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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

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

For the quarterly period ended June 30, 2014

 

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

For the transition period from                     to                    

 

 

CU BANCORP

(Exact name of registrant as specified in its charter)

 

 

 

California   90-0779788
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)
15821 Ventura Boulevard, Suite 110
Encino, California
  91436
(Address of principal executive offices)   (Zip Code)

(818) 257-7700

(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 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 Web site, 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  x    No  ¨

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

 

Large Accelerated Filer   ¨    Accelerated Filer   x
Non Accelerated Filer   ¨    Smaller reporting company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of August 1, 2014 the number of shares outstanding of the registrant’s no par value Common Stock was 11,222,235.

 

 

 


Table of Contents

CU BANCORP

June 30, 2014 FORM 10-Q

TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION

  

ITEM 1.

  Financial Statements   
 

Consolidated Balance Sheets June 30, 2014 (Unaudited) and December 31, 2013

     3   
 

Consolidated Statements of Income Three and Six Months Ended June 30, 2014 and 2013 (Unaudited)

     4   
 

Consolidated Statements of Comprehensive Income Three and Six Months Ended June 30, 2014 and 2013 (Unaudited)

     5   
 

Consolidated Statements of Changes in Shareholders’ Equity Year Ended December 31, 2013 and Six Months Ended June 30, 2014 (Unaudited)

     6   
 

Consolidated Statements of Cash Flows Six Months Ended June 30, 2014 and 2013 (Unaudited)

     7   
 

Notes to the Consolidated Financial Statements (Unaudited)

     9   

ITEM 2.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations      41   
  Overview      45   
  Results of Operations      48   
  Financial Condition      58   
  Liquidity      63   
  Dividends      64   
  Capital Resources      65   

ITEM 3.

  Quantitative and Qualitative Disclosures About Market Risk      67   

ITEM 4.

  Controls and Procedures      68   

PART II. OTHER INFORMATION

  

ITEM 1.

  Legal Proceedings      69   

ITEM 1A. 

  Risk Factors      69   

ITEM 2.

  Unregistered Sales of Equity Securities and Use of Proceeds      69   

ITEM 3.

  Defaults Upon Senior Securities      69   

ITEM 4.

  Mine Safety Disclosures      69   

ITEM 5.

  Other Information      69   

ITEM 6.

  Exhibits      69   

Signatures 

       70   

 

Page 2 of 70


Table of Contents

CU BANCORP

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands)

 

     June 30,
2014
    December 31,
2013
 
     (Unaudited)     (Audited)  

ASSETS

    

Cash and due from banks

   $ 40,657      $ 23,156   

Interest earning deposits in other financial institutions

     179,409        218,131   
  

 

 

   

 

 

 

Total Cash and Cash Equivalents

     220,066        241,287   

Certificates of deposit in other financial institutions

     64,577        60,307   

Investment securities available-for-sale, at fair value

     102,143        106,488   

Loans

     979,890        933,194   

Allowance for loan loss

     (11,284     (10,603
  

 

 

   

 

 

 

Net loans

     968,606        922,591   

Other real estate owned, net

     219        —     

Premises and equipment, net

     3,785        3,531   

Deferred tax assets, net

     11,018        11,835   

Goodwill

     12,292        12,292   

Core deposit and leasehold right intangibles

     2,349        2,525   

Bank owned life insurance

     21,507        21,200   

Accrued interest receivable and other assets

     23,751        25,760   
  

 

 

   

 

 

 

Total Assets

   $ 1,430,313      $ 1,407,816   
  

 

 

   

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

    

LIABILITIES

    

Non-interest bearing demand deposits

   $ 682,300      $ 632,192   

Interest bearing transaction accounts

     143,312        155,735   

Money market and savings deposits

     361,936        380,915   

Certificates of deposit

     57,732        63,581   
  

 

 

   

 

 

 

Total deposits

     1,245,280        1,232,423   

Securities sold under agreements to repurchase

     13,852        11,141   

Subordinated debentures, net

     9,459        9,379   

Accrued interest payable and other liabilities

     16,284        16,949   
  

 

 

   

 

 

 

Total Liabilities

     1,284,875        1,269,892   
  

 

 

   

 

 

 

Commitments and Contingencies (Note 14)

     —          —     

SHAREHOLDERS’ EQUITY

    

Serial Preferred Stock – authorized, 50,000,000 shares no par value, no shares issued or outstanding

     —          —     

Common stock – authorized, 75,000,000 shares no par value, 11,222,235 and 11,081,364 shares issued and outstanding at June 30, 2014 and December 31, 2013, respectively

     122,760        121,675   

Additional paid-in capital

     9,354        8,377   

Retained earnings

     13,129        8,077   

Accumulated other comprehensive income (loss)

     195        (205
  

 

 

   

 

 

 

Total Shareholders’ Equity

     145,438        137,924   
  

 

 

   

 

 

 

Total Liabilities and Shareholders’ Equity

   $ 1,430,313      $ 1,407,816   
  

 

 

   

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

Page 3 of 70


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CU BANCORP

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

(Dollars in thousands, except per share data)

 

    

Three Months

Ended

June 30,

    

Six Months

Ended

June 30,

 
  

 

 

    

 

 

    

 

 

    

 

 

 
     2014      2013      2014      2013  

Interest Income

           

Interest and fees on loans

   $ 12,366       $ 12,462       $ 24,290       $ 23,887   

Interest on investment securities

     467         495         968         979   

Interest on interest bearing deposits in other financial institutions

     206         157         417         317   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Interest Income

     13,039         13,114         25,675         25,183   
  

 

 

    

 

 

    

 

 

    

 

 

 

Interest Expense

           

Interest on interest bearing transaction accounts

     66         64         124         116   

Interest on money market and savings deposits

     222         249         456         509   

Interest on certificates of deposit

     55         74         111         150   

Interest on securities sold under agreements to repurchase

     11         21         19         40   

Interest on subordinated debentures

     107         126         214         250   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Interest Expense

     461         534         924         1,065   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net Interest Income

     12,578         12,580         24,751         24,118   

Provision for loan losses

     408         1,153         483         1,287   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net Interest Income After Provision For Loan Losses

     12,170         11,427         24,268         22,831   
  

 

 

    

 

 

    

 

 

    

 

 

 

Non-Interest Income

           

Gain on sale of securities, net

     —           —           —           5   

Gain on sale of SBA loans, net

     167         60         605         410   

Deposit account service charge income

     630         583         1,260         1,151   

Other non-interest income

     986         1,047         1,708         1,550   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Non-Interest Income

     1,783         1,690         3,573         3,116   
  

 

 

    

 

 

    

 

 

    

 

 

 

Non-Interest Expense

           

Salaries and employee benefits (includes stock based compensation expense of $479 and $217 for the three months, and $887 and $475 for the six months ended June 30, 2014 and 2013, respectively)

     5,807         5,655         11,820         11,330   

Occupancy

     985         1,019         1,971         2,083   

Data processing

     476         479         951         961   

Legal and professional

     411         572         934         1,079   

FDIC deposit assessment

     180         189         401         435   

Merger related expenses

     497         —           497         43   

OREO valuation write-downs and expenses

     6         23         6         49   

Office services expenses

     238         259         502         525   

Other operating expenses

     1,098         1,085         2,165         2,085   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Non-Interest Expense

     9,698         9,281         19,247         18,590   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net Income Before Provision for Income Tax Expense

     4,255         3,836         8,594         7,357   

Provision for income tax expense

     1,869         1,515         3,542         2,881   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net Income

   $ 2,386       $ 2,321       $ 5,052       $ 4,476   
  

 

 

    

 

 

    

 

 

    

 

 

 

Earnings Per Share

           

Basic earnings per share

   $ 0.22       $ 0.22       $ 0.46       $ 0.43   

Diluted earnings per share

   $ 0.21       $ 0.22       $ 0.45       $ 0.42   

The accompanying notes are an integral part of these consolidated financial statements.

 

Page 4 of 70


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CU BANCORP

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

(In thousands)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2014      2013     2014      2013  

Net Income

   $ 2,386       $ 2,321      $ 5,052       $ 4,476   

Other Comprehensive Income, net of tax:

          

Non-credit portion of other-than-temporary impairments arising during the period

     —           —          —           (22

Net unrealized gains (losses) on investment securities arising during the period

     242         (734     400         (786
  

 

 

    

 

 

   

 

 

    

 

 

 

Other Comprehensive Income (Loss)

     242         (734     400         (808
  

 

 

    

 

 

   

 

 

    

 

 

 

Comprehensive Income

   $ 2,628       $ 1,587      $ 5,452       $ 3,668   
  

 

 

    

 

 

   

 

 

    

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

Page 5 of 70


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CU BANCORP

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

For the Year Ended December 31, 2013 and the Six Months Ended June 30, 2014

(2014 activity unaudited)

(Dollars and shares in thousands)

 

     Common Stock                           
     Outstanding
Shares
    Amount      Additional
Paid in
Capital
    Retained
Earnings

(Deficit)
    Accumulated
Other
Comprehensive
Income (Loss)
    Total
Shareholders’
Equity
 

Balance at December 31, 2012

     10,759      $ 118,885       $ 7,052      $ (1,708   $ 1,394      $ 125,623   

Net Issuance of Restricted Stock

     69        —           —          —          —          —     

Exercise of Stock Options

     282        2,790         —          —          —          2,790   

Stock based compensation expense related to employee stock options and restricted stock

     —          —           1,088        —          —          1,088   

Restricted Stock Repurchase

     (29     —           (422     —          —          (422

Excess tax benefit – stock based compensation

     —          —           659        —          —          659   

Net Income

     —          —           —          9,785        —          9,785   

Other Comprehensive (Loss)

     —          —           —          —          (1,599     (1,599
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2013

     11,081      $ 121,675       $ 8,377      $ 8,077      $ (205   $ 137,924   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Net Issuance of Restricted Stock

     45        —           —          —          —          —     

Exercise of Stock Options

     110        1,085         —          —          —          1,085   

Stock based compensation expense related to employee stock options and restricted stock

     —          —           887        —          —          887   

Restricted Stock Repurchase

     (14     —           (242     —          —          (242

Excess tax benefit – stock based compensation

     —          —           332        —          —          332   

Net Income

     —          —           —          5,052        —          5,052   

Other Comprehensive Income

     —          —           —          —          400        400   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Balance at June 30, 2014

     11,222      $ 122,760       $ 9,354      $ 13,129      $ 195      $ 145,438   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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CU BANCORP

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(Dollars in thousands)

 

     Six Months Ended
June 30,
 
     2014     2013  

Cash flows from operating activities:

    

Net income:

   $ 5,052      $ 4,476   

Adjustments to reconcile net income to net cash provided by operating activities:

    

Provision for loan losses

     483        1,287   

Provision for unfunded loan commitments

     73        34   

Stock based compensation expense

     887        475   

Depreciation

     479        568   

Net accretion of discounts/premiums for loans acquired and deferred loan fees/costs

     (2,690     (3,071

Net amortization from investment securities

     779        840   

Increase in bank owned life insurance

     (307     (308

Amortization of core deposit intangibles

     138        166   

Amortization of time deposit premium

     (13     (106

Net amortization of leasehold right intangible asset and liabilities

     151        (285

Accretion of subordinated debenture discount

     80        114   

Gain on sale of securities, net

     —          (5

Gain on sale of SBA loans, net

     (605     (410

Decrease in deferred tax assets

     538        1,228   

(Increase) decrease in accrued interest receivable and other assets

     2,009        (390

Increase (decrease) in accrued interest payable and other liabilities

     (457     314   

Decrease in fair value of derivative swap liability

     (394     (1,482
  

 

 

   

 

 

 

Net cash provided by operating activities

     6,203        3,445   
  

 

 

   

 

 

 

Cash flows from investing activities:

    

Purchases of available-for-sale investment securities

     (6,215     (20,395

Proceeds from sales of available-for-sale investment securities

     —          2,854   

Proceeds from repayment and maturities from available-for-sale investment securities

     10,460        23,531   

Loans originated, net of principal payments

     (43,422     (27,339

Purchases of premises and equipment

     (733     (339

Net increase in certificates of deposit in other financial institutions

     (4,270     (1,298

Net purchase of Federal Home Loan Bank and other bank stock

     —          150   
  

 

 

   

 

 

 

Net cash (used in) investing activities

     (44,180     (22,836
  

 

 

   

 

 

 

Cash flows from financing activities:

    

Net increase in Non-interest bearing demand deposits

     50,108        27,518   

Net increase (decrease) in Interest bearing transaction accounts

     (12,423     14,838   

Net decrease in Money market and savings deposits

     (18,979     (1,581

Net decrease in Certificates of deposit

     (5,836     (21,038

Net increase in Securities sold under agreements to repurchase

     2,711        6,755   

Net proceeds from stock options exercised

     1,085        53   

Restricted stock repurchase

     (242     (283

Net excess in tax benefit on stock compensation

     332        31   
  

 

 

   

 

 

 

Net cash provided by financing activities

     16,756        26,293   
  

 

 

   

 

 

 

Net increase (decrease) in cash and cash equivalents

     (21,221     6,902   

Cash and cash equivalents, beginning of year

     241,287        182,896   
  

 

 

   

 

 

 

Cash and cash equivalents, end of year

   $ 220,066      $ 189,796   
  

 

 

   

 

 

 

 

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CU BANCORP

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(Unaudited)

(Dollars in thousands)

 

     Six Months Ended
June 30,
 
     2014      2013  

Supplemental disclosures of cash flow information:

     

Cash paid during the period for interest

   $ 849       $ 1,074   

Cash paid during the period for taxes

   $ 750       $ 1,304   

Supplemental disclosures of non-cash investing activities:

     

Net increase (decrease) in unrealized gain or loss on investment securities, net of tax

   $ 400       $ (808

Loans transferred to other real estate owned

   $ 219       $ —     

The accompanying notes are an integral part of these consolidated financial statements

 

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CU BANCORP

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2014

(Unaudited)

Note 1 - Basis of Financial Statement Presentation

CU Bancorp (the “Company”) is a bank holding company whose operating subsidiary is California United Bank. CU Bancorp was established to facilitate the reorganization and merger of Premier Commercial Bank, N.A. into California United Bank, which took place after the close of business on July 31, 2012. As a bank holding company, CU Bancorp is subject to regulation of the Federal Reserve Board (“FRB”). The term “Company”, as used throughout this document, refers to the consolidated balance sheets and consolidated statements of income of CU Bancorp and California United Bank.

California United Bank (the “Bank”) is a full-service commercial business bank offering a broad range of banking products and services including: deposit services, lending and cash management to small and medium-sized businesses in Los Angeles, Orange and Ventura counties, to non-profit organizations, to business principals and entrepreneurs, to the professional community, including attorneys, certified public accountants, financial advisors, healthcare providers and investors. The Bank opened for business in 2005, with its headquarters office located in Encino, California. As a state chartered non-member bank, the Bank is subject to regulation by the California Department of Business Oversight, (the “DBO”) and the Federal Deposit Insurance Corporation (“FDIC”). The deposits of the Bank are insured by the FDIC, to the maximum amount allowed by law.

On June 3, 2014, CU Bancorp and 1st Enterprise Bank (“1st Enterprise”) announced the execution of a definitive agreement and plan of merger whereby 1st Enterprise will merge into California United Bank in a transaction valued at approximately $102.2 million. The transaction combines two of the leading commercial banking franchises in Southern California with more than $2.2 billion in combined assets which operate offices in Los Angeles, Orange, Ventura and San Bernardino counties. California United Bank will survive the merger and will continue the commercial banking operations of the combined bank following the merger. The transaction is intended to qualify as a tax-free reorganization under the applicable provision of the Internal Revenue Code and 1st Enterprise shareholders who receive shares of CU Bancorp common stock in the merger should not recognize any taxable gain on the exchange. Shareholders of 1st Enterprise will receive a fixed exchange ratio at closing of 1.3450 shares of CU Bancorp common stock for each share of 1st Enterprise common stock. Based on the CU Bancorp stock price as of August 1, 2014, total consideration for each 1st Enterprise share would be $25.00.

The consolidated financial statements include the accounts of the Company and the Bank. Significant intercompany items have been eliminated in consolidation. The accounting and reporting policies of the Company conform to U.S. generally accepted accounting principles (“GAAP”) and pursuant to the rules and regulations of the Securities and Exchange Commission.

CU Bancorp is the common shareholder of Premier Commercial Statutory Trust I, Premier Commercial Statutory Trust II, and Premier Commercial Statutory Trust III, entities which were acquired in the merger with Premier Commercial Bancorp (“PC Bancorp”). These trusts were established for the sole purpose of issuing trust preferred securities and do not meet the criteria for consolidation in accordance with ASC 810 Consolidation. For more detail, see Note 8 – Borrowings and Subordinated Debentures.

Certain information and footnote disclosures presented in the annual consolidated financial statements are not included in the interim consolidated financial statements. Accordingly, the accompanying unaudited interim consolidated financial statements should be read in conjunction with the Company’s 2013 Annual Report on Form 10-K. In the opinion of management, the accompanying financial statements contain all necessary adjustments of a normal recurring nature, to present fairly the consolidated financial position of the Company and the results of its operations for the interim period presented.

Use of Estimates in the Preparation of Financial Statements

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. In addition, these accounting principles require the disclosure of contingent assets and liabilities as of the date of the financial statements.

 

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Estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan loss and various assets and liabilities measured at fair value. While management uses the most current available information to recognize losses on loans, future additions to the allowance for loan loss may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan loss. Regulatory agencies may require the Company to recognize additions to the allowance for loan loss based on their judgment about information available to them at the time of their examination.

Business Segments

The Company is organized and operated as a single reporting segment, principally engaged in commercial business banking. The Company conducts its lending and deposit operations through eight full service branch offices located in Los Angeles, Orange, and Ventura counties.

Note 2 - Recent Accounting Pronouncements

In January 2014, the FASB issued ASU No. 2014-01, Investments – Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects (a consensus of the FASB Emerging Issues Task Force). ASU 2014-01 modifies the conditions that a reporting entity must meet to be eligible to use a method other than the equity or cost methods to account for qualified affordable housing project investments. If the modified conditions are met, the amendments permit an entity to amortize the initial cost of the investment in proportion to the amount of the tax credits and other tax benefits received and recognize the net investment performance in the income statement as a component of income tax expense (benefit). Additionally, ASU 2014-01 introduces new recurring disclosures about all investments in qualified affordable housing projects irrespective of the method used to account for the investments. Prior to these amendments, a reporting entity that invests in qualified affordable housing projects may elect to account for that investment using the level yield method if specific conditions are met. For investments that are not accounted for using the effective yield method, the investment must be accounted for under either the equity method or the cost method. Because the conditions which allow an entity to utilize the effective yield method were overly restrictive, this prevented many investors from using the effective yield method. Under the effective yield method, all tax credits, tax benefits, and the write-down of the investments are accounted for net of taxes as a component of income tax expense (benefit). This method more fairly represents the economics of the transaction than accounting under the equity method or cost method. The amendments in ASU 2014-01 are expected to enable more entities to qualify for the proportional amortization method to account for affordable housing project investments than the number of entities that currently qualify for the effective yield method. The amendments are effective for public business entities for annual periods and interim reporting periods within those annual periods, beginning after December 15, 2014. For all entities other than public business entities, the amendments are effective for annual periods beginning after December 15, 2014, and interim periods within annual reporting periods beginning after December 15, 2015. Early adoption is permitted. The Company early adopted ASU 2014-01 in the fourth quarter of 2013. See Note 11 – Investments in Qualified Affordable Housing Projects, in the Company’s 2013 Form 10-K, for the Company’s disclosures on its investments in LIHTC projects required under ASU 2014-01.

In January 2014, the FASB issued ASU No. 2014-04, Receivables – Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon foreclosure (a consensus of the FASB Emerging Issues Task Force). The objective of this Update is to reduce diversity in practice by clarifying when an in substance repossession or foreclosure occurs, that is, when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan such that the loan receivable should be derecognized and the real estate property recognized. ASU 2014-04 clarifies that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, the amendments require interim and annual disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. These amendments are effective for public business entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. For entities other than public business entities, the amendments are effective for annual periods beginning after December 15, 2014, and interim periods within annual periods beginning after December 15, 2015. An entity can elect to adopt these amendments using either a modified retrospective transition method or a prospective transition method. Early adoption is permitted. We do not expect the adoption of this ASU to have a material impact on the Company’s financial position or results of operations.

 

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In June 2014, the FASB issued ASU No. 2014-11, Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures, to address investor concerns about the distinction in generally accepted accounting principles between repurchase agreements that settle at the same time as the maturity of the transferred financial asset and those that settle any time before maturity. ASU 2014-11 aligns the accounting for repurchase-to-maturity transactions and repurchase agreements executed as a repurchase financing with the accounting for other typical repurchase agreements. Going forward, these transactions all will be accounted for as secured borrowings. The new guidance eliminates sale accounting for repurchase-to-maturity transactions and supersedes the guidance under which a transfer of a financial asset and a contemporaneous repurchase financing could be accounted for on a combined basis as a forward agreement, which has resulted in outcomes referred to as off-balance-sheet accounting. ASU 2014-11 also requires a new disclosure for transactions economically similar to repurchase agreements in which the transferor retains substantially all of the exposure to the economic return on the transferred financial assets throughout the term of the transaction. Further, the ASU requires expanded disclosures about the nature of collateral pledged in repurchase agreements and similar transactions accounted for as secured borrowings. The accounting changes are effective for public companies for the first interim or annual period beginning after December 15, 2014. In addition, for public companies, the disclosure for certain transactions accounted for as a sale is effective for the first interim or annual period beginning after December 15, 2014, and the disclosure for transactions accounted for as secured borrowings is required to be presented for annual periods beginning after December 15, 2014, and interim periods beginning after March 15, 2014. For all other entities, all changes are effective for annual periods beginning after December 14, 2014, and interim periods beginning after December 15, 2015. Earlier application for a public company is prohibited, but all other companies and organizations may elect to apply the requirements for interim periods beginning after December 15, 2014. We do not expect the adoption of this ASU to have an impact on the Company’s financial position or results of operations.

 

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Note 3 - Computation of Book Value and Tangible Book Value per Common Share

The Company utilizes the term Tangible Common Equity (“TCE”), a non-GAAP financial measure. Management believes that TCE is useful because it is a measure utilized by both regulators and market analysts in evaluating a consolidated bank holding company’s financial condition and capital strength. TCE represents common shareholders’ equity less goodwill and certain intangible assets.

Book value per common share was calculated by dividing total shareholders’ equity by the number of common shares issued and outstanding. Tangible book value per common share was calculated by dividing tangible common equity by the number of common shares issued and outstanding.

The table below presents the computation of TCE, book value and tangible book value per common share as of the dates indicated (dollars in thousands, except share and per share data):

 

     June 30,
2014
     December 31,
2013
 

Total Shareholders’ Equity

   $ 145,438       $ 137,924   

Less: Goodwill

     12,292         12,292   

Less: Core deposit and leasehold right intangibles

     2,349         2,525   
  

 

 

    

 

 

 

Tangible common equity

   $ 130,797       $ 123,107   
  

 

 

    

 

 

 

Common shares issued and outstanding

     11,222,235         11,081,364   

Book value per common share

   $ 12.96       $ 12.45   
  

 

 

    

 

 

 

Tangible book value per common share

   $ 11.66       $ 11.11   
  

 

 

    

 

 

 

Note 4 - Computation of Earnings per Common Share

Basic and diluted earnings per common share were determined by dividing the net income by the applicable basic and diluted weighted average common shares outstanding. The following table shows weighted average basic shares outstanding, potential dilutive shares related to stock options, unvested restricted stock, and weighted average diluted shares for the periods indicated (dollars in thousands, except share and per share data):

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
     2014      2013      2014      2013  

Net Income

   $ 2,386       $ 2,321       $ 5,052       $ 4,476   
  

 

 

    

 

 

    

 

 

    

 

 

 

Weighted average basic common shares outstanding

     10,952,087         10,501,504         10,913,227         10,493,846   

Dilutive effect of potential common share issuances from stock options and restricted stock

     206,479         281,774         213,313         194,859   
  

 

 

    

 

 

    

 

 

    

 

 

 

Weighted average diluted common shares outstanding

     11,158,566         10,783,278         11,126,540         10,688,705   
  

 

 

    

 

 

    

 

 

    

 

 

 

Income per common share

        

Basic

   $ 0.22       $ 0.22       $ 0.46       $ 0.43   

Diluted

   $ 0.21       $ 0.22       $ 0.45       $ 0.42   
  

 

 

    

 

 

    

 

 

    

 

 

 

Anti-dilutive shares not included in the calculation of diluted earnings per share

     82,154         203,176         83,437         209,655   

 

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Note 5 - Investment Securities

The investment securities portfolio has been classified as available-for-sale, and as such is recorded at estimated fair market value.

The following tables present the amortized cost and estimated fair values of investment securities by major category as of the dates indicated. There were no impaired securities at June 30, 2014 or December 31, 2013, and as such there were no other than temporary impairment losses in the securities portfolio for the periods indicated in the tables below (dollars in thousands):

 

            Gross Unrealized         

June 30, 2014 – Available-for-sale:

   Amortized
Cost
     Gains      Losses      Fair Market
Value
 

U.S. Govt Agency and Sponsored Agency - Note Securities

   $ 3,084       $ 7       $ —         $ 3,091   

U.S. Govt Agency - SBA Securities

     52,487         742         448         52,781   

U.S. Govt Agency - GNMA Mortgage-Backed Securities

     24,938         268         538         24,668   

U.S. Govt Sponsored Agency - CMO & Mortgage-Backed Securities

     14,178         406         234         14,350   

Corporate Securities

     4,056         108         —           4,164   

Municipal Securities

     3,069         20         —           3,089   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total investment securities

   $ 101,812       $ 1,551       $ 1,220       $ 102,143   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

            Gross Unrealized         

December 31, 2013 – Available-for-sale:

   Amortized
Cost
     Gains      Losses      Fair Market
Value
 

U.S. Govt Agency and Sponsored Agency - Note Securities

   $ 4,153       $ 1       $ 2       $ 4,152   

U.S. Govt Agency - SBA Securities

     50,521         875         491         50,905   

U.S. Govt Agency - GNMA Mortgage-Backed Securities

     28,107         180         909         27,378   

U.S. Govt Sponsored Agency - CMO & Mortgage-Backed Securities

     15,348         345         479         15,214   

Corporate Securities

     5,086         125         —           5,211   

Municipal Securities

     3,621         9         2         3,628   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total investment securities

   $ 106,836       $ 1,535       $ 1,883       $ 106,488   
  

 

 

    

 

 

    

 

 

    

 

 

 

The Company’s investment securities portfolio at June 30, 2014, consists of U.S. Agency and U.S. Sponsored Agency issued AAA and AA rated investment-grade securities, investment grade corporate bond securities, and municipal securities. Securities with a market value of $14.1 million and $11.8 million were pledged to secure securities sold under agreements to repurchase at June 30, 2014 and December 31, 2013, respectively. See Note 8 – Borrowings and Subordinated Debentures. Securities with a market value of $11.3 million and $11.0 million were pledged to secure a certificate of deposit of $10.0 million with the State of California Treasurer’s office at June 30, 2014 and December 31, 2013. Securities with a market value of $30.6 million and $29.3 million were pledged to secure outstanding standby letters of credit confirmed/issued by a correspondent bank for the benefit of our customers in the amount of $21.3 million and $21.9 million at June 30, 2014 and December 31, 2013, respectively. Securities with a market value of $947,000 and $275,000 were pledged to secure local agency deposits at June 30, 2014 and December 31, 2013, respectively.

 

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The following tables present investment securities with unrealized losses that are considered to be temporarily-impaired, summarized and classified according to the duration of the loss period as of the dates indicated (dollars in thousands).

 

     < 12 Continuous
Months
     > 12 Continuous
Months
     Total  
June 30, 2014    Fair
Value
     Net
Unrealized
Loss
     Fair
Value
     Net
Unrealized
Loss
     Fair
Value
     Net
Unrealized
Loss
 

Temporarily-impaired available-for-sale investment securities:

                 

U.S. Govt. - Agency and Sponsored Agency Note Securities

   $ —         $ —         $ —         $ —         $ —         $ —     

U.S. Govt. Agency SBA Securities

     8,793         127         8,556         322         17,349         449   

U.S. Govt. Agency – GNMA Mortgage-Backed Securities

     7,905         71         7,373         337         15,278         408   

U.S. Govt. Sponsored Agency – CMO & Mortgage-Backed Securities

     —           —           9,642         363         9,642         363   

Corporate Securities

     —           —           —           —           —           —     

Municipal Securities

     —           —           —           —           —           —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total temporarily-impaired available-for-sale investment securities

   $ 16,698       $ 198       $ 25,571       $ 1,022       $ 42,269       $ 1,220   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

     < 12 Continuous
Months
     > 12 Continuous
Months
     Total  
December 31, 2013    Fair
Value
     Net
Unrealized
Loss
     Fair
Value
     Net
Unrealized
Loss
     Fair
Value
     Net
Unrealized
Loss
 

Temporarily-impaired available-for-sale investment securities:

                 

U.S. Govt. - Agency and Sponsored Agency Note Securities

   $ 1,041       $ 2       $ —         $ —         $ 1,041       $ 2   

U.S. Govt. Agency SBA Securities

     11,686         491         —           —           11,686         491   

U.S. Govt. Agency – GNMA Mortgage-Backed Securities

     15,693         721         1,864         188         17,557         909   

U.S. Govt. Sponsored Agency – CMO & Mortgage-Backed Securities

     7,650         479         —           —           7,650         479   

Corporate Securities

     —           —           —           —           —           —     

Municipal Securities

     —           —           1,029         2         1,029         2   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total temporarily-impaired available-for-sale investment securities

   $ 36,070       $ 1,693       $ 2,893       $ 190       $ 38,963       $ 1,883   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

The Company evaluates all securities for declines in the fair market values below the securities cost basis for possible impairment on each reporting date.

During the six months ended June 30, 2014, the Company did not recognize any gross gain or losses on sales of available-for-sale securities and recognized gross gains on sales of securities in the amount of $5,000 for the six months ended June 30, 2013 and $47,000 for the year ended December 31, 2013. The Company did not recognize any net proceeds from the sale of available-for-sale securities at June 30, 2014 and had net proceeds from the sale of available-for-sale securities of $2.9 million for the six months ended June 30, 2013 and $7.0 million for the year ended December 31, 2013.

The amortized cost, estimated fair value and average yield of debt securities at June 30, 2014, are reflected in the table below (dollars in thousands). Maturity categories are determined as follows:

 

    U.S. Govt. Agency and U.S. Govt. Sponsored Agency bonds and notes – maturity date

 

    U.S. Govt. Sponsored Agency CMO or Mortgage-Backed Securities, U.S. Govt. Agency GNMA Mortgage-Backed Securities and U.S. Gov. Agency SBA Securities – estimated cash flow taking into account estimated pre-payment speeds

 

    Investment grade Corporate Bonds and Municipal Securities – maturity date

 

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Although, U.S. Government Agency and U.S. Government Sponsored Agency mortgage-backed and CMO securities have contractual maturities through 2048, the expected maturity will differ from the contractual maturities because borrowers or issuers may have the right to prepay such obligations without penalties.

 

     June 30, 2014  

Maturities Schedule of Securities

   Amortized
Cost
     Fair Value      Weighted
Average
Yield
 

Due through one year

   $ 18,136       $ 18,208         1.52

Due after one year through five years

     39,808         40,151         1.88

Due after five years through ten years

     26,781         26,522         2.27

Due after ten years

     17,087         17,262         2.71
  

 

 

    

 

 

    

Total

   $ 101,812       $ 102,143         2.06
  

 

 

    

 

 

    

The weighted average yields in the above table are based on effective rates of book balances at the end of the period. Yields are derived by dividing interest income, adjusted for amortization of premiums and accretion of discounts, by total amortized cost.

Investment in FHLB Common Stock

The Company’s investment in the common stock of the FHLB of San Francisco is carried at cost and was $4.2 million as of June 30, 2014 and December 31, 2013. See Note 8—Borrowings and Subordinated Debentures for a detailed discussion regarding the Company’s borrowings and the requirements to purchase FHLB common stock. See Note 5—Investment Securities in the Company’s December 31, 2013 10-K for additional discussion on the Company’s evaluation and accounting for its investment in FHLB common stock.

 

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Note 6 - Loans

The following table presents the composition of the Company’s loan portfolio as of the dates indicated (dollars in thousands):

 

     June 30,
2014
     December 31,
2013
 

Commercial and Industrial Loans:

   $ 303,870       $ 299,473   

Loans Secured by Real Estate:

     

Owner-Occupied Nonresidential Properties

     208,936         197,605   

Other Nonresidential Properties

     296,629         271,818   

Construction, Land Development and Other Land

     61,165         47,074   

1-4 Family Residential Properties

     64,583         65,711   

Multifamily Residential Properties

     36,727         33,780   
  

 

 

    

 

 

 

Total Loans Secured by Real Estate

     668,040         615,988   
  

 

 

    

 

 

 

Other Loans:

     7,980         17,733   
  

 

 

    

 

 

 

Total Loans

   $ 979,890       $ 933,194   
  

 

 

    

 

 

 

The following table is a breakout of the Company’s loan portfolio stratified by the industry concentration of the borrower by their respective NAICS code as of the dates indicated (dollars in thousands):

 

     June 30,      December 31,  
     2014      2013  

Real Estate

   $ 431,243       $ 381,830   

Manufacturing

     86,350         83,319   

Hotel/Lodging

     82,787         76,143   

Construction

     69,935         62,835   

Wholesale

     57,195         60,291   

Professional Services

     45,745         49,739   

Finance

     52,615         46,393   

Healthcare

     32,756         38,662   

Restaurant/Food Service

     23,574         35,244   

Other Services

     23,781         21,448   

Retail

     17,856         23,157   

Administrative Management

     18,619         15,218   

Information

     10,635         11,709   

Education

     9,985         10,270   

Transportation

     10,562         9,531   

Entertainment

     5,195         6,207   

Other

     1,057         1,198   
  

 

 

    

 

 

 

Total

   $ 979,890       $ 933,194   
  

 

 

    

 

 

 

SBA Loans

The Company originates loans under the guidelines of the Small Business Administration (“SBA”) program. The total portfolio of the SBA contractual loan balances being serviced by the Company at June 30, 2014 was $105 million, of which $73 million has been sold. Of the $32 million remaining on the Company’s books, $23 million is un-guaranteed and $9 million is guaranteed by the SBA.

For SBA guaranteed loans, a secondary market exists to purchase the guaranteed portion of these loans with the Company continuing to “service” the entire loan. The secondary market for guaranteed loans is comprised of investors seeking long term assets with yields that adapt to the prevailing interest rates. These investors are typically financial institutions, insurance companies, pension funds, and other types of investors specializing in the acquisition of this product. When a decision to sell the guaranteed portion of an SBA loan is made by the Company, bids are solicited from secondary market investors and the loan is normally sold to the highest bidder.

 

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At June 30, 2014, there were no loans classified as held for sale. At June 30, 2014, the balance of unsold SBA 7a loans that have been originated in 2014 is $1.5 million, of which $1.1 million is guaranteed by the SBA. The Company does not currently plan on selling these loans, but it may choose to do so in the future.

Allowance for Loan Loss

The following table is a summary of the activity for the allowance for loan loss for the periods indicated (dollars in thousands):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2014     2013     2014     2013  

Allowance for loan loss at beginning of period

   $ 10,823      $ 8,841      $ 10,603      $ 8,803   

Provision for loan losses

     408        1,153        483        1,287   

Net (charge-offs) recoveries:

        

Charge-offs

     (157     (616     (157     (737

Recoveries

     210        34        355        59   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net (charge-offs) recoveries

     53        (582     198        (678
  

 

 

   

 

 

   

 

 

   

 

 

 

Allowance for loan loss at end of period

   $ 11,284      $ 9,412      $ 11,284      $ 9,412   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net (charge-offs) recoveries to average loans

     0.00     (0.07 )%      0.02     (0.08 )% 

 

     June 30,
2014
    December 30,
2013
 

Allowance for loan loss to total loans

     1.15     1.14

Allowance for loan loss to total loans accounted for at historical cost, which excludes loans and the related allowance for loans acquired through acquisition

     1.45     1.50

The allowance for losses on unfunded loan commitments to extend credit is primarily related to commercial lines of credit and construction loans. The amount of unfunded loan commitments at June 30, 2014 and December 31, 2013 was $417.1 million and $345.9 million, respectively. The inherent risk associated with a loan is evaluated at the same time the credit is extended. However, the allowance held for the commitments is reported in other liabilities within the accompanying balance sheets and not as part of the allowance for loan loss in the above table. The allowance for losses on unfunded loan commitments to extend credit was $403,000 and $329,000 at June 30, 2014 and December 31, 2013, respectively.

 

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The following tables present, by portfolio segment, the changes in the allowance for loan loss and the recorded investment in loans as of the dates and for the periods indicated (dollars in thousands):

 

     Commercial
and
Industrial
    Construction,
Land
Development
and
Other Land
     Commercial
and
Other
Real Estate
    Other     Total  

Three Months Ended June 30, 2014

           

Allowance for loan loss – Beginning balance

   $ 5,278      $ 1,334       $ 4,161      $ 50      $ 10,823   

Provision for loan losses

     91        88         228        1        408   

Net (charge-offs) recoveries:

           

Charge-offs

     (93     —           (64     —          (157

Recoveries

     109        —           101        —          210   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Net recoveries

     16        —           37        —          53   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Ending balance

   $ 5,385      $ 1,422       $ 4,426      $ 51      $ 11,284   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Three Months Ended June 30, 2013

           

Allowance for loan loss – Beginning balance

   $ 4,187      $ 2,147       $ 2,400      $ 107      $ 8,841   

Provision for loan losses

     1,014        213         (6     68        1,153   

Net (charge-offs) recoveries:

           

Charge-offs

     (569     —           (47     —          (616

Recoveries

     27        —           4        3        34   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Net (charge-offs) recoveries

     (542     —           (43     3        (582
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Ending balance

   $ 4,659      $ 2,360       $ 2,351      $ 42      $ 9,412   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 
     Commercial
and
Industrial
    Construction,
Land
Development
and
Other Land
     Commercial
and
Other
Real Estate
    Other     Total  

Six Months Ended June 30, 2014

           

Allowance for loan loss – Beginning balance

   $ 5,534      $ 1,120       $ 3,886      $ 63      $ 10,603   

Provision for loan losses

     (308     302         501        (12     483   

Net (charge-offs) recoveries:

           

Charge-offs

     (93     —           (64     —          (157

Recoveries

     252        —           103        —          355   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Net recoveries

     159        —           39        —          198   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Ending balance

   $ 5,385      $ 1,422       $ 4,426      $ 51      $ 11,284   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Six Months Ended June 30, 2013

           

Allowance for loan loss – Beginning balance

   $ 4,572      $ 2,035       $ 2,084      $ 112      $ 8,803   

Provision for loan losses

     650        325         379        (67     1,287   

Net (charge-offs) recoveries:

           

Charge-offs

     (612     —           (117     (8     (737

Recoveries

     49        —           5        5        59   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Net (charge-offs)

     (563     —           (112     (3     (678
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Ending balance

   $ 4,659      $ 2,360       $ 2,351      $ 42      $ 9,412   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

 

Page 18 of 70


Table of Contents

The following tables present both the allowance for loan loss and the associated loan balance classified by loan portfolio segment and by credit evaluation methodology (dollars in thousands):

 

     Commercial
and

Industrial
     Construction,
Land
Development
and

Other Land
     Commercial
and

Other
Real Estate
     Other      Total  

June 30, 2014

           

Allowance for loan loss:

           

Individually evaluated for impairment

   $ 240       $ —         $ —         $ —         $ 240   

Collectively evaluated for impairment

     5,143         1,422         4,426         51         11,042   

Purchased credit impaired

(loans acquired with deteriorated credit quality)

     2         —         $ —         $ —           2   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total Allowance for Loan Loss

   $ 5,385       $ 1,422       $ 4,426       $ 51       $ 11,284   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Loans receivable:

           

Individually evaluated for impairment

   $ 2,582       $ —         $ 2,960       $ —         $ 5,542   

Collectively evaluated for impairment

     300,730         61,165         601,877         7,980         971,752   

Purchased credit impaired

(loans acquired with deteriorated credit quality)

     558         —           2,038         —           2,596   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total Loans Receivable

   $ 303,870       $ 61,165       $ 606,875       $ 7,980       $ 979,890   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
     Commercial
and

Industrial
     Construction,
Land
Development
and

Other Land
     Commercial
and

Other
Real Estate
     Other      Total  

December 31, 2013

           

Allowance for loan loss:

           

Individually evaluated for impairment

   $ 4       $ —         $ —         $ —         $ 4   

Collectively evaluated for impairment

     5,520         1,120         3,886         63         10,589   

Purchased credit impaired

(loans acquired with deteriorated credit quality)

     10         —           —           —           10   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total Allowance for Loan Loss

   $ 5,534       $ 1,120       $ 3,886       $ 63       $ 10,603   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Loans receivable:

           

Individually evaluated for impairment

   $ 2,640       $ —         $ 3,680       $ —         $ 6,320   

Collectively evaluated for impairment

     295,787         47,074         561,952         17,733         922,546   

Purchased credit impaired

(loans acquired with deteriorated credit quality)

     1,046         —           3,282         —           4,328   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total Loans Receivable

   $ 299,473       $ 47,074       $ 568,914       $ 17,733       $ 933,194   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

Page 19 of 70


Table of Contents

Credit Quality of Loans

The Company utilizes an internal loan classification system as a means of reporting problem and potential problem loans. Under the Company’s loan risk rating system, loans are classified as “Pass,” with problem and potential problem loans as “Special Mention,” “Substandard,” “Doubtful” and “Loss”. Individual loan risk ratings are updated continuously or at any time the situation warrants. In addition, management regularly reviews problem loans to determine whether any loan requires a classification change, in accordance with the Company’s policy and applicable regulations. The grading analysis estimates the capability of the borrower to repay the contractual obligations of the loan agreements as scheduled or at all. The internal loan classification risk grading system is based on experiences with similarly graded loans.

The Company’s internally assigned grades are as follows:

 

    Pass – loans which are protected by the current net worth and paying capacity of the obligor or by the value of the underlying collateral. There are several different levels of Pass rated credits, including “Watch” which is considered a transitory grade for pass rated loans that require greater monitoring. Loans not meeting the criteria of special mention, substandard, doubtful or loss that have been analyzed individually as part of the above described process are considered to be pass-rated loans.

 

    Special Mention – loans where a potential weakness or risk exists, which could cause a more serious problem if not corrected. Special Mention loans do not currently expose the Company to sufficient risk to warrant classification as a Substandard, Doubtful or Loss classification, but possess weaknesses that deserve management’s close attention.

 

    Substandard – loans that have a well-defined weakness based on objective evidence and can be characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.

 

    Doubtful – loans classified as doubtful have all the weaknesses inherent in those classified as substandard with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable.

 

    Loss – loans classified as a loss are considered uncollectible, or of such value that continuance as an asset is not warranted.

The following tables present the risk category of loans by class of loans based on the most recent internal loan classification as of the dates indicated (dollars in thousands):

 

     Commercial
and

Industrial
     Construction,
Land
Development
and
Other Land
     Commercial
and
Other
Real Estate
     Other      Total  

June 30, 2014

              

Pass

   $ 292,219       $ 61,165       $ 585,390       $ 7,979       $ 946,753   

Special Mention

     2,200         —           4,035         —           6,235   

Substandard

     9,451         —           17,450         1         26,902   

Doubtful

     —           —           —           —           —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 303,870       $ 61,165       $ 606,875       $ 7,980       $ 979,890   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2013

              

Pass

   $ 289,594       $ 47,074       $ 547,600       $ 17,731       $ 901,999   

Special Mention

     1,540         —           2,613         —           4,153   

Substandard

     8,339         —           18,701         2         27,042   

Doubtful

     —           —           —           —           —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 299,473       $ 47,074       $ 568,914       $ 17,733       $ 933,194   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

Page 20 of 70


Table of Contents

Age Analysis of Past Due and Non-Accrual Loans

The following tables present an aging analysis of the recorded investment of past due loans and non-accrual loans as of the dates indicated (dollars in thousands):

 

     31-60
Days
Past Due
     61-90
Days
Past Due
     Greater
than

90 Days
Past Due
and
Accruing
     Total
Past Due
and
Accruing
     Total
Non
Accrual
     Current      Total
Loans
 

June 30, 2014

                    

Commercial and Industrial

   $ 340       $ —         $ —         $ 340       $ 3,136       $ 300,394       $ 303,870   

Construction, Land Development and Other Land

     —           —           —           —           —           61,165         61,165   

Commercial and Other Real Estate

     631         —           —           631         3,892         602,352         606,875   

Other

     —           —           —           —           —           7,980         7,980   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 971       $ —         $ —         $ 971       $ 7,028       $ 971,891       $ 979,890   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
     31-60
Days
Past Due
     61-90
Days
Past Due
     Greater
than

90 Days
Past Due
and
Accruing
     Total
Past Due
and
Accruing
     Total
Non
Accrual
     Current      Total
Loans
 

December 31, 2013

                    

Commercial and Industrial

   $ —         $ 241       $ —         $ 241       $ 3,682       $ 295,550       $ 299,473   

Construction, Land Development and Other Land

     —           —           —           —           —           47,074         47,074   

Commercial and Other Real Estate

     —           —           —           —           5,874         563,040         568,914   

Other

     —           —           —           —           —           17,733         17,733   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ —         $ 241       $ —         $ 241       $ 9,556       $ 923,397       $ 933,194   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

Page 21 of 70


Table of Contents

Impaired Loans

Impaired loans are evaluated by comparing the fair value of the collateral, if the loan is collateral dependent, and the present value of the expected future cash flows discounted at the loan’s effective interest rate, if the loan is not collateral dependent.

A valuation allowance is established for an impaired loan when the fair value of the loan is less than the recorded investment. In certain cases, portions of impaired loans are charged-off to realizable value instead of establishing a valuation allowance and are included, when applicable, in the table below as impaired loans “with no specific allowance recorded.” The valuation allowance disclosed below is included in the allowance for loan loss reported in the consolidated balance sheets as of June 30, 2014 and December 31, 2013.

The following tables present, by loan category, the recorded investment and unpaid principal balances for impaired loans with the associated allowance amount, if applicable, for the dates and periods indicated (dollars in thousands). This table excludes purchased credit impaired loans (loans acquired in acquisitions with deteriorated credit quality) of $2.6 million and $4.3 million at June 30, 2014 and December 31, 2013, respectively.

 

     June 30, 2014      December 31, 2013  
     Recorded
Investment
     Unpaid
Principal
Balance
     Related
Allowance
     Recorded
Investment
     Unpaid
Principal
Balance
     Related
Allowance
 

With no specific allowance recorded:

                 

Commercial and Industrial

   $ 1,060       $ 1,138       $ —         $ 2,540       $ 5,347       $ —     

Commercial and Other Real Estate

     2,960         3,864         —           3,680         6,112         —     

With a specific allowance recorded:

                 

Commercial and Industrial

     1,522         1,929         240         100         355         4   

Total

                 

Commercial and Industrial

     2,582         3,067         240         2,640         5,702         4   

Commercial and Other Real Estate

     2,960         3,864         —           3,680         6,112         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 5,542       $ 6,931       $ 240       $ 6,320       $ 11,814       $ 4   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

    Three Months Ended
June 30,
    Six Months Ended
June 30,
 
    2014     2013     2014     2013  
    Average
Recorded
Investment
    Interest
Income
Recognized
    Average
Recorded
Investment
    Interest
Income
Recognized
    Average
Recorded
Investment
    Interest
Income
Recognized
    Average
Recorded
Investment
    Interest
Income
Recognized
 

With no specific allowance recorded:

               

Commercial and Industrial

  $ 1,008      $ 34      $ 1,500      $ —        $ 1,027      $ 34      $ 994      $ —     

Construction, Land Development and Other Land

    —          —          1,159        —          —          —          1,179        —     

Commercial and Other Real Estate

    2,981        —          3,340        —          3,325        —          3,398        —     

With a specific allowance recorded:

               

Commercial and Industrial

    1,535        —          488        —          1,553        —          319        —     

Total:

               

Commercial and Industrial

    2,543        34        1,988        —          2,580        34        1,313        —     

Construction, Land Development and Other Land

    1,535        —          1,159        —          —          —          1,179        —     

Commercial and Other Real Estate

    2,981        —          3,340        —          3,325        —          3,398        —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 5,524      $ 34      $ 6,487      $ —        $ 5,905      $ 34      $ 5,890      $ —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

Page 22 of 70


Table of Contents

The following is a summary of additional information pertaining to impaired loans for the periods indicated (dollars in thousands):

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
     2014      2013      2014      2013  

Interest foregone on impaired loans

   $ 103       $ 141       $ 274       $ 230   

Cash collections applied to reduce principal balance

   $ 2,763       $ 110       $ 2,871       $ 152   

Interest income recognized on cash collections

   $ 34       $ —         $ 34       $ —     

Troubled Debt Restructuring

The Company’s loan portfolio contains certain loans that have been modified in a Troubled Debt Restructuring (“TDR”), where economic concessions have been granted to borrowers experiencing financial difficulties. Loans are restructured in an effort to maximize collections. Economic concessions can include: reductions to the interest rate, payment extensions, forgiveness of principal or other actions.

The modification process includes evaluation of impairment based on the present value of expected future cash flows, discounted at the contractual interest rate of the original loan agreement, except when the sole (remaining) source of repayment for the loan is the operation or liquidation of the loan collateral. In these cases, management uses the current fair value of the collateral, less selling costs, to evaluate the loan for impairment. If management determines that the value of the modified loan is less than the recorded investment in the loan (net of previous charge-offs and unamortized premium or discount), impairment is recognized through a specific allowance or a charge-off.

The following tables include the recorded investment and unpaid principal balances for troubled debt restructured loans for the periods ending June 30, 2014 and December 31, 2013 (dollars in thousands). These tables include TDR loans that were purchased credit impaired (PCI). As of June 30, 2014, there were three PCI loans with a recorded investment of $304,000 and unpaid principal balances of $491,000.

 

Period ended June 30, 2014    Recorded
Investment
     Unpaid
Principal
Balance
     Interest
Income
Recognized
 

Commercial and Industrial

   $ 746       $ 1,183       $ —     

Commercial and Other Real Estate

     2,109         2,785         —     
  

 

 

    

 

 

    

 

 

 

Total

   $ 2,855       $ 3,968       $ —     
  

 

 

    

 

 

    

 

 

 
Year ended December 31, 2013    Recorded
Investment
     Unpaid
Principal
Balance
     Interest
Income
Recognized
 

Commercial and Industrial

   $ 541       $ 843       $ —     

Commercial and Other Real Estate

     2,173         2,785         —     
  

 

 

    

 

 

    

 

 

 

Total

   $ 2,714       $ 3,628       $ —     
  

 

 

    

 

 

    

 

 

 

 

Page 23 of 70


Table of Contents

The following table shows the pre- and post-modification recorded investment in TDR loans by loan segment that have occurred during the periods indicated (dollars in thousands):

 

     Three Months Ended
June 30,
 
     2014      2013  
     Number
of

Loans
     Pre-Modification
Recorded
Investment
     Post-
Modification
Recorded
Investment
     Number
of

Loans
     Pre-Modification
Recorded
Investment
     Post-
Modification
Recorded
Investment
 

Troubled Debt Restructured Loans:

                 

Commercial and Industrial

     1         224         224         —           —           —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

     1       $ 224       $ 224         —         $ —         $ —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
     Six Months Ended
June 30,
 
     2014      2013  
     Number
of

Loans
     Pre-Modification
Recorded
Investment
     Post-
Modification
Recorded
Investment
     Number
of

Loans
     Pre-Modification
Recorded
Investment
     Post-
Modification
Recorded
Investment
 

Troubled Debt Restructured Loans:

                 

Commercial and Industrial

     1         224         224         1         310         310   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

     1       $ 224       $ 224         1       $ 310       $ 310   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Loans are restructured in an effort to maximize collections. There was no financial impact for specific reserves or from charge-offs for the modified loans included in the table above. Impairment analyses are performed on the Company’s troubled debt restructured loans in conjunction with the normal allowance for loan loss process. The Company’s troubled debt restructured loans are analyzed to ensure adequate cash flow or collateral supports the outstanding loan balance.

There have been no payment defaults in the six months ended June 30, 2014 or June 30, 2013 subsequent to modification on troubled debt restructured loans that have been modified within the last twelve months.

Loans Acquired Through Acquisition

The following table reflects the accretable net discount for loans acquired through acquisition, for the periods indicated (dollars in thousands):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2014     2013     2014     2013  

Balance, beginning of period

   $ 7,350      $ 11,269      $ 7,912      $ 12,189   

Accretion, included in interest income

     (889     (1,139     (1,451     (2,083

Reclassifications (to) from non-accretable yield

     (49     —          (49     24   
  

 

 

   

 

 

   

 

 

   

 

 

 

Balance, end of period

   $ 6,412      $ 10,130      $ 6,412      $ 10,130   
  

 

 

   

 

 

   

 

 

   

 

 

 

The above table reflects the fair value adjustment on the loans acquired from mergers that will be amortized to loan interest income based on the effective yield method over the remaining life of the loans. These amounts do not include the fair value adjustments on the purchased credit impaired loans acquired from mergers.

 

Page 24 of 70


Table of Contents

Purchased Credit Impaired Loans

Purchased Credit Impaired Loans (“PCI”) loans are acquired loans with evidence of deterioration of credit quality since origination and it is probable at the acquisition date, that the Company will not be able to collect all contractually required amounts.

When the timing and/or amounts of expected cash flows on such loans are not reasonably estimable, no interest is accreted and the loan is reported as a non-accrual loan; otherwise, if the timing and amounts of expected cash flows for PCI loans are reasonably estimable, then interest is accreted and the loans are reported as accruing loans.

The non-accretable difference represents the difference between the undiscounted contractual cash flows and the undiscounted expected cash flows, and also reflects the estimated credit losses in the acquired loan portfolio at the acquisition date and can fluctuate due to changes in expected cash flows during the life of the PCI loans.

The following table reflects the outstanding balance and related carrying value of PCI loans as of the dates indicated (dollars in thousands):

 

     June 30, 2014      December 31, 2013  
     Unpaid
Principal
Balance
     Carrying
Value
     Unpaid
Principal
Balance
     Carrying
Value
 

Commercial and Industrial

   $ 935       $ 558       $ 1,599       $ 1,046   

Commercial and Other Real Estate

     3,321         2,038         5,611         3,282   

Other

     —           —           —           —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 4,256       $ 2,596       $ 7,210       $ 4,328   
  

 

 

    

 

 

    

 

 

    

 

 

 

The following table reflects the activities in the accretable net discount for PCI loans for the period indicated (dollars in thousands):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2014     2013     2014     2013  

Balance, beginning of period

   $ 378      $ 9      $ 395      $ 9   

Accretion, included in interest income

     (18     (9     (35     (9

Reclassifications from non-accretable yield

            428               428   
  

 

 

   

 

 

   

 

 

   

 

 

 

Balance, end of period

   $ 360      $ 428      $ 360      $ 428   
  

 

 

   

 

 

   

 

 

   

 

 

 

Note 7 – Qualified Affordable Housing Project Investments

The Company’s investment in Qualified Affordable Housing Projects that generate Low Income Housing Tax Credits (“LIHTC”) at June 30, 2014 was $4.3 million, compared to $4.5 million at December 31, 2013. The decrease of $200,000 represents the amortization of the principal balance for the six months of 2014. The funding liability for the LIHTC at June 30, 2014 was $3.5 million compared to $4.0 million, at December 31, 2013. See Note 11 – Qualified Affordable Housing Project Investments in the Company’s 10-K financial statements at December 31, 2013 for additional detail regarding the Company’s investment in LIHTC.

 

Page 25 of 70


Table of Contents

Note 8 - Borrowings and Subordinated Debentures

Securities Sold Under Agreements to Repurchase

The Company enters into certain transactions, the legal form of which are sales of securities under agreements to repurchase (“Repos”) at a later date at a set price. Securities sold under agreements to repurchase generally mature within 1 day to 180 days from the issue date and are routinely renewed.

As discussed in Note 5 – Investment Securities, the Company has pledged certain investments as collateral for these agreements. Securities with a fair value of $14.1 million and $11.8 million were pledged to secure the Repos at June 30, 2014 and December 31, 2013, respectively. The Company segregates both the principal and accrued interest on these securities with the Company’s third party safekeeping custodians. All principal and interest payments on the investment securities that are pledged as collateral on the Repo program are received directly by the safekeeping custodian.

The tables below describe the terms and maturity of the Company’s securities sold under agreements to repurchase as of the dates indicated (dollars in thousands):

 

     June 30, 2014

Date Issued

   Amount      Interest Rate     Original
Term
     Maturity Date

June 30, 2014

   $ 13,852         0.10% – 0.38     1 day       July 1, 2014
  

 

 

         

Total

   $ 13,852         0.25     
  

 

 

         
     December 31, 2013

Date Issued

   Amount      Interest Rate     Original
Term
     Maturity Date

December 3, 2013

   $ 750         0.10     62 days       February 3, 2014

December 31, 2013

     10,391         0.10% – 0.40     2 days       January 2, 2014
  

 

 

         

Total

   $ 11,141         0.30     
  

 

 

         

Federal Home Loan Bank Borrowings

The Company maintains a secured credit facility with the Federal Home Loan Bank of San Francisco “FHLB”, allowing the Company to borrow on an overnight and term basis. The Company’s credit facility with the FHLB is $345.4 million, which represents approximately 25% of the Bank’s total assets, as reported by the Bank in its March 31, 2014 FFIEC Call Report.

As of June 30, 2014, the Company had $582 million of loan collateral pledged with the FHLB which provides $249.9 million in borrowing capacity. The Company has no investment securities pledged with the FHLB to support this credit facility. In addition, the Company must maintain an investment in the Capital Stock of the FHLB. Under the FHLB Act, the FHLB has a statutory lien on the FHLB capital stock that the Company owns and the FHLB capital stock serves as further collateral under the borrowing line.

The Company had no outstanding advances (borrowings) with the FHLB as of June 30, 2014 or December 31, 2013.

 

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Subordinated Debentures

The following table summarizes the terms of each issuance of subordinated debentures outstanding as of June 30, 2014:

 

Series

   Amount
(in thousands)
    Issuance
Date
     Maturity
Date
     Rate Index     Current
Rate
    Next Reset
Date
 

Trust I

   $ 6,186        12/10/04         03/15/35         3 month LIBOR + 2.05     2.28     9/15/14   

Trust II

     3,093        12/23/05         03/15/36         3 month LIBOR + 1.75     1.98     9/15/14   

Trust III

     3,093        06/30/06         09/15/36         3 month LIBOR + 1.85     2.08     9/15/14   
  

 

 

             

Subtotal

     12,372               

Unamortized fair value adjustment

     (2,913            
  

 

 

             

Net

   $ 9,459               
  

 

 

             

The Company had an aggregate outstanding contractual balance of $12.4 million in subordinated debentures at June 30, 2014. These subordinated debentures were issued in three separate series. Each issuance had a maturity of 30 years from their approximate date of issue. All three subordinated debentures are variable rate instruments that reprice quarterly based on the three month LIBOR plus a margin (see tables above). All three subordinated debentures had their interest rates reset in June 2014 at the current three month LIBOR plus their spread, and will continue to reprice quarterly through their maturity date. All three subordinated debentures are currently callable at par with no prepayment penalties.

The Company currently includes in Tier 1 capital an amount of subordinated debentures equal to no more than 25% of the sum of all core capital elements, which is generally defined as shareholders’ equity less goodwill, core deposit and leasehold right intangibles and a portion of the SBA servicing assets.

Interest payments made by the Company on subordinated debentures are considered dividend payments under FRB regulations. Notification to the FRB is required prior to the Company declaring and paying a dividend during any period in which the Company’s quarterly net earnings are insufficient to fund the dividend amount. This notification requirement is included in regulatory guidance regarding safety and soundness surrounding capital and includes other non-financial measures such as asset quality, financial condition, capital adequacy, liquidity, future earnings projections, capital planning and credit concentrations. Should the FRB object to the dividend payments, the Company would be precluded from paying interest on the subordinated debentures after giving notice within 15 days before the payment date. Payments would not commence until approval is received or the Company no longer needs to provide notice under applicable guidance. The Company has the right, assuming no default has occurred, to defer payments of interest on the subordinated debentures at any time for a period not to exceed 20 consecutive quarters. The Company has not deferred any interest payments.

 

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Note 9 - Derivative Financial Instruments

At June 30, 2014, the Company has twenty three pay-fixed, receive-variable, interest rate contracts that are designed to convert fixed rate loans into variable rate loans. The Company acquired these interest rate swap contracts (“swaps”) on July 31, 2012 as a result of the merger with PC Bancorp.

The Company also acquired as part of the PC Bancorp acquisition, a pay-fixed, receive-variable, interest rate swap contract that was originally utilized to convert a fixed rate borrowing on a subordinated debenture to a variable rate borrowing. The fixed rate subordinated debenture converted to a variable rate borrowing in December of 2012 and the swap matured in 2013.

Prior to the merger with PC Bancorp, the Company did not utilize interest rate swaps to manage its interest rate risk position. The Company has incorporated these instruments into its asset liability program when monitoring its interest rate risk position. All of the interest rate swap contracts are with the same counterparty bank. The total notional amount of the outstanding swap contracts as of June 30, 2014 is $31.3 million. The outstanding swaps have original maturities of up to 15 years.

Balance Sheet Classification of Derivative Financial Instruments

The following tables present the notional amount and the fair values of the asset and liability of the Company’s derivative instruments as of the dates and periods indicated (dollars in thousands):

 

    Derivative Liabilities  
    June 30,
2014
    December 31,
2013
 

Interest rate contacts notional amount

  $ 31,344      $ 31,914   

Derivatives not designated as hedging instruments:

   

Interest rate swap contracts fair value

  $ 645      $ 738   

Derivatives designated as hedging instruments:

   

Interest rate swap contracts fair value

    2,904        3,205   
 

 

 

   

 

 

 

Total interest rate contracts fair value

  $ 3,549      $ 3,943   
 

 

 

   

 

 

 

Balance sheet location

   
 
Accrued Interest Payable
and Other Liabilities
  
  
   
 
Accrued Interest Payable
and Other Liabilities
  
  

 

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The Effect of Derivative Instruments on the Consolidated Statements of Income

The following table summarizes the effect of derivative financial instruments on the consolidated statements of income for the periods indicated (dollars in thousands):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2014     2013     2014     2013  

Derivatives not designated as hedging instruments:

        

Interest rate swap contracts – loans

        

Increase in fair value of interest rate swap contracts

   $ 32      $ 155      $ 93      $ 217   

Payments on interest rate swap contracts on loans

     (68     (69     (136     (156
  

 

 

   

 

 

   

 

 

   

 

 

 

Net (decrease) increase in other non-interest income

     (36     86        (43     61   
  

 

 

   

 

 

   

 

 

   

 

 

 

Interest rate swap contracts – subordinated debenture

        

Increase in fair value of interest rate swap contracts

     —          —          —          70   

Payments on interest rate swap contracts on subordinated debentures

     —          —          —          (70
  

 

 

   

 

 

   

 

 

   

 

 

 

Net decrease in other non-interest income

     —          —          —          —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Net (decrease) increase in other non-interest income

   $ (36   $ 86      $ (43   $ 61   
  

 

 

   

 

 

   

 

 

   

 

 

 

Derivatives designated as hedging instruments:

        

Interest rate swap contracts – loans

        

Increase in fair value of interest rate swap contracts

   $ 118      $ 851      $ 301      $ 1,196   

Increase (decrease) in fair value of hedged loans

     165        (521     238        (590

Payment on interest rate swap contracts on loans

     (317     (331     (633     (633
  

 

 

   

 

 

   

 

 

   

 

 

 

Net decrease in interest income on loans

   $ (34   $ (1   $ (94   $ (27
  

 

 

   

 

 

   

 

 

   

 

 

 

The interest rate swap contract associated with the subordinated debenture that was to mature in June 2013 was liquidated during the first quarter of 2013.

Under the interest rate swap contracts, the Company is required to pledge and maintain collateral for the credit support under these agreements. At June 30, 2014, the Company had $2.7 million in certificates of deposit and $1.9 million in non-interest bearing balances for a total of $4.6 million with the counterparty, Pacific Coast Bankers Bank. Of this amount, $3.8 million is required to be pledged as collateral under the interest rate swap contracts.

 

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Note 10 – Balance Sheet Offsetting

Assets and liabilities relating to certain financial instruments, including derivatives, and securities sold under repurchase agreements (“Repos”), may be eligible for offset in the consolidated balance sheets as permitted under accounting guidance. The Company’s interest rate swap derivatives are subject to a master bilateral netting and offsetting arrangement under specific conditions as defined within a master agreement governing all interest rate swap contracts that the Company and the counterparty bank have entered into. In addition, the master agreement under which the interest rate contracts have been written require the pledging of assets by the Company based on certain risk thresholds. The Company has pledged as collateral, both a certificate of deposit and cash that is maintained in a due from bank account with the counterparty bank. The pledged collateral under the swap agreements are reported in the Company’s consolidated balance sheets, unless the Company defaults under the master agreement. The Company currently does not net or offset the interest rate swap contracts in its consolidated balance sheets, as reflected within the table below.

The Company’s securities sold under repurchase agreements represent transactions the Company has entered into with several individual deposit customers. These transactions represent the sale of securities on an overnight or on a term basis to our deposit customers under an agreement to repurchase the securities from the customers the next business day or at maturity. There is an individual contract for each customer with only one transaction per customer. There is no master agreement that provides for the netting arrangement or the offsetting of these individual transactions or for the netting of collateral positions. The Company does not net or offset the Repos in its consolidated balance sheets as reflected within the table below.

The table below presents the Company’s financial instruments that may be eligible for offsetting which include securities sold under agreements to repurchase that have no enforceable master netting arrangement and derivative securities that could be offset in the consolidated financial statements due to an enforceable master netting arrangement (dollars in thousands):

 

     Gross
Amounts
Recognized
in the
Consolidated
Balance
Sheets
     Gross
Amounts
Offset in the
Consolidated
Balance
Sheets
     Net Amounts
of Assets
Presented

in the
Consolidated
Balance
Sheets
     Gross Amounts
Not Offset in the
Consolidated Balance Sheets
     Net Amount
(Collateral
over liability
balance
required to
be pledged)
 
            Financial
Instruments
     Collateral
Pledged
    

June 30, 2014

                 

Financial Liabilities:

                 

Interest rate swap contracts fair value (See Note 9 – Derivative Financial Instruments)

   $ 3,549       $ —         $ 3,549       $ 3,549       $ 3,814       $ 265   

Securities sold under agreements to repurchase (See Note 8 – Borrowings and Subordinated Debentures)

     13,852         —           13,852         13,852         14,129         277   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 17,401       $ —         $ 17,401       $ 17,401       $ 17,943       $ 542   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2013

                 

Financial Liabilities:

                 

Interest rate swap contracts fair value (See Note 9 – Derivative Financial Instruments)

   $ 3,943       $ —         $ 3,943       $ 3,943       $ 4,194       $ 251   

Securities sold under agreements to repurchase (See Note 8 – Borrowings and Subordinated Debentures)

     11,141         —           11,141         11,141         11,750         609   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 15,084       $ —         $ 15,084       $ 15,084       $ 15,944       $ 860   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

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Note 11 - Stock Options and Restricted Stock

Equity Compensation Plans

The Company’s 2007 Equity and Incentive Plan, the “Equity Plan,” was adopted by the Company in 2007 and replaced two prior equity compensation plans. The Equity Plan provides for significant flexibility in determining the types and terms of awards that may be made to participants. The Equity Plan was revised and approved by the Company’s shareholders in 2011 and adopted by the Company as part of the Bank holding company reorganization. The Equity Plan is designed to promote the interest of the Company in aiding the Company to attract and retain employees, officers and non-employee directors who are expected to contribute to the future success of the organization. The Equity Plan is intended to provide participants with incentives to maximize their efforts on behalf of the Company through stock-based awards that provide an opportunity for stock ownership. The Equity Plan provides the Company with a flexible equity incentive compensation program, which allows the Company to grant stock options, restricted stock, restricted stock award units and performance units. Certain options and share awards provide for accelerated vesting, if there is a change in control, as defined in the Equity Plan. The Equity Plan is described more fully in Note 16 - Stock Options and Restricted Stock in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

At June 30, 2014, future compensation expense related to un-vested stock option and un-vested restricted stock grants are reflected in the table below (dollars in thousands):

 

Future Stock Based Compensation Expense

   Stock
Options
     Restricted
Stock
     Total  

Remainder of 2014

   $ 3       $ 761       $ 764   

2015

     2         748         750   

2016

     —           206         206   

2017

     —           27         27   

2018

     —           6         6   

Thereafter

     —           —           —     
  

 

 

    

 

 

    

 

 

 

Total

   $ 5       $ 1,748       $ 1,753   
  

 

 

    

 

 

    

 

 

 

The estimated fair value of both incentive stock options and non-qualified stock options granted in prior years, have been calculated using the Black-Scholes option pricing model. The use of the Black-Scholes model and the variables and assumptions are described in Note 16 - Stock Options and Restricted Stock in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

Stock Options

There have been no stock options granted by the Company after 2010.

The following table summarizes the share option activity under the plans as of the date and for the period indicated:

 

     Shares      Weighted
Average
Exercise
Price
     Weighted
Average
Remaining
Contractual
Term

(in years)
     Aggregate
Intrinsic
Value

(in thousands)
 

Outstanding stock options at December 31, 2013

     434,740       $ 13.89         2.1       $ 1,913   

Granted

     —           —           

Exercised

     110,044         9.87         

Forfeited

     —           —           

Expired

     —           —           
  

 

 

          

Outstanding stock options at June 30, 2014

     324,696       $ 15.25         1.9       $ 1,456   
  

 

 

          

Exercisable options at June 30, 2014

     315,496       $ 15.33         1.9       $ 1,394   

Unvested options at June 30, 2014

     9,200       $ 12.30         2.3       $ 62   
  

 

 

          

 

 

 

Outstanding, vested and expected to vest at June 30, 2014

     324,696       $ 15.25         1.9       $ 1,456   
  

 

 

          

 

 

 

 

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The Company recorded stock option compensation expense of $2,000 and $3,000 for the three month period ended June 30, 2014 and 2013, and $6,000 and $12,000 for the six month period ended June 30, 2014 and 2013, respectively.

At December 31, 2013, there was one executive officer of the Company that had a remaining balance of 88,344 shares that were exercisable under Rule 10b5-1(c) (1) “10b5 Plan” under the Securities Exchange Act of 1934, as amended. This plan had been adopted by the executive officer in the fourth quarter of 2013. During the first quarter of 2014 all 88,344 options that remained outstanding were exercised and sold. In addition, there were an additional 21,700 options exercised by employees in the first and second quarters of 2014.

The total intrinsic value of options exercised during the six months ended June 30, 2014 was $894,000 and there were no options exercised during the six months ended June 30, 2013.

Restricted Stock

The weighted-average grant-date fair value per share in the table below is calculated by taking the total aggregate cost of the restricted shares issued divided by the number of shares of restricted stock issued. The aggregate cost of the restricted stock was calculated by multiplying the number of shares granted at each of the grant dates by the closing stock price of the Company’s common stock on the date of the grant. The following table summarizes the restricted stock activity under the Equity Plan for the period indicated:

 

     Number of Shares     Weighted-Average
Grant-Date Fair Value
per Share
 

Restricted Stock:

    

Unvested at December 31, 2013

     266,050      $ 13.49   

Granted

     45,900        18.17   

Vested

     (48,975     12.32   

Cancelled and forfeited

     (500     11.75   
  

 

 

   

Unvested at June 30, 2014

     262,475      $ 14.53   
  

 

 

   

Restricted stock compensation expense related to the restricted stock grants reflected in the table above was $477,000 and $414,000 for the three month period ended June 30, 2014 and 2013, and $881,000 and $463,000 for the six month period ended June 30, 2014 and 2013, respectively. Restricted stock awards reflected in the table above are valued at the closing stock price on the date of grant and are expensed to stock based compensation expense over the period for which the related service is performed.

Note 12 - Common Stock

During the first and second quarters of 2014, the Company’s outstanding common stock increased by 140,871 shares to 11,222,235 at June 30, 2014. The components of this increase are as follows: The Company issued 110,044 shares of stock from the exercise of employee stock options for a total value of $1.1 million. The Company issued 45,900 shares of restricted stock to the Company’s employees, cancelled 500 shares of unvested restricted stock related to employee turnover and repurchased 14,573 shares of restricted stock that had a value of $242,000 related to employees electing to pay their tax obligation via the repurchase of the stock by the Company. The net issuance of restricted stock for 2014 was 30,827 shares. See Note 11 – Stock Options and Restricted Stock for additional detail related to the issuances of these shares.

During 2013, the Company issued 282,031 shares of stock from the exercise of employee stock options for a total value of $2.8 million. The Company issued 81,050 shares of restricted stock to the Company’s directors and employees, cancelled 11,600 shares of unvested restricted stock related to employee turnover and cancelled 28,791 shares of restricted stock that had a value of $422,000, when employees elected to pay their tax obligation via the repurchase of the stock by the Company. The net issuance of restricted stock for 2013 was 69,450 shares.

 

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Note 13 - Other Comprehensive Income (Loss)

The following table presents the changes in accumulated other comprehensive income (loss) by component for the periods indicated (dollars in thousands):

 

     Before Tax     Tax Effect     Net of Tax  

Three Months Ended – June 30, 2014

      

Net unrealized gains (losses) on investment securities:

      

Beginning balance

   $ (80   $ (33   $ (47
  

 

 

   

 

 

   

 

 

 

Net unrealized gains arising during the period

     411        169        242   
  

 

 

   

 

 

   

 

 

 

Reclassification adjustment for gains realized in net income

     0        0        0   
  

 

 

   

 

 

   

 

 

 

Net other comprehensive income

     411        169        242   
  

 

 

   

 

 

   

 

 

 

Ending balance

   $ 331      $ 136      $ 195   
  

 

 

   

 

 

   

 

 

 
     Before Tax     Tax Effect     Net of Tax  

Three Months Ended – June 30, 2013

      

Net unrealized gains on investment securities:

      

Beginning balance

   $ 2,243      $ 923      $ 1,320   
  

 

 

   

 

 

   

 

 

 

Non-credit portion of other-than-temporary impairments arising during the period

     —          —          —     

Net unrealized losses arising during the period

     (1,247     (513     (734
  

 

 

   

 

 

   

 

 

 

Net other comprehensive loss

     (1,247     (513     (734
  

 

 

   

 

 

   

 

 

 

Ending balance

   $ 996      $ 410      $ 586   
  

 

 

   

 

 

   

 

 

 
     Before Tax     Tax Effect     Net of Tax  

Six Months Ended – June 30, 2014

      

Net unrealized gains (losses) on investment securities:

      

Beginning balance

   $ (348   $ (143   $ (205
  

 

 

   

 

 

   

 

 

 

Net unrealized gains arising during the period

     679        279        400   
  

 

 

   

 

 

   

 

 

 

Reclassification adjustment for gains realized in net income

     0        0        0   
  

 

 

   

 

 

   

 

 

 

Net other comprehensive income

     679        279        400   
  

 

 

   

 

 

   

 

 

 

Ending balance

   $ 331      $ 136      $ 195   
  

 

 

   

 

 

   

 

 

 
     Before Tax     Tax Effect     Net of Tax  

Six Months Ended – June 30, 2013

      

Net unrealized gains on investment securities:

      

Beginning balance

   $ 2,369      $ 975      $ 1,394   
  

 

 

   

 

 

   

 

 

 

Non-credit portion of other-than-temporary impairments arising during the period

     (32     (13     (19

Net unrealized losses arising during the period

     (1,336     (550     (786
  

 

 

   

 

 

   

 

 

 

Other comprehensive loss before reclassifications

     (1,368     (563     (805

Reclassification adjustment for gains realized in net income

     (5     (2     (3
  

 

 

   

 

 

   

 

 

 

Net other comprehensive loss

     (1,373     (565     (808
  

 

 

   

 

 

   

 

 

 

Ending balance

   $ 996      $ 410      $ 586   
  

 

 

   

 

 

   

 

 

 

 

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Note 14 - Commitments and Contingencies

Litigation

From time to time the Company is a party to claims and legal proceedings arising in the ordinary course of business. The Company accrues for any probable loss contingencies that are estimable and discloses any material losses. As of June 30, 2014, there were no legal proceedings against the Company the outcome of which are expected to have a material adverse impact on the Company’s financial position, results of operations or cash flows, as a whole.

Financial Instruments with Off Balance Sheet Risk

See Note 22 – Commitments and Contingencies in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013. Financial instruments with off balance sheet risk include commitments to extend credit of $417 million and $346 million at June 30, 2014 and December 31, 2013, respectively. Included in the aforementioned commitments were standby letters of credit outstanding of $40.7 million and $40.6 million at June 30, 2014 and December 31, 2013, respectively.

Note 15 - Fair Value of Assets and Liabilities

Fair Value Measurement

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for an asset or liability in an orderly transaction between market participants at the measurement date. The required disclosure within the financial statements of the fair value of financial assets and financial liabilities includes both those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis and those reported on a non-recurring basis. The methodologies for estimating the fair value of financial assets and financial liabilities that are measured at fair value, and for estimating the fair value of financial assets and financial liabilities not recorded at fair value, are discussed below.

In accordance with accounting guidance, the Company groups its financial assets and financial liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are as follows:

 

    Level 1 – Observable unadjusted quoted market prices in active markets for identical assets and liabilities that the reporting entity has the ability to access at the measurement date.

 

    Level 2 – Significant other observable market based inputs, other than Level 1 prices such as quoted prices for similar assets or liabilities or unobservable inputs that are corroborated by market data. This includes quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data, either directly or indirectly. This would include those financial instruments that are valued using models or other valuation methodologies where substantially all of the assumptions are observable in the marketplace, can be derived from observable market data or are supported by observable levels at which transactions are executed in the marketplace.

 

    Level 3 – Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability. Assets measured utilizing level 3 are for positions that are not traded in active markets or are subject to transfer restrictions, and or where valuations are adjusted to reflect illiquidity and or non-transferability. These assumptions are not corroborated by market data. This is comprised of financial instruments whose fair value is estimated based on internally developed models or methodologies utilizing significant inputs that are generally less readily observable from objective sources. Management uses a combination of reviews of the underlying financial statements, appraisals and management’s judgment regarding credit quality to determine the value of the financial asset or liability.

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. Management maximizes the use of observable inputs and attempts to minimize the use of unobservable inputs when determining fair value measurements. The following is a description of both the general and specific valuation methodologies used for certain instruments measured at fair value, as well as the general classification of these instruments pursuant to the valuation hierarchy.

 

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Investment Securities Available-for-Sale: The fair value of securities available-for-sale may be determined by obtaining quoted prices in active markets, when available, from nationally recognized securities exchanges (Level 1 financial assets) If quoted market prices are not available, the fair value is determined by a matrix pricing, which is a mathematical technique widely used in the securities industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities which are observable market inputs (Level 2 financial assets). Debt securities’ pricing is generally obtained from one of the matrix pricing models developed from one of the three national pricing agencies. In cases where significant credit valuation adjustments are incorporated into the estimation of fair value, reported amounts are classified as Level 3 financial assets.

Securities classified as available-for-sale are accounted for at their current fair value rather than amortized historical cost. Unrealized gains or losses are excluded from net income and reported as an amount net of taxes as a separate component of accumulated other comprehensive income included in shareholders’ equity.

The Company considers the inputs utilized to fair value the U.S. Agency and U.S. Sponsored Agency issued debt securities (callable and non-callable notes), mortgage backed securities guaranteed by those agencies, collateralized mortgage obligations issued by those agencies, corporate bond securities, and municipal securities to be observable market inputs and classified these financial assets within the Level 2 fair value hierarchy. Management bases the fair value for these investments primarily on third party price indications provided by independent pricing sources utilized by the Company’s bond accounting system to obtain market pricing on its individual securities. Vining Sparks, who provides the Company with its bond accounting system, utilizes pricing from three independent third party pricing sources for pricing of securities. These third party pricing sources utilize, quoted market prices or when quoted market prices are not available, then fair values are estimated using nationally recognized third-party vendor pricing models of which the inputs are observable. However, the fair value reported may not be indicative of the amounts that could be realized in an actual market exchange.

The fair value of the Company’s U.S. Agency and U.S. Sponsored Agency callable and non-callable agency securities, mortgage backed securities guaranteed by those agencies, and collateralized mortgage obligations issued by those agencies, corporate bond securities, and municipal securities are calculated using an option adjusted spread model from one of the nationally recognized third-party pricing models. Depending on the assumptions used and the treasury yield curve and other interest rate assumptions, the fair value could vary significantly in the near term.

Loans: The fair value for loans is estimated by discounting the expected future cash flows using current interest rates at which similar loans would be made to borrowers with similar credit ratings for the same remaining maturities, adjusted for the allowance for loan loss. Loans are segregated by type such as commercial and industrial, commercial real estate, construction and other loans with similar credit characteristics and are further segmented into fixed and variable interest rate loan categories. Expected future cash flows are projected based on contractual cash flows, adjusted for estimated prepayments. The inputs utilized in determining the fair value of loans are unobservable and accordingly, these financial assets are classified within Level 3 of the fair value hierarchy.

Impaired Loans: The fair value of impaired loans is determined based on an evaluation at the time the loan is originally identified as impaired, and periodically thereafter, at the lower of cost or fair value. Fair value on impaired loans is measured based on the value of the collateral securing these loans, less costs to sell, if the loan is collateral dependent, or based on the discounted cash flows for non-collateral dependent loans. Collateral on collateral dependent loans may be real estate and/or business assets including equipment, inventory and/or accounts receivable and is determined based on appraisals performed by qualified licensed appraisers hired by the Company. Appraised and reported values may be discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and client’s business. Such discounts are typically significant and unobservable. For unsecured loans, the estimated future discounted cash flows of the business or borrower, are used in evaluating the fair value. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors identified above. The inputs utilized in determining the fair value of impaired loans are unobservable and accordingly, these financial assets are classified within Level 3 of the fair value hierarchy.

Interest Rate Swap Contracts: The fair value of the interest rate swap contracts are provided by an independent third party vendor that specializes in interest rate risk management and fair value analysis using a model that utilizes current market data to estimate cash flows of the interest rate swaps utilizing the future LIBOR yield curve for accruing and the future Overnight Index Swap Rate (Fed Funds Effective Swap Rate) “OIS” yield curve for discounting through the maturity date of the interest rate swap contract. The future LIBOR yield curve is the primary input in the valuation of the interest rate swap contracts. Both the LIBOR and OIS yield curves are readily observable in the marketplace. Accordingly, the interest rate swap contracts are classified within Level 2 of the fair value hierarchy.

 

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Other Real Estate Owned: The fair value of other real estate owned is generally based on real estate appraisals (unless more current market information is available) less estimated costs of sale. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant. The inputs utilized in determining the fair value of other real estate owned are unobservable and accordingly, these financial assets are classified within Level 3 of the fair value hierarchy.

SBA Servicing Asset: The Company acquired an SBA servicing asset with the PC Bancorp merger and has added to the servicing asset with the sale of SBA loans subsequent to the merger. This servicing asset was initially fair valued at the merger date based on an evaluation by a third party who specializes in fair value analysis. The fair value of this asset was based on the estimated discounted future cash flows utilizing market based discount rates and estimated prepayment speeds. The discount rate was based on the current U.S. Treasury yield curve, plus a spread for marketplace risk associated with these assets. Prepayment speeds were selected based on the historical prepayments of similar SBA pools. The prepayment speeds determine the timing of the cash flows. The SBA servicing asset is amortized over the estimated life of the loans based on an effective yield approach. In addition, the Company’s servicing asset is evaluated regularly for impairment by discounting the estimated future cash flows using market-based discount rates and prepayment speeds. If the calculated present value of the servicing asset declines below the Company’s current carrying value, the servicing asset is written down to its present value. Based on the Company’s methodology in its valuation of the SBA servicing asset, the current carrying value is estimated to approximate the fair value. The inputs utilized in determining the fair value of SBA servicing asset are unobservable and accordingly, these financial assets are classified within Level 3 of the fair value hierarchy.

Non-Maturing Deposits: The fair values for non-maturing deposits (deposits with no contractual termination date), which include non-interest bearing demand deposits, interest bearing transaction accounts, money market deposits and savings accounts are equal to their carrying amounts, which represent the amounts payable on demand. Because the carrying value and fair value are by definition identical, and accordingly non-maturity deposits are classified within Level 1 of the fair value hierarchy, these balances are not listed in the following tables.

Maturing Deposits: The fair values of fixed maturity certificates of deposit (time deposits) ) “CD’s” are estimated using a discounted cash flow calculation that applies current market deposit interest rates to the Company’s current certificates of deposit interest rates for similar term certificates. The inputs utilized in determining the fair value of maturing deposits are observable from published and quoted CD rates marketed by other financial institutions and accordingly, these financial liabilities are classified within Level 2 of the fair value hierarchy.

Securities Sold under Agreements to Repurchase (“Repos”): The fair value of securities sold under agreements to repurchase is estimated based on the discounted value of future cash flows expected to be paid on the deposits. The carrying amounts of Repos with maturities of 90 days or less approximate their fair values. The fair value of Repos with maturities greater than 90 days is estimated based on the discounted value of the contractual future cash flows. The inputs utilized in determining the fair value of securities sold under agreements to repurchase are observable and accordingly, these financial liabilities are classified within Level 2 of the fair value hierarchy.

Subordinated Debentures: The fair value of the three variable rate subordinated debentures (“debentures”) is estimated using a discounted cash flow calculation that applies the three month LIBOR plus the margin index at June 30, 2014, to the cash flows from the debentures, based on the actual interest rate the debentures were accruing at June 30, 2014. Because all three of the debentures re-priced on June 16, 2014 based on the current three month LIBOR index rate plus the index margin at that date, and with relatively little to no change in the three month LIBOR index rate from the re-pricing date through June 30, 2014, the current face value of the debentures and their calculated fair value are approximately equal. The inputs utilized in determining the fair value of subordinated debentures are observable and accordingly, these financial liabilities are classified within Level 2 of the fair value hierarchy.

Fair Value of Commitments: Loan commitments that are priced on an index plus a margin to a market rate of interest are reported at the carrying value of the loan commitment. Loan commitments on which the committed fixed interest rate is less or more than the current market rate were insignificant at June 30, 2014 and December 31, 2013.

Interest Rate Risk: The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the Company’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match

 

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maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. In addition, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company’s overall rate risk.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following table summarizes the financial assets and financial liabilities measured at fair value on a recurring basis as of the dates indicated, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value (dollars in thousands):

 

     Fair
Value
     (Level 1)      (Level 2)      (Level 3)  

Financial Assets – June 30, 2014

           

Investment securities available-for-sale

   $ 102,143       $ —         $ 102,143       $ —     

Financial Liabilities – June 30, 2014

           

Interest Rate Swap Contracts

   $ 3,549       $ —         $ 3,549       $ —     

Financial Assets – December 31, 2013

           

Investment securities available-for-sale

   $ 106,488       $ —         $ 106,488       $ —     

Financial Liabilities – December 31, 2013

           

Interest Rate Swap Contracts

   $ 3,943       $ —         $ 3,943       $ —     

 

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At December 31, 2013 and at June 30, 2014 the Company had no financial assets or liabilities that were measured at fair value on a recurring basis that required the use of significant unobservable inputs (Level 3), and thus a table has not been provided for the six months ended June 30, 2014. The following table presents a roll forward of all assets and liabilities and additional information about the financial assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the date and period indicated (dollars in thousands):

 

Financial Assets – Measured at

Fair Value on a Recurring Basis

using Unobservable Inputs

   Balance
at
January 1
     Included
in
Earnings
    Included in
Other
Comprehensive
Income

(Loss)
     Purchases,
Issuances,
Sales,
Settlements
    Transfers
into

(out of)
Level 3
     Balance
at
June 30
 

Period ended June 30, 2013

            

Private Issue CMO Securities

   $ 2,910       $ (20   $ —         $ (2,890   $ —         $ —     
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 2,910       $ (20   $ —         $ (2,890   $ —         $ —     
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

There were no transfers of assets either between Level 1 and Level 2 nor in or out of Level 3 of the fair value hierarchy for assets measured on a recurring basis for the period ended June 30, 2014 and 2013. The above table reflects the sale of the Company’s Private Issue CMO securities during the first quarter of 2013.

Assets Measured at Fair Value on a Non-recurring Basis

The Company may be required periodically, to measure certain financial assets and financial liabilities at fair value on a nonrecurring basis, that is, the instruments are not measured at fair value on an ongoing basis, but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). These include assets that are measured at the lower of cost or market value that were recognized at fair value below cost at the end of or during the period.

There was one loan transferred to other real estate owned “OREO” during the quarter ending June 30, 2014. At December 31, 2013 this loan was included in the collateral dependent impaired loans table below with a carrying value of $219,000. This asset was transferred to OREO during the 2nd quarter of 2014 at a value of $219,000. There was no change in the valuation hierarchy for this asset. Two other loans with a carrying value of $45,000 were included in the $264,000 balance at December 31, 2013. These loans were both paid down resulting in no carrying value at June 30, 2014. There were no other reclassifications of assets either between Level 1 and Level 2 nor in or out of Level 3 of the fair value hierarchy for assets measured on a non-recurring basis for the three months ended June 30, 2014 and 2013.

The following table presents the balances of assets and liabilities measured at fair value on a non-recurring basis by caption and by level within the fair value hierarchy as of the dates indicated (dollars in thousands):

 

     Recorded
Investment
Carrying

Value
     (Level 1)      (Level 2)      (Level 3)  

Financial Assets – June 30, 2014

           

Other real estate owned, net

   $ 219       $ —         $ —         $ 219   
  

 

 

    

 

 

    

 

 

    

 

 

 
     219         —           —           219   
  

 

 

    

 

 

    

 

 

    

 

 

 

Financial Assets – December 31, 2013

           

Collateral dependent impaired loans with specific valuation allowance and/or partial charge-offs (non-purchased credit impaired loans)

   $ 264       $ —         $ —         $ 264   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 264       $ —         $ —         $ 264   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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The following table presents the significant unobservable inputs used in the fair value measurements for Level 3 assets and liabilities measured at fair value on a recurring or non-recurring basis as of the dates indicated (dollars in thousands):

 

     Fair
Value
    

Valuation

Methodology

  

Valuation Model

and/or Factors

   Unobservable
Input Values
 

Financial Assets – June 30, 2014

           

Other real estate, net

   $ 219       Commercial real estate appraisal    Sales approach (3)   
         Estimated selling costs      8

Financial Assets – December 31, 2013

           

Collateral dependent impaired loans with specific valuation allowance and/or partial charge-off (1)

   $ 45       Credit loss estimate of aged accounts receivable collateral    Credit loss factors on aging of accounts receivable collateral      80
   $ 219       Commercial real estate appraisal    Sales approach (2)   
         Estimated selling costs      8

 

(1) The Company has recorded total charge-offs of $605,000 on the principal balance on two of the loans included in the balance in the above table. These charge-offs were recorded in 2013.
(2) For the one commercial real estate loan included in the above table at December 31, 2013, the Company established the fair value of the loan based on a recent commercial real estate appraisal. The Company selected the “sales approach” for valuing the collateral.
(3) For the one commercial real estate property included in other real estate owned at June 30, 2014 as reflected in the above table, the Company established the fair value of this property based on a recent commercial real estate appraisal. The Company selected the “sales approach” for valuing the collateral.

 

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Fair Value of Financial Assets and Liabilities

The required disclosure within the financial statements of the fair value of financial assets and financial liabilities, include both those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis and those reported on a non-recurring basis. The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required to develop the estimates of fair value. Accordingly, the estimates presented below are not necessarily indicative of the amounts the Company could have realized in a current market exchange as of June 30, 2014 and December 31, 2013. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. The description of the valuation methodologies used for assets and liabilities measured at fair value and for estimating fair value for financial instruments not recorded at fair value has been described above.

The table below presents the carrying amounts and fair values of financial instruments based on their fair value hierarchy indicated (dollars in thousands):

 

            Fair Value  
     Recorded
Investment
Carrying
Value
     (Level 1)      (Level 2)      (Level 3)  

June 30, 2014

           

Financial Assets

           

Investment securities available-for-sale

   $ 102,143       $ —         $ 102,143       $ —     

Loans, net

     968,606         —           —           972,960   

Financial Liabilities

           

Certificates of deposit

     57,732         —           57,775         —     

Securities sold under agreements to repurchase

     13,852         —           13,852         —     

Subordinated debentures

     9,459         —           12,372         —     

Interest rate swap contracts

     3,549         —           3,549         —     

December 31, 2013

           

Financial Assets

           

Investment securities available-for-sale

   $ 106,488       $ —         $ 106,488       $ —     

Loans, net

     922,591         —           —           926,500   

Financial Liabilities

           

Certificates of deposit

     63,581         —           63,680         0   

Securities sold under agreements to repurchase

     11,141         —           11,141         —     

Subordinated debentures

     9,379         —           12,372         —     

Interest rate swap contracts

     3,943         —           3,943         —     

 

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ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

See “Cautionary Statement for Purposes of the “Safe Harbor” Provisions of the Private Securities Litigation Reform Act of 1995” below relating to “forward-looking” statements included in this report.

The following is management’s discussion and analysis of the major factors that influenced the results of the operations and financial condition of CU Bancorp, the (“Company”) for the current period. This analysis should be read in conjunction with the audited financial statements and accompanying notes included in the Company’s 2013 Annual Report on Form 10K and with the unaudited financial statements and notes as set forth in this report.

CAUTIONARY STATEMENT FOR PURPOSES OF THE “SAFE HARBOR” PROVISIONS OF THE

PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

We have made forward-looking statements in this document about the Company, for which the Company claims the protection of the safe harbor provisions contained in the Private Securities Litigation Reform Act of 1995.

The Company’s forward-looking statements include descriptions of plans or objectives of management for future operations, products or services, and forecasts of its revenues, earnings or other measures of economic performance. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include the words “believe,” “expect,” “intend,” “estimate” “anticipates,” “project”, “assume”, “plan”, “predict” or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could” or “may.”

We make forward-looking statements as set forth above and regarding projected sources of funds, availability of acquisition and growth opportunities, dividends, adequacy of our allowance for loan losses and provision for loan losses, our loan portfolio and subsequent charge-offs. Forward-looking statements involve substantial risks and uncertainties, many of which are difficult to predict and are generally beyond our control. There are many factors that could cause actual results to differ materially from those contemplated by these forward-looking statements. Risks and uncertainties that could cause our financial performance to differ materially from our goals, plans, expectations and projections expressed in forward-looking statements include those set forth in our filings with the SEC, Item 1A of our Annual Report on Form 10-K, and the following:

 

    Current and future economic and market conditions in the United States generally or in the communities we serve, including the effects of declines in property values, high unemployment rates and overall slowdowns in economic growth.

 

    Loss of customer checking and money-market account deposits as customers pursue other, higher-yield investments.

 

    Possible changes in consumer and business spending and saving habits and the related effect on our ability to increase assets and to attract deposits.

 

    Competitive market pricing factors.

 

    Deterioration in economic conditions that could result in increased loan losses.

 

    Risks associated with concentrations in real estate related loans.

 

    Risks associated with concentrations in deposits.

 

    Market interest rate volatility.

 

    Possible changes in the creditworthiness of customers and the possible impairment of the collectability of loans.

 

    Changes in the speed of loan prepayments, loan origination and sale volumes, loan loss provisions, charge offs or actual loan losses.

 

    Compression of our net interest margin.

 

    Stability of funding sources and continued availability of borrowings.

 

    Changes in legal or regulatory requirements or the results of regulatory examinations that could restrict growth.

 

    The inability of our internal disclosure controls and procedures to prevent or detect all errors or fraudulent acts.

 

    Inability of our framework to manage risks associated with our business, including operational risk and credit risk, to mitigate all risk or loss to us.

 

    Our ability to keep pace with technological changes, including our ability to identify and address cyber-security risks such as data security breaches, “denial of service” attacks, “hacking” and identity theft.

 

    The effects of man-made and natural disasters, including earthquakes, floods, droughts, brush fires, tornadoes and hurricanes.

 

    Our ability to recruit and retain key management and staff.

 

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    Availability of and competition for acquisition opportunities.

 

    Risks associated with merger and acquisition integration.

 

    Significant decline in the market value of the Company that could result in an impairment of goodwill.

 

    Regulatory limits on the Bank’s ability to pay dividends to the Company.

 

    New accounting pronouncements.

 

    The impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) and related rules and regulations on the Company’s business operations and competitiveness.

 

    Our ability to comply with applicable capital and liquidity requirements (including the finalized Basel III capital standards), including our ability to generate capital internally or raise capital on favorable terms.

 

    The effects of any damage to our reputation resulting from developments related to any of the items identified above.

Merger

On June 3, 2014, the Company announced it had entered into the Agreement and Plan of Merger, dated June 2, 2014, (the “merger agreement”) by and among CU Bancorp, the (“Company”), California United Bank, the (“Bank”) and 1st Enterprise Bank (“1st Enterprise”). In connection with the execution of that merger agreement, the Company has supplemented the risk factors previously disclosed in the Company’s most recent annual report on Form 10-K as follows:

We may fail to realize all of the anticipated benefits of the merger if the combined company does not achieve certain cost savings and other benefits or if the Bank and 1st Enterprise do not successfully integrate.

The Company’s belief that the cost savings and revenue enhancements are achievable is a forward-looking statement that is inherently uncertain. The combined company’s actual cost savings and revenue enhancements, if any, cannot be quantified at this time. Actual cost savings and revenue enhancements will depend on future expense levels and operating levels, the timing of certain events and general industry, regulatory and business conditions. Many of these events will be beyond the control of the combined company.

Further, if the Company is unable to successfully integrate the businesses of the Bank and 1st Enterprise, operating results may suffer. The Bank and 1st Enterprise have operated and, until completion of the merger, will continue to operate independently of one another. It is possible that the integration process could result in the loss of key employees, disruption of their ongoing businesses, or inconsistencies in standards, controls, policies or procedures. These could negatively affect both the Bank’s and 1st Enterprise’s ability to maintain relationships with customers and employees, or achieve the anticipated benefits of the merger. As with any completed merger of financial institutions, there may also be disruptions that cause customers, both deposit and loan, to take their business to competitors.

The Company will be subject to business uncertainties while the merger is pending that could adversely affect its business.

The parties’ efforts to complete the merger could cause substantial disruptions in the Company’s business, which could have an adverse effect on its financial results. Among other things, uncertainty as to whether the merger will be completed may affect the ability of each of the parties to recruit prospective employees or to retain and motivate existing employees. Employee retention may be particularly challenging while the merger is pending because employees may experience uncertainty about their future roles with the combined Company.

Uncertainty as to the future could adversely affect the Company’s business, reputation and relationships with potential depositors, borrowers and vendors. For example, vendors, customers and others who deal with the Company could defer decisions concerning working with the Company, or seek to change existing business relationships with the Company. Further, a substantial amount of the attention and management and employees of the Company is being directed toward the completion of the merger and thus is being diverted from the Company’s day-to-day operations because matters related to the merger, (including integration planning) require substantial commitments of time and resources.

In addition the merger agreement restricts the Company from taking certain actions without 1st Enterprises’ consent while the merger is pending. These restrictions may, among other matters, prevent the Company from pursuing otherwise attractive business opportunities, selling assets, changing the capital structure, entering into other transactions or making other changes to our business prior to consummation of the merger or termination of the merger agreement. These restrictions could have a material adverse effect on the Company’s business, financial condition and results of operations.

 

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The Company will incur significant transaction and merger-related integration costs in connection with the merger.

The Company expects to incur significant costs associated with completing the merger and integrating the operations of the Bank and 1st Enterprise. Although the Company believes that the elimination of duplicate costs and the realization of other efficiencies related to the integration of the businesses of the Bank and 1st Enterprise will offset incremental transition and merger-related costs over time, this net benefit may not be achieved in the near term, or at all.

Company shareholders will experience significant dilution as a result of the merger.

In connection with the merger, 1st Enterprise shareholders will receive 1.3450 shares of Company common stock in exchange for each share of 1st Enterprise common stock (except with respect to fractional shares) pursuant to the terms of the merger agreement. As a consequence, the shareholders of the Company will experience significant dilution in their ownership percentage and voting power in the Company following the merger. If the merger is consummated and based upon the exchange ratio of 1.3450, current 1st Enterprise common stock shareholders will own approximately 31.5% of the Company’s common stock, on a fully diluted basis. Accordingly, while the Company’s shareholders will still own a majority of the outstanding voting stock of the combined company after the merger, their interests will be diluted and would significantly reduce their ability to out vote current 1st Enterprise shareholders if such current 1st Enterprise shareholders voted together as a group.

The market price of Company common stock after the merger may be affected by factors different from those currently affecting the market price of 1st Enterprise common stock and Company common stock.

Upon completion of the merger, holders of 1st Enterprise common stock will become holders of Company common stock, and the Treasury, as the sole holder of the 1st Enterprise preferred stock, will become a holder of Company preferred stock. The Company’s business differs from that of 1st Enterprise and, accordingly, the results of operations of the combined company and the market price of Company common stock after the completion of the merger may be affected by factors different from those currently affecting the independent results of operations of each of the Company and 1st Enterprise.

The merger will not be completed unless important conditions are satisfied.

Specified conditions set forth in the merger agreement must be satisfied or waived to complete the merger. If the conditions are not satisfied or waived, to the extent permitted by law or NASDAQ rules, the merger will not occur or will be delayed, and the Company may lose some or all of the intended benefits of the merger. The following conditions must be satisfied or, with respect to conditions other than shareholder and regulatory approval, waived, if permissible, before the Company, the Bank, and 1st Enterprise are obligated to complete the merger:

 

    the merger agreement must be approved by the affirmative vote of at least a majority of the shares of Company common stock outstanding as of the record date for the Company annual meeting;

 

    the merger agreement must be approved by the affirmative vote of at least a majority of the shares of 1st Enterprise common stock and by the affirmative vote of at least a majority of the shares of 1st Enterprise preferred stock outstanding as of the record date for the 1st Enterprise annual meeting;

 

    all required regulatory approvals and consents must be obtained, including approvals and/or non-objections from the FRB, the FDIC and the California Department of Business Oversight, (the “DBO”);

 

    the absence of any law or order by a court or regulatory authority that would prohibit, restrict or make illegal the merger;

 

    the number of shares of 1st Enterprise common stock for which dissenters’ rights have been properly asserted shall not be more than 5% of the total issued and outstanding shares of 1st Enterprise common stock; and

 

    the Treasury, as the holder of the 1st Enterprise preferred stock, does not exercise dissenters’ rights with respect to any shares of the 1st Enterprise preferred stock it holds.

Failure to complete the merger could negatively impact the Company’s and the Bank’s business, financial condition, results of operations and / or stock price.

 

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If the merger agreement is terminated and the merger is not completed, the ongoing businesses of the Company and the Bank may be adversely affected. For example:

 

    the risk that the pursuit of the merger could lead to the Company’s failure to pursue other beneficial opportunities due to the focus of the Company’s management on completing the merger;

 

    pursuant to the merger agreement, the Company and the Bank are subject to certain restrictions on the conduct of their business prior to completing the merger, which restrictions could adversely affect their ability to realize certain of their business strategies;

 

    the market price of the Company’s common stock may decline to the extent that the current market price reflects a market assumption that the merger will be completed;

 

    the Company and the Bank may experience negative reactions to the termination of the merger from customers, depositors, investors, vendors and others who deal with the Company and the Bank;

 

    the Company would not realize any of the anticipated benefits of having completed the merger;

 

    the Company may be required to pay a termination fee of $1.0 million to 1st Enterprise and to reimburse 1st Enterprise for its merger-related expenses (up to $1.0 million) if the merger agreement is terminated under certain circumstances; and

 

    the expenses of the Company incurred in connection with the merger, such as legal and accounting fees, must be paid even if the merger is not completed and may not, except in certain circumstances, be recovered from the other party.

In addition, any delay in the consummation of the merger, or any uncertainty about the consummation of the merger, may adversely affect the Company’s and the Bank’s future business, growth, revenue and results of operations.

The consideration to be paid in the merger is fixed and will not be adjusted for changes in the Company’s or 1st Enterprises’ business, assets, liabilities, prospects, outlook, financial condition or results of operations, or in the event of any change in the Company’s or 1st Enterprises stock price.

The merger consideration is fixed in the merger agreement and will not be adjusted for changes in the Company’s or 1st Enterprises’ business, assets, liabilities, prospects, outlook financial condition or results of operations, or changes in the market price of, analyst estimates of, or projections relating to, the Company’s common stock or 1st Enterprises’ common stock. For example, if the Company experienced an improvement in its business, assets, liabilities, prospects, outlook, financial condition or results of operations prior to the consummation of the merger, there would be no adjustment to the amount of the merger consideration

Forward-looking statements speak only as of the date they are made. The Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events.

For a more complete discussion of these risks and uncertainties, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2013 and particularly, Item 1A, titled “Risk Factors.”

 

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OVERVIEW

CU Bancorp (the “Company”) is a bank holding company whose operating subsidiary is California United Bank. As a bank holding company, CU Bancorp is subject to regulation of the Federal Reserve Board (“FRB”). The term “Company”, as used throughout this document, refers to the consolidated balance sheets and consolidated statements of income of CU Bancorp and California United Bank.

California United Bank (the “Bank”) is a full-service commercial business bank offering a broad range of banking products and services including: deposit services, lending and cash management to small and medium-sized businesses in Los Angeles, Orange and Ventura counties, to non-profit organizations, to business principals and entrepreneurs, to the professional community, including attorneys, certified public accountants, financial advisors, healthcare providers and investors. The Bank opened for business in 2005, with its headquarters office located in Encino, California. As a state chartered non-member bank, the Bank is subject to regulation by the California Department of Business Oversight, (the “DBO”) and the Federal Deposit Insurance Corporation (“FDIC”). The deposits of the Bank are insured by the FDIC, to the maximum amount allowed by law.

On June 3, 2014, CU Bancorp and 1st Enterprise Bank (“1st Enterprise”) announced the execution of a definitive agreement and plan of merger whereby 1st Enterprise will merger into California United Bank. The transaction combines two of the leading commercial banking franchises in Southern California with more than $2.2 billion in combined assets which operate offices in Los Angeles, Orange, Ventura and San Bernardino counties. California United Bank will survive the merger and will continue the commercial banking operations of the combined bank following the merger. The transaction is intended to qualify as a tax-free reorganization under the applicable provision of the Internal Revenue Code and 1st Enterprise shareholders who receive shares of CU Bancorp common stock in the merger should not recognize any taxable gain on the exchange. Shareholders of 1st Enterprise will receive a fixed exchange ratio at closing of 1.3450 shares of CU Bancorp common stock for each share of 1st Enterprise common stock. Based on the CU Bancorp stock price as of June 2, 2014, the merger transaction is valued at approximately $103.4 million.

Total assets increased $22.5 million or 1.6% from December 31, 2013 to $1.4 billion mainly due to deposit growth of $12.9 million, growth in securities sold under agreements to repurchase of $2.7 million and net income of $5.1 million. Loan growth during the period was concentrated primarily in Commercial and Industrial loans of $4.4 million, Owner-Occupied Nonresidential Property loans of $ 11.3 million, Other Nonresidential Property loans of $24.8 million and Construction, Land Development and Other Land loans of $14.1 million. Funding the growth of the Company for the six months ending June 30, 2014 was an increase in non-interest bearing deposits of $50.1 million, partially offset by a decline in interest bearing deposits of $37.3 million. At June 30, 2014 and December 31, 2013, non-interest bearing deposits represented 55% and 51% of total deposits, respectively.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities at the date of our financial statements. Actual results may differ from these estimates under different assumptions or conditions.

Various elements of our accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions, and other subjective assessments. We have identified several accounting policies that, due to judgments, estimates, and assumptions inherent in those policies, are essential to an understanding of our consolidated financial statements. These policies relate to the methodologies that determine our allowance for loan loss, the valuation of impaired loans, the classification and valuation of investment securities, accounting for and valuation of derivatives and hedging activities, accounting for business combinations, evaluation of goodwill for impairment, and accounting for income taxes.

Our critical accounting policies are described in greater detail in the Company’s 2013 Annual Report on Form 10-K, Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies and Estimates. We believe that our most critical accounting policies upon which our financial condition depends, and which involve the most complex or subjective decisions or assessment, are as follows:

 

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Allowance for Loan Loss

We maintain an allowance for loan loss (“Allowance”) to provide for probable losses in the loan portfolio. Additions to the Allowance are made by charges to operating expense in the form of a provision for loan losses. All loans that are judged to be uncollectible are charged against the Allowance while any recoveries are credited to the Allowance. We have instituted loan policies and procedures which enable us to adequately evaluate, analyze and monitor risk factors associated with our loan portfolio. These policies and procedures enable us to assess risk factors prior to granting new loans and to continually monitor the risk levels in the loan portfolio. We conduct a critical evaluation of the loan portfolio and the level of the Allowance quarterly. We have instituted loan policies to adequately evaluate and analyze risk factors associated with our loan portfolio and to enable us to assess such risk factors prior to granting new loans and to assess the sufficiency of the Allowance. This evaluation includes an assessment of the following factors: the results of any internal and external loan reviews and any regulatory examination, changes in management or lending policies and underwriting standards, levels of past due loans, loan loss experience, estimated probable loss exposure on each impaired credit, concentrations of credit, value of collateral and any known impairment in the borrowers’ ability to repay, and current economic conditions.

Investment Securities

The Company currently classifies its investment securities under the available-for-sale classification. Under the available-for-sale classification, securities can be sold in response to certain conditions, such as changes in interest rates, changes in the credit quality of the securities, when the credit quality of a security does not conform with current investment policy guidelines, fluctuations in deposit levels or loan demand or need to restructure the portfolio to better match the maturity or interest rate characteristics of liabilities with assets. Securities classified as available-for-sale are accounted for at their current fair value rather than amortized cost. Unrealized gains or losses are excluded from net income and reported as a separate component of accumulated other comprehensive income (loss) net of taxes included in shareholders’ equity.

At each reporting date, investment securities are assessed to determine whether there is an other-than-temporary impairment. If it is probable, based on current information, that we will be unable to collect all amounts due according to the contractual terms of a debt security not impaired at acquisition, an other-than-temporary impairment shall be considered to have occurred. If it’s determined that an other-than-temporary impairment exists on a debt security, the Company then determines if (a) it intends to sell the security or (b) it is more likely than not that it will be required to sell the security before its anticipated recovery. If either of the conditions is met, the Company will recognize an other-than-temporary impairment in earnings equal to the difference between the security’s fair value and its adjusted cost basis, the credit portion of the loss is required to be recognized in current earnings, while the non-credit portion of the loss is recorded as a separate component of shareholders’ equity. If neither of the conditions is met, the Company determines (a) the amount of the impairment related to credit loss and (b) the amount of the impairment due to all other factors. The difference between the present value of the cash flows expected to be collected and the amortized cost basis is the credit loss. The credit loss portion of such impairment, if any, is the portion of the other-than-temporary impairments that is recognized in current earnings rather than as a separate component of shareholders’ equity and is a reduction to the cost basis of the security. The portion of total impairment related to all other factors is included in accumulated other comprehensive income (loss). Significant judgment is required in this analysis that includes, but is not limited to assumptions regarding the collectability of principal and interest, future default rates, future prepayment speeds, the amount of current delinquencies that will result in defaults and the amount of eventual recoveries expected on these defaulted loans through the foreclosure process.

Realized gains and losses on sales of securities are recognized in earnings at the time of sale and are determined on a specific-identification basis. Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. For mortgage-backed securities, the amortization or accretion is based on estimated lives of the securities. The lives of these securities can fluctuate based on the amount of prepayments received on the underlying collateral of the securities.

Derivative Financial Instruments and Hedging Activities

All derivative instruments are recorded on the consolidated balance sheet at fair value. For derivatives designated as fair value hedges, changes in the fair value of the derivative and hedged item related to the hedged risk are recognized in earnings. Current financial accounting and reporting standards require every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the consolidated balance sheet as either an asset or liability measured at its fair value. Accounting standards require that changes in the derivative’s fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Accounting for qualifying hedges allows a derivative’s gains and losses to offset related results on the hedged item in the income statement, and requires that a company must formally document, designate and assess the effectiveness of transactions that receive hedge accounting.

 

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On the date a derivative contract is entered into, the Company will designate the derivative contract as either a fair value hedge (i.e. a hedge of the fair value of a recognized asset or liability), a cash flow hedge (i.e. a hedge of the variability of cash flows to be received or paid related to a recognized asset or liability), or a stand-alone derivative (i.e. an instrument with no hedging designation). For a derivative designated as a fair value hedge, the changes in the fair value of the derivative and of the hedged item attributable to the hedged risk are recognized in earnings. If the derivative is designated as a cash flow hedge, the effective portions of changes in the fair value of the derivative are recorded in other comprehensive income and are recognized in the income statement when the hedged item affects earnings. Changes in the fair value of derivatives that do not qualify for hedge accounting are reported currently in earnings, as other non-interest income.

The Company will discontinue hedge accounting prospectively when: it is determined that the derivative is no longer effective in offsetting change in the fair value of the hedged item, the derivative expires or is sold, is terminated, is exercised or management determines that designation of the derivative as a hedging instrument is no longer appropriate. When hedge accounting is discontinued, the Company will continue to carry the derivative on the consolidated balance sheet at its fair value (if applicable), but will no longer adjust the hedged asset or liability for changes in fair value. The adjustments of the carrying amount of the hedged asset or liability will be accounted for in the same manner as other components of the carrying amount of that asset or liability, and the adjustments are amortized to interest income over the remaining life of the hedged item upon the termination of hedge accounting.

Business Combinations

The Company has a number of fair value adjustments recorded within the consolidated financial statements at June 30, 2014 that were created from the business combinations with California Oaks State Bank (“COSB”) and Premier Commercial Bancorp (“PC Bancorp”) on December 31, 2010 and July 31, 2012, respectively. These fair value adjustments include the Company’s goodwill, fair value adjustments on loans, core deposit intangible assets, other intangible assets, fair value adjustments to acquired lease obligations, fair value adjustments to high rate certificates of deposit and fair value adjustments on derivatives. The assets and liabilities acquired through acquisition have been accounted for at fair value as of the date of the acquisition. The goodwill that was recorded on the transactions represented the excess of the purchase price over the fair value of net assets acquired. If the consideration paid would have been less than the fair value of the net assets acquired, the Company would have recorded a bargain purchase gain. Goodwill is not amortized and is reviewed for impairment on October 1st of each year. If an event occurs or circumstances change that result in the Company’s fair value declining to below its book value, the Company would perform an impairment analysis at that time.

Purchased Credit Impaired Loans (“PCI”) loans are acquired loans with evidence of deterioration of credit quality since origination and it is probable at the acquisition date, that the Company will not be able to collect all contractually required amounts. When the timing and/or amounts of expected cash flows on such loans are not reasonably estimable, no interest is accreted and the loan is reported as a non-accrual loan; otherwise, if the timing and amounts of expected cash flows for PCI loans are reasonably estimable, then interest is accreted and the loans are reported as accruing loans. The non-accretable difference represents the difference between the undiscounted contractual cash flows and the undiscounted expected cash flows, and also reflects the estimated credit losses in the acquired loan portfolio at the acquisition date and can fluctuate due to changes in expected cash flows during the life of the PCI loans. For non-PCI loans, loan fair value adjustments consist of an interest rate premium or discount on each individual loan and are amortized to loan interest income based on the effective yield method over the remaining life of the loans.

Income Taxes

Deferred income tax assets and liabilities are computed using the asset and liability method, which recognizes a liability or asset representing the tax effects, based on current tax law, of future deductible or taxable amounts attributable to events that have been recognized in the financial statements. A valuation allowance may be established to the extent necessary to reduce the deferred tax asset to the level at which it is “more likely than not” that the tax assets or benefits will be realized. Realization of tax benefits depends on having sufficient taxable income, available tax loss carrybacks or credits, the reversing of taxable temporary differences and/or tax planning strategies within the reversal period and that current legislative tax law allows for the realization of those tax benefits.

 

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RESULTS OF OPERATIONS

Key Profitability Measures

The following table presents key profitability measures for the periods indicated and the dollar and percentage changes between the periods (dollars in thousands, except per share data):

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     Amounts     Increase
(Decrease)
    Amounts     Increase
(Decrease)
 
     2014     2013           %     2014     2013           %  

Net Income

   $ 2,386      $ 2,321      $ 65        2.8   $ 5,052      $ 4,476      $ 576        12.9
  

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

   

Earnings per share

                

Basic

   $ 0.22      $ 0.22      $ 0.00        0.0   $ 0.46      $ 0.43      $ 0.03        7.0

Diluted

   $ 0.21      $ 0.22      $ (0.01     (4.5 )%    $ 0.45      $ 0.42      $ 0.03        7.1

Return on average equity

     6.63     7.16     (0.53 )%      (7.5 )%      7.15     7.02     0.13     1.9

Return on average assets

     0.69     0.73     (0.04 )%      (5.3 )%      0.73     0.71     0.02     3.4

Net interest rate spread

     3.70     4.06     (0.36 )%      (8.9 )%      3.67     3.94     (0.27 )%      (6.9 )% 

Net interest margin

     3.88     4.25     (0.37 )%      (8.7 )%      3.85     4.13     (0.28 )%      (6.8 )% 

Efficiency ratio (1)

     67.53     65.04     2.49     3.8     67.95     69.32     (0.32 )%      (0.47 )% 

 

(1) Efficiency ratio is defined as non-interest expense divided by the sum of net interest income, gain on sale of SBA loans, and other non-interest income.

Operations Performance Summary

Three Months Ended June 30, 2014 Compared to Three Months Ended June 30, 2013

Net income for the three months ended June 30, 2014 was $2.4 million, or $0.21 per diluted share, compared to $2.3 million, or $0.22 per diluted share for the three months ended June 30, 2013. The $65,000 increase, or 2.8%, was primarily due to the following: Total interest income for the quarter decreased by $75,000 or 0.6% to $13.0 million at June 30, 2014, which was almost completely offset by the decrease in interest expense of $73,000 or 13.7% to $461,000. The provision for loan loss decreased by $745,000 and non-interest income increased by $93,000. These changes were offset by the increase in non-interest expense of $417,000, primarily due to merger-related expenses of $497,000, and the increase in the provision for income taxes of $354,000. The increases in the tax provision is related to the non-deductibility of the merger costs for tax purposes which has resulted in a higher effective tax rate for the second quarter of 2014 compared to 2013. Each of these increases and or decreases is more fully described below.

Six Months Ended June 30, 2014 Compared to Six Months Ended June 30, 2013

Net income for the six months ended June 30, 2014 was $5.1 million, or $0.45 per diluted share, compared to $4.5 million, or $0.42 per diluted share for the six months ended June 30, 2013. The $576,000 increase, or 12.9%, was primarily due to the following: Total interest income for the quarter increased by $492,000 or 2.0% to $25.7 million at June 30, 2014, while interest expense decreased by $141,000 or 13.2% to $924,000. The provision for loan loss decreased by $804,000, while non-interest income increased by $457,000. These changes were offset by the increase in non-interest expense of $657,000 and the increase in the provision for income taxes of $661,000. The increases in the tax provision is related to the non-deductibility of the merger costs for tax purposes which has resulted in a higher effective tax rate for the six month period of 2014 compared to 2013. Each of these increases and or decreases are more fully described below.

 

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    Average Balances, Interest Income and Expense, Yields and Rates

The following tables present the Company’s average balance sheets, together with the total dollar amounts of interest income and interest expense and the weighted average interest yield/rate for the periods presented. All average balances are daily average balances (dollars in thousands).

 

     Three Months Ended  
     June 30, 2014     June 30, 2013  
     Average
Balance
     Interest      Average
Yield/
Rate (5)
    Average
Balance
     Interest      Average
Yield/
Rate (5)
 

Interest Earning Assets:

                

Deposits in other financial institutions

   $ 240,335       $ 206         0.34   $ 208,871       $ 157         0.30

Investment securities (2)

     101,410         467         1.84     106,706         495         1.86

Loans (1)

     958,129         12,366         5.18     872,048         12,462         5.73
  

 

 

    

 

 

      

 

 

    

 

 

    

Total interest-earning assets

     1,299,874         13,039         4.02     1,187,625         13,114         4.43

Non-interest-earning assets

     90,383              92,770         
  

 

 

         

 

 

       

Total Assets

   $ 1,390,257            $ 1,280,395         
  

 

 

         

 

 

       

Interest Bearing Liabilities:

                

Interest bearing transaction accounts

   $ 139,425       $ 66         0.19   $ 132,392       $ 64         0.19

Money market and savings deposits

     353,962         222         0.25     334,729         249         0.30

Certificates of deposit

     60,752         55         0.36     67,914         74         0.44
  

 

 

    

 

 

      

 

 

    

 

 

    

Total Interest Bearing Deposits

     554,139         343         0.25     535,035         387         0.29

Securities sold under agreements to repurchase

     15,425         11         0.29     27,913         21         0.30

Subordinated debentures

     9,439         107         4.48     9,599         126         5.26
  

 

 

    

 

 

      

 

 

    

 

 

    

Total Interest Bearing Liabilities

     579,003         461         0.32     572,547         534         0.37

Non-interest bearing demand deposits

     652,094              566,018         
  

 

 

         

 

 

       

Total funding sources

     1,231,097              1,138,565         

Non-interest bearing liabilities

     14,733              11,820         

Shareholders’ Equity

     144,427              130,010         
  

 

 

         

 

 

       

Total Liabilities and Shareholders’ Equity

   $ 1,390,257            $ 1,280,395         
  

 

 

         

 

 

       

Net interest income

      $ 12,578            $ 12,580      
     

 

 

         

 

 

    

Net interest rate spread (3)

           3.70           4.06

Net interest margin (4)

           3.88           4.25

Core net interest margin (6)

           3.73           3.89

 

(1) Average balances of loans are calculated net of deferred loan fees and fair value discounts, but would include non-accrual loans which have a zero yield.
(2) Average balances of investment securities are presented on an amortized cost basis and thus do not include the unrealized market gain or loss on the securities.
(3) Net interest rate spread represents the yield earned on average total interest-earning assets less the rate paid on average total interest bearing liabilities.
(4) Net interest margin is computed by dividing annualized net interest income by average total interest-earning assets.
(5) Annualized
(6) Core net interest margin is computed by dividing annualized net interest income, excluding accelerated accretion of fair value discounts earned on early loan payoffs of acquired loans and interest recovered or reversed on non-accrual loans, by average total interest-earning assets. See the reconciliation table for core net interest margin.

 

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     Six Months Ended  
     June 30, 2014     June 30, 2013  
     Average
Balance
     Interest      Average
Yield/Rate (5)
    Average
Balance
     Interest      Average
Yield/Rate (5)
 

Interest Earning Assets:

                

Deposits in other financial institutions

   $ 252,973       $ 417         0.33   $ 211,520       $ 317         0.30

Investment securities (2)

     103,080         968         1.88     109,537         979         1.79

Loans (1)

     940,648         24,290         5.21     857,224         23,887         5.62
  

 

 

    

 

 

      

 

 

    

 

 

    

Total interest-earning assets

     1,296,701         25,675         3.99     1,178,281         25,183         4.31

Non-interest-earning assets

     91,362              92,776         
  

 

 

         

 

 

       

Total Assets

   $ 1,388,063            $ 1,271,057         
  

 

 

         

 

 

       

Interest Bearing Liabilities:

                

Interest bearing transaction accounts

   $ 138,720       $ 124         0.18   $ 125,416       $ 116         0.19

Money market and savings deposits

     363,556         456         0.25     342,502         509         0.30

Certificates of deposit

     61,852         111         0.36     72,057         150         0.42
  

 

 

    

 

 

      

 

 

    

 

 

    

Total Interest Bearing Deposits

     564,128         691         0.25     539,975         775         0.29

Securities sold under agreements to repurchase

     13,698         19         0.28     26,889         40         0.30

Subordinated debentures

     9,419         214         4.52     9,400         250         5.36
  

 

 

    

 

 

      

 

 

    

 

 

    

Total Interest Bearing Liabilities

     587,245         924         0.32     576,264         1,065         0.37

Non-interest bearing demand deposits

     642,716              553,808         
  

 

 

         

 

 

       

Total funding sources

     1,229,961              1,130,072         

Non-interest bearing liabilities

     15,658              12,328         

Shareholders’ Equity

     142,444              128,657         
  

 

 

         

 

 

       

Total Liabilities and Shareholders’ Equity

   $ 1,388,063            $ 1,271,057         
  

 

 

         

 

 

       

Net interest income

      $ 24,751            $ 24,118      
     

 

 

         

 

 

    

Net interest rate spread (3)

           3.67           3.94

Net interest margin (4)

           3.85           4.13

Core net interest margin (6)

           3.69           3.94

 

(1) Average balances of loans are calculated net of deferred loan fees and fair value discounts, but would include non-accrual loans which have a zero yield.
(2) Average balances of investment securities are presented on an amortized cost basis and thus do not include the unrealized market gain or loss on the securities.
(3) Net interest rate spread represents the yield earned on average total interest-earning assets less the rate paid on average total interest bearing liabilities.
(4) Net interest margin is computed by dividing annualized net interest income by average total interest-earning assets.
(5) Annualized
(6) Core net interest margin is computed by dividing annualized net interest income, excluding accelerated accretion of fair value discounts earned on early loan payoffs of acquired loans and interest recovered or reversed on non-accrual loans, by average total interest-earning assets. See the reconciliation table for core net interest margin.

 

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The following table represents a reconciliation of GAAP net interest margin to core net interest margin used by the Company. The table presents the information for the periods indicated (dollars in thousands):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2014     2013     2014     2013  

Net Interest Income

   $ 12,578      $ 12,580      $ 24,751      $ 24,118   

Less: Interest recovered on non-accrual loans

     —          162        —          162   

Accelerated accretion of fair value adjustment on early loan payoffs

     483        891        1,002        928   
  

 

 

   

 

 

   

 

 

   

 

 

 

Core Net Interest Income

   $ 12,095      $ 11,527      $ 23,749      $ 23,028   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest margin

     3.88     4.25     3.85     4.13

Core net interest margin

     3.73     3.89     3.69     3.94
  

 

 

   

 

 

   

 

 

   

 

 

 

The following table reflects the composition of the net deferred loan fees, costs and fair value discounts at June 30, 2014 and December 31, 2013 (dollars in thousands):

 

     June 30,
2014
     December 31,
2013
 

Accreting loan discount

   $ 6,772       $ 7,912   

Non-accreting loan discount

     1,155         2,683   
  

 

 

    

 

 

 

Acquired loans remaining discount

     7,927         10,595   

Organic loans net deferred fees

     2,731         2,014   
  

 

 

    

 

 

 

Total

   $ 10,658       $ 12,609   
  

 

 

    

 

 

 

 

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Net Changes in Average Balances, Composition, Yields and Rates

The following tables set forth the composition of average interest-earning assets and average interest bearing liabilities by category and by the percentage of each category to the total for the periods indicated, including the change in average balance, composition, and yield/rate between these respective periods (dollars in thousands):

 

     Three Months Ended June 30,        
     2014     2013     Increase (Decrease)  
     Average
Balance
     %
of
Total
    Average
Yield/
Rate
    Average
Balance
     %
of
Total
    Average
Yield/
Rate
    Average
Balance
    %
of
Total
    Average
Yield/
Rate
 

Interest Earning Assets:

                    

Deposits in other financial institutions

   $ 240,335         18.5     0.34   $ 208,871         17.6     0.30   $ 31,464        0.9     0.04

Investment securities

     101,410         7.8     1.84     106,706         9.0     1.86     (5,296     (1.2 )%      (0.02 )% 

Loans

     958,129         73.7     5.18     872,048         73.4     5.73     86,081