $12.2 million, representing 86.3% of
non-accruing CRE balances. The Bank added approximately $11.8 million
in balances to non-accruing status within this category during the first six
months of 2010. Approximately $8.6 million of the increase can be
attributed to three loans to two borrowers of which approximately $1.5 million
has since been charged-off. Payments received and applied to
principal totaled approximately $2.6 million, the majority of which relates to
the liquidation of collateral on several loans. The following
provides a break-down of significant non-accruing CRE balances as of June 30,
2010:
|
·
|
Approximately
$1.4 million can be attributed to one loan in which the Bank is working
with the borrower to bring it current. Recent data suggests
that the borrower’s financial condition is currently sound. The
borrower is also working to sell other assets to pay-down the
loan.
|
|
·
|
Two
loans made to two separate borrowers totaling approximately $1.8 million
that the Bank has restructured. A third party has expressed
interest in assuming responsibility for one of these notes. The
Bank is pursuing judicial foreclosure on the other
loan.
|
|
·
|
One
loan totaling approximately $0.7 million. The Bank is currently
pursuing foreclosure on the underlying
collateral.
|
|
·
|
One
loan totaling approximately $3.4 million. As previously
discussed, the borrower is currently seeking alternative financing to
pay-down their outstanding obligation to the Bank. However, the
Bank is proceeding with the foreclosure
process.
|
|
·
|
One
loan in the amount of $3.7 million. The borrower is currently
paying on the note and is working with the Bank to bring about a
resolution. A recent appraisal indicates significant value in
the underlying collateral to cover the Bank’s recorded investment in the
loan.
|
|
·
|
Two
loans to one borrower in the approximate amount of $1.0
million. The Bank is currently pursuing foreclosure on the
underlying collateral.
|
|
·
|
One
loan in the amount of $0.4 million. The Bank is currently in
the process of foreclosing on the underlying collateral securing this
loan.
|
Heritage
Oaks Bancorp | - 63
-
|
Management’s
Discussion and Analysis
|
Commercial
and Industrial (“C&I”)
Non-accruing
C&I balances totaled approximately $4.6 million, the majority of which can
be attributed to six loans to four borrowers in the aggregate amount of $2.7
million or 57.6% of C&I non-accruing balances. During the first
six months of 2010 the Bank charged-off approximately $8.8 million in C&I
balances, contributing significantly to the year to date decline within this
category. Approximately $3.6 million or 41.3% of C&I charge-offs
are attributable to one loan. Although the Bank’s position is well
secured, continued concerns about certain circumstances surrounding the borrower
led the Bank to further write-down the loan. Payments received and
applied to principal totaled approximately $0.7 million during the first six
months of 2010. Additions of $6.0 million to non-accruing status
within this category can be attributed to smaller business lines of credit that
were subsequently charged-off during the same period. The following
provides a break-down of significant non-accruing C&I balances as of June
30, 2010:
|
·
|
One
loan in the approximate amount of $0.1 million is secured by real estate
in the Bank’s primary market as well as various business
assets. Recent financial information concerning the client
indicates the borrower currently has the cash flow to continue to service
the loan.
|
|
·
|
Three
loans to one borrower totaling approximately $0.9 million. The
underlying collateral represents leased residential real
estate. The Bank is in the process of taking possession of the
collateral and its rent proceeds to liquidate and pay-down the
loan.
|
|
·
|
One
loan in the approximate amount of $0.4 million contains an SBA
guarantee. Physical collateral has been repossessed and is in
the process of being liquidated.
|
|
·
|
One
loan in the approximate amount of $1.3 million. The Bank is
currently working with the borrower to bring about a
resolution.
|
Construction
Non-accruing
construction balances totaled approximately $2.5 million at June 30, 2010,
approximately $1.4 million lower than that reported at December 31,
2009. Balances within this category are primarily comprised of three
loans to three borrowers. The Bank is currently in the process of foreclosing on
collateral securing two loans within this category, while property securing the
third loan is currently in escrow with an expected close date of sometime within
the third quarter of 2010. During the first six months of 2010 the
Bank received approximately $1.6 million in principal payments, primarily from
the liquidation of collateral securing loans within this
category. The Bank also moved approximately $0.9 million in
non-accruing construction balances to OREO status during the first six months of
2010. Construction charge-offs totaled approximately $1.0 million and
are primarily the result of updated valuations on underlying collateral securing
loans within this category.
Land
Non-accruing
land balances totaled approximately $8.3 million, down approximately $1.9
million from that reported at December 31, 2009. Although the Bank
placed approximately $4.9 million in land balances on non-accruing status during
the first six months of 2010, the Bank also received approximately $2.7 million
in principal payments from the liquidation of collateral. During the
first six months of 2010, the Bank also moved approximately $3.2 million in land
balances to OREO status, the majority of which can be attributed to collateral
formerly securing one loan. Charge-offs of $1.0 million within this
category can be attributed to updated valuations on underlying collateral
securing loans within this category. The majority of non-accruing
land balances at June 30, 2010 can be attributed to three loans to three
borrowers totaling approximately $7.3 million or 88.1% of total non-accruing
land loans. The following provides a break-down of these balances as
of June 30, 2010:
|
·
|
One
loan totaling approximately $1.1 million. The Bank is working
with the borrower to liquidate the collateral and pay-down the
loan.
|
|
·
|
One
loan totaling approximately $1.9 million secured by land for hospitality
construction in the Bank’s primary market area. The Bank is
currently in the process of foreclosing on the collateral securing the
loan.
|
|
·
|
One
loan in the amount of $4.3 million is secured by land for tract
development in the Bank’s primary market area. Although the
borrower is currently seeking alternative financing from other financial
institutions to pay-down the loan, the Bank has begun the foreclosure
process.
|
Agriculture
Non-accruing
agriculture balances totaled approximately $0.7 million at June 30, 2010, down
approximately $2.5 million from that reported at December 31,
2009. The primary factor behind the year to date decline within this
category can be attributed to proceeds received from the sale of collateral
securing one loan and the subsequent charge-off of the remaining balance of the
loan. The Bank is currently pursuing foreclosure on collateral
securing two loans to one borrower within this category. The
aggregate balance of these loans at June 30, 2010 was approximately $0.3
million.
Heritage
Oaks Bancorp | - 64
-
|
Management’s Discussion and
Analysis
|
At June
30, 2010, substantially all non-accruing balances were carried at their current
estimated fair values.
Other
Real Estate Owned (“OREO”)
The
following table provides a summary for the year to date change in the balance of
OREO as of June 30, 2010:
For the six months ended
|
||||
(dollars in thousands)
|
June 30, 2010
|
|||
Balance
December 31, 2009
|
$ | 946 | ||
Additions
|
4,987 | |||
Dispositions
|
(775 | ) | ||
Write-downs
|
(205 | ) | ||
Balance
June 30, 2010
|
$ | 4,953 |
At June
30, 2010, OREO balances totaled approximately $5.0 million, approximately $4.0
million higher than that reported at December 31, 2009. During the
first six months of 2010 the Bank transferred approximately $5.0 million to
OREO. Of the additions during 2010, approximately $2.4 million can be
attributed to collateral formerly securing four loans to one borrower in the
construction and land segment of the loan portfolio. These properties
are in escrow and are expected to close sometime in the second half of
2010. Another property booked for approximately $0.5 million is also
in escrow and is expected to close in the third quarter of
2010. Write-downs on OREO of $0.2 million occurred in the first
quarter of 2010 and were the result of updated appraisal information on two
properties.
Total
Cash and Cash Equivalents
Total
cash and cash equivalents were $62.0 million and $40.7 million at June 30, 2010
and December 31, 2009, respectively. This line item will vary depending on cash
letters from the previous night and actual cash on hand in the
branches. Cash and cash equivalents were substantially higher than
that reported at December 31, 2009 due in large part to the proceeds the Company
received from the close of its March 2010 private placement as well as deposit
growth during the first six months of 2010. For additional
information related to the Company’s March 2010 private placement, please see
Note 10. Preferred Stock, of the consolidated financial statements filed on this
Form 10-Q/A.
Investment
Securities and Other Earning Assets
Other
earning assets are comprised of Interest Bearing Due from Federal Reserve,
Federal Funds Sold (funds the Bank lends on a short-term basis to other banks),
investments in securities and short-term interest bearing deposits at other
financial institutions. These assets are maintained for liquidity
needs of the Bank, collateralization of public deposits, and diversification of
the earning asset mix.
The table
below summarizes the year to date change in the balances of other earning assets
as of June 30, 2010:
June 30,
|
December 31,
|
Variance
|
||||||||||||||
(dollars in thousands)
|
2010
|
2009
|
dollar
|
percentage
|
||||||||||||
Interest
bearing due from banks
|
$ | 38,682 | $ | 17,046 | $ | 21,636 | 126.93 | % | ||||||||
Federal
funds sold
|
5,500 | 4,350 | 1,150 | 26.44 | % | |||||||||||
Interest
bearing deposits other financial institutions
|
119 | 119 | - | 0.00 | % | |||||||||||
Securities
available for sale
|
192,904 | 121,180 | 71,724 | 59.19 | % | |||||||||||
Federal
Home Loan Bank stock
|
5,611 | 5,828 | (217 | ) | -3.72 | % | ||||||||||
Total
other earning assets
|
$ | 242,816 | $ | 148,523 | $ | 94,293 | 63.49 | % |
Heritage
Oaks Bancorp | - 65 -
|
Management’s Discussion and
Analysis
|
Federal
Funds Sold and Interest Bearing Due from Federal Reserve
As of
June 30, 2010, the total of federal funds sold and interest bearing due from
balances was approximately $44.2 million or $21.6 million higher than that
reported at December 31, 2009. Although the balance of federal funds
sold and interest bearing due from can vary significantly from day to day as a
result of many factors, including the liquidity needs of the Bank’s depositors,
the year to date increase, as previously mentioned, is mainly attributable to
funds received upon completion of the Company’s March 2010 private placement as
well as a year to date increase in deposit balances, resulting in excess funds
available for short-term overnight investment.
Investment
Securities
The
Company manages its securities portfolio to provide a source of both liquidity
and earnings. The Bank has an Asset/Liability Committee that develops
current investment policies based upon its operating needs and market
circumstance. The Bank’s investment policy is formally reviewed and
approved annually by the Board of Directors. The Asset/Liability
Committee of the Bank is responsible for reporting and monitoring compliance
with the investment policy. Reports are provided to the Bank’s Board
of Directors on a regular basis.
At June
30, 2010, the balance of the investment portfolio was approximately $192.9
million or $71.7 million higher than that reported at December 31,
2009. The change in the balance of the portfolio can be attributed in
large part to purchases the Bank made during the first six months of the year in
the aggregate amount $83.4 million, principal pay downs on mortgage related
securities totaling approximately $10.3 million and proceeds from the sale, call
and maturity of investments totaling approximately $2.5
million. During the three months ended June 30, 2010 the Bank
recorded a net pre-tax loss of approximately $97 thousand on the sale of various
investment securities. No sales of investment securities occurred in
the first quarter of 2010.
Securities
available-for-sale are carried at fair value, with related unrealized net gains
or losses, net of deferred income taxes, recorded as an adjustment to equity
capital. At June 30, 2010 the securities portfolio had net unrealized
losses, net of taxes of approximately $24 thousand, a decrease of approximately
$1.1 million from that reported at December 31, 2009. Changes in the
fair value of the investment portfolio in the last two years can be attributed
in part to extreme market turbulence, stemming in part from continued weakened
economic conditions and uncertain market conditions.
During
the last two years, the credit markets came under significant duress as investor
and consumer confidence in the U.S. financial system became significantly
destabilized. As a result, many financial institutions in severe need
of liquidity were forced to de-leverage for a variety of reasons, selling
significant portions of their investment holdings which in turn placed
considerable pressure on the values of many classes of investment
securities. In particular, mortgage related securities came under
substantial pressure and the Bank’s portfolio was not immune to
this. Although substantially all of the Bank’s mortgage related
securities are considered “investment grade,” overall lack of confidence in the
housing market, the inability of many consumers to meet their mortgage related
obligations, and the strong need for liquidity during the last two years have,
among other things, been influential in placing pressure on the prices of these
types of securities.
At June
30, 2010, the Bank owned ten Whole Loan Private Label Mortgage Backed Securities
(“PMBS”) with a remaining principal balance of approximately $19.1
million. PMBS do not carry a government guarantee (explicit or
implicit) and require much more detailed due diligence in the form of pre and
post purchase analysis. All PMBS bonds were rated AAA by one or more
of the major rating agencies at the time of purchase. Due to the
severe and prolonged downturn in the economy PMBS bonds along with other asset
classes have seen deterioration in price, credit quality, and
liquidity. Rating agencies have been reassessing all ratings
associated with bonds starting with lower tranche or subordinate pieces (which
have increased loss exposure) then moving on to senior and super senior bonds
which is what the Bank owns with the exception of one mezzanine bond
(subordinate). At June 30, 2010, five bonds with an aggregate fair
value of approximately $9.8 million remained below investment
grade. All five of these bonds are in senior or super senior tranche
positions of their respective deals, meaning the Bank has priority in cash flows
and has subordinate tranches below its position providing credit support.
As more
fully disclosed in Note 2. Investments, of the consolidated financial statements
filed on this Form 10-Q/A, during the fourth quarter of 2009 the Company
performed an analysis, with the assistance of an independent third party, on
several PMBS in the investment portfolio for other than temporary impairment
(“OTTI”), including those mentioned in the previous paragraph. Based
on that analysis, the Company determined four securities to be other than
temporarily impaired. As a result, the Bank realized approximately
$372 thousand in aggregate pre-tax losses related to these securities during the
fourth quarter of 2009. During the second quarter of 2010 the Bank
sold one of the four securities mentioned above in an effort to take advantage
of current, more favorable, market pricing. The Bank recognized a
loss of approximately $150 thousand on the sale of this security. The
loss recognized on the sale of this security was due to changes in market
pricing.
The
Company continues to engage an independent third party to review these same
securities for additional OTTI on a quarterly basis. The results of
those analyses indicate there was no additional OTTI on these securities during
the first six months of 2010. The Company will continue to engage an
independent third party to review these securities on a quarterly basis for the
foreseeable future.
Heritage
Oaks Bancorp | - 66 -
|
Management’s Discussion and
Analysis
|
The Bank
continues to perform regular extensive analyses on PMBS bonds in the portfolio
including but not limited to updates on: credit enhancements, loan-to-values,
credit scores, delinquency rates and default rates. These investment
securities continue to demonstrate cash flows as expected, based on pre-purchase
analyses. As of June 30, 2010, Management does not believe that
losses on PMBS in the portfolio, other than those previously discussed, are
other than temporary.
All PMBS
the Bank owns are in senior or super senior tranche positions of their
respective deals, except for one mezzanine bond, meaning that the Bank has
priority in cash flows and has subordinate tranches below its position providing
credit support. The more credit support or enhancement, the more
protection is provided from possible losses on non-performing
collateral. Credit support on PMBS the Bank owns has increased from
the time of purchase through June 30, 2010, except for one bond. As
the Bank receives cash flow on its senior positions and principle is reduced
quicker than default losses are applied to the subordinate positions, the credit
enhancement percentage grows.
The
majority of the Bank’s mortgage securities were issued by: The Government
National Mortgage Association (“Ginnie Mae”), The Federal National Mortgage
Association (“Fannie Mae”), and The Federal Home Loan Mortgage Corporation
(“Freddie Mac”). These securities carry the guarantee of the issuing
agencies. At June 30, 2010 approximately $147.0 million or 89.2% of
the Bank’s mortgage related securities were issued by a government agency such
as those listed above.
All fixed
and adjustable rate mortgage pools contain a certain amount of risk related to
the uncertainty of prepayments of the underlying mortgages. Interest
rate changes have a direct impact upon prepayment rates. The Bank
uses computer simulation models to test the average life, duration, market
volatility and yield volatility of adjustable rate mortgage pools under various
interest rate assumptions to monitor volatility. Stress tests are
performed quarterly.
Federal
Home Loan Bank (“FHLB”) Stock
As a
member of the Federal Home Loan Bank of San Francisco, the Bank is required to
hold a specified amount of FHLB capital stock based on the level of borrowings
the Bank has obtained from the FHLB. As such, the amount of FHLB
stock the Bank carries can vary from one period to another based on among other
things the current liquidity needs of the Bank. At June 30, 2010 and
December 31, 2009, the Bank held approximately $5.6 million and $5.8 million in
FHLB stock, respectively. The year to date decline in the balance of
FHLB stock can be attributed to redemptions of approximately $0.2 million
occurring in the second quarter of 2010.
Deposits
and Borrowed Funds
The
following table provides a summary for the year to date change in various
categories of deposit balances as of June 30, 2010:
Variance Exclusive of
|
||||||||||||||||||||||||
June 30,
|
December 31,
|
Variance
|
Volatile Balances
|
|||||||||||||||||||||
(dollars in thousands)
|
2010
|
2009
|
dollar
|
percentage
|
dollar
|
percentage
|
||||||||||||||||||
Non-interest
bearing demand
|
$ | 182,846 | $ | 174,635 | $ | 8,211 | 4.70 | % | $ | 15,300 | 8.76 | % | ||||||||||||
Interest
bearing demand
|
68,295 | 77,765 | (9,470 | ) | -12.18 | % | (9,735 | ) | -12.52 | % | ||||||||||||||
Savings
|
26,844 | 27,166 | (322 | ) | -1.19 | % | (322 | ) | -1.19 | % | ||||||||||||||
Money
market
|
284,118 | 259,671 | 24,447 | 9.41 | % | 34,679 | 13.35 | % | ||||||||||||||||
Time
deposits
|
232,630 | 224,998 | 7,632 | 3.39 | % | 7,632 | 3.39 | % | ||||||||||||||||
Total
retail deposits
|
794,733 | 764,235 | 30,498 | 3.99 | % | 47,554 | 6.22 | % | ||||||||||||||||
Brokered
time deposits
|
100 | 10,230 | (10,130 | ) | -99.02 | % | (10,130 | ) | -99.02 | % | ||||||||||||||
Brokered
money market funds
|
1,000 | 1,000 | - | - | 0.00 | % | ||||||||||||||||||
Total
brokered deposits
|
1,100 | 11,230 | (10,130 | ) | -90.20 | % | (10,130 | ) | -90.20 | % | ||||||||||||||
Total
deposits
|
$ | 795,833 | $ | 775,465 | $ | 20,368 | 2.63 | % | $ | 37,424 | 4.83 | % |
Heritage
Oaks Bancorp | - 67 -
|
Management’s Discussion and
Analysis
|
Deposits
As
indicated in the table above total deposit balances at June 30, 2010 were
approximately $795.8 million. This represents an increase of
approximately $20.4 million when compared to that reported at December 31,
2009. Higher core deposit balances during 2009 allowed the Bank to
rely less on wholesale funding and brokered deposits. At June 30,
2010 brokered deposits totaled $1.1 million, representing a decline of
approximately $10.1 million from that reported at December 31,
2009.
During
the first six months of 2010, the Bank saw core deposit balances (non-interest
and interest bearing demand, savings, money market and time certificate accounts
with balances less than $100 thousand) increase approximately $21.4 million from
that reported at December 31, 2009.
Volatile
Deposits
The Bank
monitors the balance of various accounts that it considers to be volatile for a
variety of reasons and provides this data to the Board of Directors on a regular
basis. Accounts may be added to or removed from the volatile
liability dependency report when, based on Management’s judgment, it is
determined that these funds are not suitable for any form of long term
investment or that the risk associated with these funds leaving the Bank has
become minimal. Typically a material change in the balances of these
accounts is reflected in the balance of federal funds sold and/or interest
bearing due from Federal Reserve. At June 30, 2010, the aggregate
balance of deposits the Bank considers to be volatile was approximately $14.6
million or $17.1 million lower than that reported at December 31,
2009. Although these accounts are deemed to be volatile, the Bank
considers a significant majority of these accounts to be core
relationships.
The
following table provides a summary of the deposit balances the Bank considers to
be volatile as of June 30, 2010 and December 31, 2009:
Percent of
|
Percent of
|
|||||||||||||||||||
June 30,
|
Total
|
December 31,
|
Total
|
Dollar
|
||||||||||||||||
(dollars in thousands)
|
2010
|
Deposits
|
2009
|
Deposits
|
Variance
|
|||||||||||||||
Non-interest
bearing demand
|
$ | 10,886 | 1.4 | % | $ | 17,975 | 2.3 | % | $ | (7,089 | ) | |||||||||
Interest
bearing demand
|
2,843 | 0.4 | % | 2,578 | 0.3 | % | 265 | |||||||||||||
Money
market
|
881 | 0.1 | % | 11,113 | 1.4 | % | (10,232 | ) | ||||||||||||
Total
volatile deposits
|
$ | 14,610 | 1.9 | % | $ | 31,666 | 4.0 | % | $ | (17,056 | ) |
The year
to date decline in balances the Bank considers to be volatile can be attributed
to declines in volatile non-interest bearing demand and money market funds
balances of approximately $17.3 million. Volatile balances have
declined within these categories in part due to customer intent to place these
funds in other investment vehicles with other institutions. It should
be noted the customers that hold the non-interest bearing deposits engage in
mortgage related activities. Management and the Board of Directors
are aware that as conditions in the market change these relationships will be
impacted.
Borrowed
Funds
The Bank
has a variety of sources from which it may obtain secondary
funding. These sources include, among others, the FHLB and credit
lines established with correspondent banks. Borrowings are obtained
for a variety of reasons which include, but are not limited to, funding loan
growth and the purchase of investments in the absence of core deposits and to
provide additional liquidity to meet the demands of depositors.
Heritage
Oaks Bancorp | - 68 -
|
Management’s Discussion and
Analysis
|
At June
30, 2010, borrowings obtained from the FHLB comprised the majority of borrowed
funds. The following table provides a summary of FHLB borrowings the
Bank had outstanding as of June 30, 2010:
(dollars in thousands)
|
|||||||||
Amount
|
Interest
|
Maturity
|
|||||||
Borrowed
|
Rate
|
Advance Type
|
Date
|
||||||
$ | 10,000 | 2.89 | % |
Fixed
|
9/16/2010
|
||||
35,000 | 0.21 | % |
Adjustable
|
1/31/2011
|
|||||
20,000 | 0.27 | % |
Variable
|
Open
|
|||||
$ | 65,000 | 0.64 | % |
As
evidenced in the table above, the balance of FHLB borrowing as of June 30, 2010
was $65.0 million, unchanged from the balance reported at December 31,
2009.
On
September 17, 2004, the Bank issued a Letter of Credit in the amount of
approximately $11.7 million, which has since been reduced to $11.4 million, to a
customer to support the primary financing of a senior care
facility. The Letter of Credit was issued pursuant to a Letter of
Credit Reimbursement Agreement between the Bank and the FHLB. It is
collateralized by a blanket lien with the FHLB that includes all qualifying
loans on the Bank’s balance sheet. The letter of credit was renewed
in July 2009 and will expire in September 2010. The letter of credit
was undrawn as of June 30, 2010.
Capital
At June
30, 2010, the balance of stockholders’ equity was approximately $133.4
million. This represents an increase of approximately $49.6 million
over that reported at December 31, 2009. The year to date change in
capital is due primarily to $60.0 million in gross proceeds the Company raised
in its March 2010 private placement. Additionally, the year to date change is
also attributed to net losses of $7.2 million, the impact of year-to-date
share-based compensation expense in the amount of $0.2 million, dividends paid
and accrued on Series A Senior Preferred stock in the amount of $0.5 million,
proceeds from the exercise of options in the amount of $42 thousand and a
decline in the balance of accumulated other comprehensive loss in the amount of
$1.1 million.
Private
Placement and Preferred Stock Conversion
On March
12, 2010 the Company completed a private placement of 52,088 shares of its
Series B Mandatorily Convertible Adjustable Cumulative Perpetual Preferred Stock
("Series B Preferred Stock") and 1,189,538 shares of its Series C Convertible
Perpetual Preferred Stock (“Series C Preferred Stock”), raising gross proceeds
of approximately $56.0 million. In addition, approximately $4.0
million was placed in escrow for a second closing of 4,072 shares of Series B
Preferred Stock. The second closing was later completed in the second
quarter of 2010. Following the receipt of shareholder approval at the Company’s
June 2010 annual meeting, the Company converted to common stock all Series B
Preferred shares issued in its private placement. The total number of
common shares issued in the conversion was 17,279,995. For additional
information regarding the Company’s private placement, please see Note 11.
Preferred Stock, of the consolidated financial statements filed on this Form
10-Q/A.
The
Series B Preferred Stock was mandatorily convertible into common stock, upon the
approval by shareholders of the Company’s common stock at a conversion price of
$3.25 per common share. As indicated above, shareholder approval
occurred during the second quarter of 2010. The conversion price of
$3.25 per common share was less than the fair market value of the Company’s
common stock on March 10, 2010, (the “commitment date”) the date the Company
made a firm commitment to issue the Series B Preferred Stock. The
fair market value of the Company’s common stock on the commitment date was $3.45
per share. Therefore, the Series B Preferred Stock was issued with a
contingent beneficial conversion feature that had an intrinsic value equal to
the $0.20 per share difference between the share price on the commitment date
and the conversion price of the Series B Preferred Stock. The
intrinsic value of the beneficial conversion feature related to the entire
Series B Preferred Stock issuance was $3.5 million. The recognition
of the beneficial conversion feature was contingent upon the approval of the
Company’s shareholders of the conversion of the Series B Preferred Stock to
common stock and thus was recognized in June 2010 when such approval was
received at the Company’s annual meeting of shareholders.
Heritage
Oaks Bancorp | - 69 -
|
Management’s Discussion and
Analysis
|
Upon
conversion of the Series B Preferred Stock the related beneficial conversion
feature was recorded in conjunction with the establishment of a discount on the
Series B Preferred Stock and a corresponding increase in additional paid in
capital. The immediate accretion of the entire Series B Preferred
Stock discount occurred through a charge to retained earnings on June 11, 2010,
the date the Company converted the outstanding Series B Preferred Stock to
common stock.
As is the
case with the Series B Preferred Stock, the fair market value of the Company’s
common stock was higher than the conversion price of $3.25 per share of the
Series C Preferred Stock on the date the Company made a firm commitment to issue
the Series C Preferred Stock. Therefore, the Series C Preferred Stock
also has a contingent beneficial conversion feature associated with
it. However, since the conversion of the Series C Preferred Stock
remains contingent upon the holder’s transfer of the securities to an
unaffiliated third party with no specified date for its conversion to common
stock, the Company will record the contingent beneficial conversion feature as
an initial discount on Series C Preferred Stock and additional paid in capital,
with a concurrent immediate accretion of the established discount and
corresponding charge to retained earnings on the date the Series C Preferred
Stock converts to common stock. The amount of the contingent
beneficial conversion feature is approximately $0.2 million and, will be
recognized as previously described, upon the original holder’s transfer of
Series C Preferred Stock to an unaffiliated third party.
U.S.
Treasury CPP Series A Senior Preferred Stock
On March
20, 2009, the Company issued $21.0 million in Series A Senior Preferred Stock to
the U.S. Treasury as part of its participation in the CPP. Pursuant to an
interim rule issued by the Federal Reserve Board, effective October 17, 2008,
all $21.0 million of preferred stock the Company issued under the CPP qualifies
as Tier I Capital. Under the terms of the CPP, the Company is
required to pay dividends on the Senior Preferred Stock in an amount equal to 5%
per annum for five years and 9% per annum thereafter. Dividends are
cumulative and payable quarterly. In the second quarter of 2010, the
Company notified the U.S. Treasury that pursuant to a Written Agreement entered
into between the Company and the Federal Reserve Bank of San Francisco, the
Company was required to defer dividend payments on its Senior Preferred
Stock. If the Company fails to pay dividends on Series A Senior
Preferred Stock for a total of six quarters, whether or not consecutive, the
U.S. Treasury will have the right to elect two members of the Company’s Board of
Directors, voting together with any other holders of preferred shares ranking
pari passu with the
Series A Senior Preferred Stock. These directors would serve on the Company’s
Board of Directors until such time as the Company has paid in full all dividends
not previously paid, at which time these directors’ terms of office would
immediately terminate.
Pursuant
to the terms outlined under the CPP, the Company issued a warrant to the U.S.
Treasury in an amount equal to 15% of the preferred issuance or approximately
$3.2 million (611,650 shares). The warrant is exercisable immediately
for a period of ten years at a price equal to the average closing price of the
Company’s common stock over the twenty day period ending the day prior to the
Company’s preliminary approval to participate in the CPP ($5.15 per
share).
For
additional information regarding the Company’s Series A Senior Preferred Stock
and its participation in the CPP, see Note 11 of the consolidated financial
statements filed on this Form 10-Q/A.
Dividends
During
the first six months of 2010, the Company paid a dividend of approximately $0.3
million on its Series A Senior Preferred Stock issued to the U.S. Treasury under
the CPP. The payment of this dividend occurred in the first quarter
of 2010.
As
mentioned above, the Company, pursuant to a Written Agreement between it and
Federal Reserve Bank of San Francisco was required to defer dividends payments
on the Senior Preferred Stock issued to the U.S. Treasury under the
CPP. For more information concerning the Written Agreement, please
refer to Note 12. Regulatory Order and Written Agreement of the consolidated
financial statements filed on this Form 10-Q/A.
The
Company paid no dividends on its common stock during the first six months of
2010.
Trust
Preferred Securities
On
October 27, 2006 the Company issued $8.2 million of Floating Rate Junior
Subordinated Debt Securities to Heritage Oaks Capital Trust II (“Trust II”), a
statutory trust created under the laws of the State of Delaware. The
debt securities issued to Trust II are subordinated to effectively all
borrowings of the Company. The Company used the proceeds from the
issuance for general corporate purposes, which included, but not limited:
capital contributions to the Bank, investments, payment of dividends, and
repurchases of our common stock.
On
September 20, 2007, the Company issued $5.2 million of Junior Subordinated
Deferrable Interest Debentures to Heritage Oaks Capital Trust III (“Trust III”),
a statutory trust created under the laws of the State of
Delaware. The Company used the proceeds from the issuance to assist
in the acquisition of Business First, for general corporate purposes, and for
capital contributions to the Bank for growth.
Heritage
Oaks Bancorp | - 70 -
|
Management’s Discussion and
Analysis
|
In June
2010 the Company announced it had used $3.3 million of the $4.0 million in
proceeds received from the second closing of its March 2010 private placement to
repurchase the $5.0 million in face amount trust preferred securities issued by
Heritage Oaks Capital Trust III, and the related junior subordinated debentures
issued by the Company. The repurchase resulted in a pre-tax gain of
approximately of $1.7 million. The repurchase was made pursuant to the
non-objection of the Federal Reserve Bank of San Francisco and approval of the
United States Treasury Department. The Company intends to dissolve
Heritage Oaks Capital Trust III in the second half of 2010.
At June
30, 2010, the Company had at total of $8.2 million in Junior Subordinated
Deferrable Interest Debentures issued and outstanding. As mentioned
in the preceding paragraphs, these securities have been issued to Trust
II. The debt securities are subordinated to effectively all
borrowings of the Company and can be redeemed at par if certain events occur
that impact the tax treatment, regulatory treatment or the capital treatment of
the issuance. Upon the issuance of the debt securities, the Company
purchased a 3.1% minority interest in Trust II, totaling $248
thousand. The balance of the equity of Trust II is comprised of
mandatory redeemable preferred securities and is included in other
assets. Interest associated with the securities issued to Trust II is
payable quarterly and varies at 3-month LIBOR plus 1.72%.
The
following table provides a summary of the securities the Company has issued to
Trust II as of June 30, 2010:
Amount
|
Current
|
Issue
|
Scheduled
|
Call
|
|||||||||||
(dollars in thousands)
|
Issued
|
Rate
|
Date
|
Maturity
|
Date
|
Rate Type
|
|||||||||
Heritage
Oaks Capital Trust II
|
$ | 8,248 | 2.01 | % |
27-Oct-06
|
Aug-37
|
Nov-11
|
Variable
3-month LIBOR + 1.72%
|
The
Company has the right under the indenture to defer interest payments for a
period not to exceed twenty consecutive quarterly periods (each an “Extension
Period”) provided that no extension period may extend beyond the maturity of the
debt securities. If the Company elects to defer interest payments
pursuant to terms of the agreements, then the Company may not (i) declare or pay
any dividends or distributions on, or redeem, purchase, acquire or make a
liquidation payment with respect to any of the Company’s capital stock, or (ii)
make any payment of principal or premium, if any, or interest on or repay,
repurchase or redeem any debt securities of the Company that rank pari passu
with or junior in interest to the Debt Securities, other than, among other
items, a dividend in the form of stock, warrants, options or other rights in the
same stock as that on which the dividend is being paid or ranks pari passu with
or junior to such stock. The prohibition on payment of dividends and
payments on pari passu or junior debt also applies in the case of an event of
default under the agreement.
Pursuant
to U.S. GAAP, the Company is not allowed to consolidate Trust II into the
Company’s financial statements. On February 28, 2005, the Federal
Reserve Board issued a rule which provides that, notwithstanding the
deconsolidation of such trusts, junior subordinated debentures, such as those
issued by the Company, may continue to constitute up to 25% of a bank holding
company's Tier I capital, subject to certain limitations which were to become
effective on March 31, 2009. However, on March 17, 2009, the Federal
Reserve Board issued a ruling to delay the effective date of limitations on
trust preferred securities until March 31, 2011. At June 30, 2010,
the Company included $8.0 million of the net junior subordinated debt in its
Tier I Capital for regulatory capital purposes.
At June
30, 2010, the Company had sufficient cash to service the $8.2 million in junior
subordinated debenture interest payments and other obligations, such as the
payment of dividends on the preferred stock issued to the U.S. Treasury, for
approximately 5.5 years without dividends from subsidiaries. However,
in the second quarter of 2010, the Company, in order to comply with the terms of
the Written Agreement entered into with the Federal Reserve Bank of San
Francisco, was required to defer interest payments on its trust preferred
securities. For more information concerning the Written Agreement, please refer
to Note 12. Regulatory Order and Written Agreement of the consolidated financial
statements filed on this Form 10-Q/A.
Regulatory
Capital Requirements
Capital
ratios for commercial banks in the United States are generally calculated using
three different formulas. These calculations are referred to as the
“Leverage Ratio” and two “risk-based” calculations known as: “Tier One Risk
Based Capital Ratio” and the “Total Risk Based Capital Ratio.” These
standards were developed through joint efforts of banking authorities from
different countries around the world. The standards essentially take
into account that different types of assets have different levels of risk
associated with them. Furthermore, they take into account the
off-balance sheet exposures of banks when assessing capital
adequacy.
The
Leverage Ratio calculation simply divides common stockholders’ equity (reduced
by any goodwill a bank may have) by the total assets. In the Tier One
Risk Based Capital Ratio, the numerator is the same as the leverage ratio, but
the denominator is the total “risk-weighted assets.” Risk weighted
assets are determined by segregating all the assets and off balance sheet
exposures into different risk categories and weighting them by a percentage
ranging from 0% (lowest risk) to 100% (highest risk). The Total Risk
Based Capital Ratio again uses “risk-weighted assets” in the denominator, but
expands the numerator to include other capital items besides equity such as a
limited amount of the loan loss reserve, long-term capital debt, preferred stock
and other instruments.
Heritage
Oaks Bancorp | - 71 -
|
Management’s Discussion and
Analysis
|
To be
categorized as well-capitalized, the Bank must maintain minimum capital ratios
as set forth in the table below. However, on February 26, 2010, the Bank
stipulated to the issuance of an Order that was issued March 4, 2010, by the
FDIC and DFI that requires higher levels of Tier I Leverage and Total Risk Based
ratios. Under the Order the Bank must maintain a Tier I Leverage
ratio of 10.0% and a Total Risk-Based Capital ratio of 11.5%. See
also Note 11. Regulatory Order and Written Agreement of the consolidated
financial statements for additional information related to the Consent Oder as
they pertain to these requirements.
The
following table provides a summary of Company and Bank regulatory capital ratios
at June 30, 2010 and 2009:
Regulatory Standard
|
June 30, 2010
|
June 30, 2009
|
||||||||||||||||||||||
Adequately
|
Well
|
Heritage Oaks
|
Heritage Oaks
|
|||||||||||||||||||||
Ratio
|
Capitalized
|
Capitalized
|
Bancorp
|
Bank
|
Bancorp
|
Bank
|
||||||||||||||||||
Leverage
ratio
|
4.00 | % | 5.00 | % | 11.89 | % | 11.34 | % | 10.87 | % | 10.33 | % | ||||||||||||
Tier
I capital to risk weighted assets
|
4.00 | % | 6.00 | % | 15.19 | % | 14.44 | % | 11.95 | % | 11.23 | % | ||||||||||||
Total
risk based capital to risk weighted assets
|
8.00 | % | 10.00 | % | 16.46 | % | 15.71 | % | 13.20 | % | 12.49 | % |
Regulatory
capital ratios as of June 30, 2010 fully reflect the $60.0 million in gross
proceeds the Company raised through the issuance of Series B and Series C
Preferred Stock in a private placement during the first six months of 2010.
Following the receipt of shareholder approval at the Company’s June 2010 annual
meeting, the Company converted to common stock all Series B Preferred shares
issued in its private placement. The conversion of preferred to
common stock is fully reflected in the capital ratios above. Following the
receipt of proceeds from the private placement, the Company down-streamed $48.0
million to the Bank as Tier I capital. These regulatory ratios also
fully reflect the issuance of $21.0 million in Series A Senior Preferred Stock
to the U.S. Treasury as part of the Company’s participation in the U.S.
Treasury’s CPP.
Liquidity
The
objective of liquidity management is to ensure the continuous availability of
funds to meet the demands of depositors, investors and
borrowers. Asset liquidity is primarily derived from loan payments
and the maturity of other earning assets. Liquidity from liabilities
is obtained primarily from the receipt of new deposits. The Bank’s
Asset Liability Committee (“ALCO”) is responsible for managing the on and
off-balance sheet commitments to meet the needs of customers while achieving the
Bank’s financial objectives. ALCO meets regularly to assess the
projected funding requirements by reviewing historical funding patterns, current
and forecasted economic conditions and individual customer funding
needs. Deposits generated from the Bank’s customers serve as the
primary source of liquidity. The Bank has credit arrangements with
correspondent banks that serve as a secondary liquidity source. At
June 30, 2010, these credit lines totaled $15.0 million and the Bank had no
borrowings against those lines. As previously mentioned the Bank is a
member of the FHLB and has collateralized borrowing capacities remaining of
approximately $69.0 million at June 30, 2010. Additionally, the Bank
has established and tested a borrowing facility with the Federal
Reserve. The amount of available credit is determined by the
collateral provided by the Bank at the time of a transaction.
The Bank
manages liquidity by maintaining a majority of the investment portfolio in
Interest Bearing Due from Federal Reserve and other liquid
investments. Most of these investments include obligations of state
and political subdivisions (municipal bonds) and mortgage related securities
that provide a relatively steady stream of cash flows. As of June 30,
2010, the Company believes investments in the portfolio can be liquidated at
their current fair values in the event they are needed to provide
liquidity. The ratio of liquid assets not pledged for collateral and
other purposes to deposits and other liabilities was 30.83% at June 30, 2010
compared to 20.50% at December 31, 2009. At June 30, 2010, the Bank
was within its internal guideline for liquidity. As of June 30, 2010
the fair market value of the Bank’s investment portfolio was approximately
$192.9 million, of which approximately $7.5 million was pledged to secure public
deposits and other purposes. The ratio of gross loans to deposits
(“LTD”), another key liquidity ratio, was 87.6% at June 30, 2010 compared to
94.0% at December 31, 2009 both of which are and were within the Bank’s policy
guidelines.
Heritage
Oaks Bancorp | - 72 -
|
Management’s
Discussion and Analysis
|
Inflation
The
assets and liabilities of a financial institution are primarily monetary in
nature. As such they represent obligations to pay or receive fixed
and determinable amounts of money that are not affected by future changes in
prices. Generally, the impact of inflation on a financial institution
is reflected by fluctuations in interest rates, the ability of customers to
repay their obligations and upward pressure on operating
expenses. Although inflationary pressures are not considered to be of
any particular hindrance in the current economic environment, they may however
have an impact on the Company’s future earnings in the event those pressures do
become more prevalent.
Off-Balance
Sheet Arrangements
Off-balance
sheet arrangements are any contractual arrangement to which an unconsolidated
entity is a party, under which the Company has: (1) any obligation under a
guarantee contract; (2) a retained or contingent interest in assets transferred
to an unconsolidated entity or similar arrangement that serves as credit,
liquidity or market risk support to that entity for such assets; (3) any
obligation under certain derivative instruments; or (4) any obligation under a
material variable interest held by the Company in an unconsolidated entity that
provides financing, liquidity, market risk or credit risk support to the
Company, or engages in leasing, hedging or research and development services
with the Company.
In the
ordinary course of business, the Company has entered into off-balance sheet
arrangements consisting of commitments to extend credit, commercial letters of
credit, and standby letters of credit. Such financial instruments are
recorded in the financial statements when they are funded or related fees are
incurred or received. For a more detailed discussion of these
financial instruments, refer to Note 11 to the Company’s Consolidated Financial
Statements under Item 8 of Part II of the Company’s December 31, 2009 Annual
Report filed on Form 10-K.
In the
ordinary course of business, the Bank is a party to various operating
leases. For a more detailed discussion of these financial
instruments, refer to Note 11 to the Company’s Consolidated Financial Statements
under Item 8 of Part II of the Company’s December 31, 2009 Annual Report filed
on Form 10-K.
In
connection with the $8.2 million in debt securities discussed under “Capital,” the Company issued
the full and unconditional payment guarantee of certain accrued
distributions.
Heritage
Oaks Bancorp | - 73 -
|
Item
3. Quantitative and Qualitative Disclosure About Market
Risk
As a
financial institution, the Company’s primary component of market risk is
interest rate volatility. Fluctuations in interest rates will ultimately impact
both the level of interest income and interest expense recorded on a large
portion of the Company’s assets and liabilities, and the market value of all
interest earning assets and interest bearing liabilities, other than those which
possess a short term to maturity. Virtually all of the Company’s interest
earning assets and interest bearing liabilities are located at the banking
subsidiary level. Thus, virtually all of the Company’s interest rate risk
exposure lies at the banking subsidiary level other than $8.2 million in
subordinated debentures issued by the Company’s subsidiary grantor trust. As a
result, all significant interest rate risk procedures are performed at the
banking subsidiary level. The subsidiary Bank’s real estate loan portfolio,
concentrated primarily within Santa Barbara and San Luis Obispo Counties,
California, are subject to risks associated with the local economy.
The
fundamental objective of the Company’s management of its assets and liabilities
is to maximize the Company’s economic value while maintaining adequate liquidity
and an exposure to interest rate risk deemed by Management to be acceptable.
Management believes an acceptable degree of exposure to interest rate risk
results from the management of assets and liabilities through maturities,
pricing and mix to attempt to neutralize the potential impact of changes in
market interest rates. The Company’s profitability is dependent to a large
extent upon its net interest income, which is the difference between its
interest income on interest earning assets, such as loans and investments, and
its interest expense on interest bearing liabilities, such as deposits and
borrowings. The Company is subject to interest rate risk to the degree that its
interest earning assets re-price differently than its interest bearing
liabilities. The Company manages its mix of assets and liabilities with the
goals of limiting its exposure to interest rate risk, ensuring adequate
liquidity, and coordinating its sources and uses of funds.
The
Company seeks to control interest rate risk exposure in a manner that will allow
for adequate levels of earnings and capital over a range of possible interest
rate environments. The Company has adopted formal policies and practices to
monitor and manage interest rate risk exposure. Management believes
historically it has effectively managed the effect of changes in interest rates
on its operating results and believes that it can continue to manage the
short-term effect of interest rate changes under various interest rate
scenarios.
Management
employs the use of an Asset and Liability Management software that is used to
measure the Bank’s exposure to future changes in interest rates. This model
measures the expected cash flows and re-pricing of each financial
asset/liability separately in measuring the Bank’s interest rate
sensitivity. Based on the results of this model, Management believes
the Bank’s balance sheet is to a large extent “asset sensitive.” This
means the Company expects (all other things being equal) to expand its net
interest income if rates rise and expects it conversely to contract if rates
fall. The level of potential or expected contraction indicated by the
tables below is considered acceptable by Management and is compliant with the
Bank’s ALCO policies. Management will continue to perform this analysis
each quarter to further validate the expected results against actual
data.
The
hypothetical impacts of sudden interest rate movements applied to the Company’s
asset and liability balances are modeled monthly. The results of these models
indicate how much of the Company’s net interest income is “at risk” from various
rate changes over a one year horizon. This exercise is valuable in identifying
risk exposures. Management believes the results for the Company’s June 30, 2010
balances indicate that the net interest income at risk over a one year time
horizon for a 1% and 2% rate increase and decrease is acceptable and within
policy guidelines at this time.
The
results in the table below indicate the change in net interest income the
Company would expect to see as of June 30, 2010, if interest rates were to
change in the amounts set forth:
Rate Shock Scenarios
|
||||||||||||||||||||
(dollars in thousands)
|
-200bp
|
-100bp
|
Base
|
+100bp
|
+200bp
|
|||||||||||||||
Net
interest income (NII)
|
$ | 42,971 | $ | 43,333 | $ | 43,315 | $ | 43,259 | $ | 43,347 | ||||||||||
$
Change from base
|
$ | (344 | ) | $ | 18 | $ | - | $ | (56 | ) | $ | 32 | ||||||||
%
Change from base
|
-0.79 | % | 0.04 | % | 0.00 | % | -0.13 | % | 0.07 | % |
It is
important to note that the above table is a summary of several forecasts and
actual results may vary. The forecasts are based on estimates and assumptions of
Management that may turn out to be different and may change over time. Factors
affecting these estimates and assumptions include, but are not limited to 1)
competitor behavior, 2) economic conditions both locally and nationally, 3)
actions taken by the Federal Reserve Board, 4) customer behavior and 5)
Management’s responses. Changes that vary significantly from the assumptions and
estimates may have significant effects on the Company’s net interest income;
therefore, the results of this analysis should not be relied upon as indicative
of actual future results.
Heritage
Oaks Bancorp | - 74 -
|
The
following tables show Management’s estimates of how the loan portfolio is broken
out between variable-daily, variable at various time lines, fixed rate loans and
estimates of re-pricing opportunities for the entire loan portfolio at June 30,
2010:
(dollars
in thousands)
|
||||||||
Percent of
|
||||||||
Rate Type
|
Balance
|
Total
|
||||||
Variable
- daily
|
$ | 234,498 | 33.6 | % | ||||
Variable
other than daily
|
330,039 | 47.4 | % | |||||
Fixed
rate
|
132,639 | 19.0 | % | |||||
Total
gross loans
|
$ | 697,176 | 100.0 | % |
The table
above identifies approximately 33.6% of the loan portfolio that will re-price
immediately in a changing rate environment. At June 30, 2010,
approximately $564.5 million or 81.0% of the Bank’s loan portfolio is considered
variable.
(dollars in thousands)
|
||||||||
Percent of
|
||||||||
Re-Pricing
|
Balance
|
Total
|
||||||
<
1 Year
|
$ | 358,265 | 51.4 | % | ||||
1-3
Years
|
188,865 | 27.1 | % | |||||
3-5
Years
|
105,904 | 15.2 | % | |||||
>
5 Years
|
44,142 | 6.3 | % | |||||
Total
gross loans
|
$ | 697,176 | 100.0 | % |
The
following table provides a summary of the loans the Bank can expect to see come
off their floors if the Prime rate were to increase by the amounts identified
below as of June 30, 2010:
Move in Prime Rate (bps)
|
||||||||||||||||
(dollars in thousands)
|
+200
|
+250
|
+300
|
+350
|
||||||||||||
Variable
daily
|
$ | 850 | $ | 10,366 | $ | 56,457 | $ | 116,342 | ||||||||
Variable
other than daily
|
2,440 | 15,656 | 62,903 | 175,816 | ||||||||||||
Cumulative
total variable at floor
|
$ | 3,290 | $ | 26,022 | $ | 119,360 | $ | 292,158 |
Given the
significant decline in Prime rate over the last two years, many loans in the
portfolio possess floors significantly higher than the current Prime
rate. Therefore, the Bank will need to see rates increase
significantly before the majority of loans in the portfolio start to come off
their floors.
Item
4. Controls and Procedures
Evaluation
of Disclosure Controls and Procedures
As of the
end of the period covered by this report, the Company carried out an evaluation,
under the supervision and with the participation of its Management, including
the Company’s Chief Executive Officer and Chief Financial Officer, of the
effectiveness of the design and operation of the Company’s disclosure controls
and procedures pursuant to Exchange Act Rules 13a-15 and 15d-15. Based upon that
evaluation, the Chief Executive Officer and Chief Financial Officer concluded
that the Company’s disclosure controls and procedures are effective to provide
reasonable assurances that information required to be disclosed in the reports
the Company files or submits under the Securities Exchange Act of 1934 is
recorded, processed, summarized and reported within the time periods specified
in the SEC’s rules and forms.
Heritage
Oaks Bancorp | - 75 -
|
In
connection with the revision to the consolidated financial statements as
described in the Explanatory Note of this Amendment No. 1, Management
reevaluated the effectiveness of the design and operation of the Company’s
disclosure controls and procedures as of June 30, 2010. In connection therewith,
Management identified a material weakness in internal control over financial
reporting. Management determined that the Company did not maintain
effective control over the financial reporting process utilized to interpret the
applicable accounting literature for computing and allocating the amount
attributable to the contingent beneficial conversion feature related to the
issuance of Series B Preferred Stock as well as the disclosure of the contingent
beneficial conversion feature related to the Series C Preferred Stock, as more
fully described in the Explanatory Note on page 2 of this Form 10-Q/A.
Management believes this control deficiency resulted in a misstatement of the
net loss applicable to common shareholders. As a result of this material
weakness, Management concluded that the Company’s disclosure controls were not
effective as of June 30, 2010. In light of the material weakness described
above, Management revised its consolidated financial statements in this Form
10-Q/A as discussed previously to ensure that the computation and allocation of
the beneficial conversion feature related to the Series B Preferred Stock and
the disclosure of the contingent beneficial conversion feature associated with
the Series C Preferred Stock was in conformity with the applicable accounting
guidance. Management also believes that the consolidated financial
statements included in this Form 10-Q/A were prepared in accordance with U.S.
generally accepted accounting principles (GAAP) in all material
respects.
Remediation
of Material Weakness
The
Company is in the process of actively remediating this material
weakness. The Company’s will focus remediation efforts on
establishing additional financial reporting processes when events or
transactions occur outside of the Company’s usual and routine course of
business.
Management
believes the additional control procedure, upon implementation, will remediate
this material weakness. Management will validate, through testing of
internal controls, the effectiveness of this remediation. However,
the effectiveness of any system of internal controls is subject to inherent
limitations and there can be no assurance that the Company’s internal control
over financial reporting will prevent or detect all errors. The
Company will continue to evaluate and strengthen its internal control over
financial reporting system in order to prevent future errors in financial
reporting.
Changes
in Internal Control Over Financial Reporting
There was
no change in the Company’s internal controls over financial reporting during the
quarter ended June 30, 2010 that has materially affected, or is reasonably
likely to materially affect, the Company’s internal controls over financial
reporting. However, as of the date of this report, and as mentioned above,
Management is in the process of remediating the material weakness disclosed
above. Upon completion of these remediation efforts, Management
believes that the material weakness it has identified will be remediated by the
quarter ended December 31, 2010.
In
designing and evaluating disclosure controls and procedures, the Company’s
Management recognized that any controls and procedures, no matter how well
designed and operated, can provide only reasonable, not absolute, assurances of
achieving the desired control objectives and Management necessarily was required
to apply its judgment in evaluating the cost-benefit relationship of possible
controls and procedures.
Part
II. Other Information
Item
1. Legal Proceedings
The Bank
is party to the following litigation:
Alpert,
et al v. Cuesta Title Company, et al. San Luis Obispo County Sup. Ct. Case
no. CV 098220. Plaintiffs have sued a title company, title
insurer, Hurst Financial and related individuals on a variety of
claims related to Hurst Financial's lending practices. The Bank, which
made a commercial loan to a developer which also borrowed from Hurst Financial,
is named in two causes of action alleging (1) negligence and (2) aiding and
abetting Hurst Financial's allegedly illegal lending practices.
The Bank did not lend to any of the plaintiffs or to Hurst Financial, nor
did the Bank have any contact whatsoever with the plaintiffs in relation to
their transactions with Hurst Financial. The Bank has foreclosed upon
and now owns one of the properties Hurst Financial purportedly financed for the
developer using funds raised from the plaintiffs. The Bank believes
the action against it is without merit. The matter has been tendered to
the Bank's insurance carrier, and the Bank is actively defending the case.
The Bank anticipates a favorable outcome to the case and does not expect the
litigation to have any significant financial impact to the Bank.
Gardality
v. Heritage Oaks Bank, et al. San Diego County Sup. Ct. Case no.
37-2010-00055218-CU-NC. Plaintiff has sued the Bank and 157 other
defendants. The pleading indicates the plaintiff’s claim is connected to
funds he borrowed from Estate Financial, Inc. (“EFI”) as the developer of a real
estate project. EFI was a customer of the Bank and is now a debtor in a
bankruptcy proceeding. The complaint is poorly written and legally
deficient to the point where it is impossible to determine the nature or
validity of the claim. The Bank had no contact with the plaintiff prior to
service of the complaint and believes that plaintiff’s action against it is
without merit. The matter has been tendered to the Bank’s insurance
carrier and the Bank is actively defending the case. The Bank currently
anticipates a favorable outcome to the matter and does not expect the litigation
to have any significant financial impact to the Bank.
Heritage
Oaks Bancorp | - 76 -
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Except as
indicated above, neither the Company nor the Bank is involved in any legal
proceedings other than routine legal proceedings occurring in the ordinary
course of business. Such routine legal proceedings, in the aggregate, are
believed by Management to be immaterial to the financial condition, results of
operations and cash flows of the Company as of June 30, 2010.
Item
1A. Risk Factors
During
the period covered by this report there were no material changes from risk
factors as previously disclosed in the Company’s December 31, 2009 Annual Report
filed on Form 10-K in response to Item A to Part I of Form
10-K.
Item
2. Unregistered Sales of Equity Securities and Use of
Proceeds
Unregistered
Sale of Equity Securities
Information
required by this item is incorporated here by reference to the Company’s 8-K
filings with the SEC on March 10, 2010, March 12, 2010 and June 10, 2010,
Commission File Number 000-25020.
Purchases
of Equity Securities
None.
Item
3. Defaults upon Senior Securities
(a)
|
None.
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(b)
|
In
the second quarter of 2010 the Company was required to defer dividend
payments on its Series A Senior Preferred Stock issued to the U.S.
Treasury under the CPP in order to comply with the terms of the Written
Agreement entered into between the Company and the Federal Reserve Bank of
San Francisco. For more information concerning the Written
Agreement, please refer to Note 12. Regulatory Order and Written Agreement
of the consolidated financial statements filed on this Form
10-Q/A. As of June 30, 2010, the Company has deferred one
dividend payment on its Series A Senior Preferred Stock totaling
approximately $0.3 million.
|
Item
4. (Removed and Reserved)
None.
Item
5. Other Information
Not
applicable.
Heritage
Oaks Bancorp | - 77 -
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Item
6. Exhibits
(a)
Exhibits:
Exhibit
(31.1)
|
Certification
of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002
|
Exhibit
(32.1)
|
Certification
of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002
|
Heritage
Oaks Bancorp | - 78 -
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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
Oaks Bancorp
Date:
September
24,
2010
Heritage
Oaks Bancorp | - 79 -
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