PACIFIC MERCANTILE BANCORP - FORM 10-Q - August 8, 2014

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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
OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                     to                    
Commission file number 0-30777
 
PACIFIC MERCANTILE BANCORP
(Exact name of Registrant as specified in its charter)
 
California
 
33-0898238
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
949 South Coast Drive, Suite 300, Costa Mesa, California
 
92626
(Address of principal executive offices)
 
(Zip Code)
(714) 438-2500
(Registrant’s telephone number, including area code)
 
 
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 (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” “non-accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
 
o
  
Accelerated filer
 
o
Non-accelerated filer
 
o
  
Smaller reporting company
 
x
Indicate by check mark whether the registrant is a shell company (as defined in Securities Exchange Act Rule 12b-2). Yes  ¨    No  x
As of August 6, 2014, there were 19,267,685 shares of Common Stock outstanding.
 

1

PACIFIC MERCANTILE BANCORP
QUARTERLY REPORT ON FORM 10Q
FOR THE QUARTER ENDED JUNE 30, 2014
TABLE OF CONTENTS
 
 
Page No.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


2



PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Dollars in thousands, except for per share data)
(Unaudited)
 
June 30, 2014
 
December 31, 2013
ASSETS
 
 
 
Cash and due from banks
$
14,301

 
$
13,489

Interest bearing deposits with financial institutions
90,441

 
93,451

Cash and cash equivalents
104,742

 
106,940

Interest-bearing time deposits with financial institutions
2,923

 
2,423

Federal Reserve Bank of San Francisco and Federal Home Loan Bank Stock, at cost
8,058

 
8,531

Securities available for sale, at fair value
62,728

 
65,989

Loans (net of allowances of $12,580 and $11,358, respectively)
793,820

 
765,426

Other real estate owned
16,072

 
12,291

Accrued interest receivable
2,006

 
2,017

Premises and equipment, net
1,042

 
1,067

Net deferred tax assets
6,858

 
7,553

Assets of discontinued operations
1,297

 
12,189

Other assets
12,454

 
12,157

Total assets
$
1,012,000

 
$
996,583

LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Deposits:
 
 
 
Noninterest-bearing
$
193,499

 
$
203,942

Interest-bearing
625,795

 
576,283

Total deposits
819,294

 
780,225

Borrowings
47,500

 
70,000

Accrued interest payable
2,614

 
2,285

Other liabilities
5,901

 
8,075

Junior subordinated debentures
17,527

 
17,527

Liabilities of discontinued operations
1,644

 
3,313

Total liabilities
894,480

 
881,425

Commitments and contingencies (Note 10)

 

Shareholders’ equity:
 
 
 
Preferred stock, no par value, 2,000,000 shares authorized:
 
 
 
Series B Convertible 8.4% Noncumulative Preferred Stock, 300,000 shares authorized; 112,000 issued and outstanding at June 30, 2014 and December 31, 2013; liquidation preference $100 per share, plus accumulated but undeclared dividends at June 30, 2014 and December 31, 2013
8,747

 
8,747

Series C Convertible 8.4% Noncumulative Preferred Stock, 300,000 shares authorized; 23,620 and 18,185 issued and outstanding at June 30, 2014 and December 31, 2013, respectively; liquidation preference $100 per share plus accumulated but undeclared dividends at June 30, 2014 and December 31, 2013
2,362

 
1,818

Common stock, no par value, 85,000,000 shares authorized; 19,264,691 and 19,135,169 shares issued and outstanding at June 30, 2014 and December 31, 2013, respectively
129,761

 
128,877

Accumulated deficit
(22,219
)
 
(22,130
)
Accumulated other comprehensive loss
(1,131
)
 
(2,154
)
Total shareholders’ equity
117,520

 
115,158

Total liabilities and shareholders’ equity
$
1,012,000

 
$
996,583

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

3

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands, except for per share data)
(Unaudited)
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
Interest income:
 
 
 
 
 
 
 
Loans, including fees
$
8,652

 
$
8,266

 
$
17,445

 
$
16,551

Securities available for sale and stock
403

 
387

 
821

 
757

Interest-bearing deposits with financial institutions
79

 
75

 
155

 
170

Total interest income
9,134

 
8,728

 
18,421

 
17,478

Interest expense:
 
 
 
 
 
 
 
Deposits
1,225

 
1,148

 
2,410

 
2,573

Borrowings
283

 
209

 
541

 
372

Total interest expense
1,508

 
1,357

 
2,951

 
2,945

Net interest income
7,626

 
7,371

 
15,470

 
14,533

Provision for loan and lease losses
600

 
—

 
1,050

 
1,150

Net interest income after provision for loan and lease losses
7,026

 
7,371

 
14,420

 
13,383

Noninterest income
 
 
 
 
 
 
 
Service fees on deposits and other banking services
218

 
196

 
426

 
392

Net gains on sale of securities available for sale
—

 
—

 
—

 
23

Net gain on sale of small business administration loans
474

 
—

 
1,160

 
—

Net loss on sale of other real estate owned
—

 
—

 
—

 
(9
)
Income from other real estate owned
225

 
1

 
341

 
68

Other noninterest income (loss)
292

 
(471
)
 
576

 
(303
)
Total noninterest income
1,209

 
(274
)
 
2,503

 
171

Noninterest expense
 
 
 
 
 
 
 
Salaries and employee benefits
5,420

 
5,150

 
11,023

 
9,516

Occupancy
610

 
597

 
1,198

 
1,086

Equipment and depreciation
363

 
392

 
732

 
818

Data processing
200

 
199

 
451

 
398

FDIC expense
359

 
547

 
653

 
1,092

Other real estate owned expense
538

 
1,245

 
1,398

 
3,362

Professional fees
490

 
845

 
1,064

 
2,211

(Recovery of) provision for contingencies
175

 
(279
)
 
175

 
(539
)
Business development
169

 
327

 
338

 
534

Loan related expense
129

 
80

 
216

 
220

Insurance
141

 
147

 
278

 
294

Other operating expense
409

 
471

 
898

 
1,007

Total noninterest expense
9,003

 
9,721

 
18,424

 
19,999

Loss from continuing operations before income taxes
(768
)
 
(2,624
)
 
(1,501
)
 
(6,445
)
Income tax provision (benefit)
—

 
—

 
—

 
(1,490
)
Net loss from continuing operations
(768
)
 
(2,624
)
 
(1,501
)
 
(4,955
)
Discontinued Operations
 
 
 
 
 
 
 
Income (loss) from discontinued operations before income taxes
772

 
(518
)
 
1,956

 
(1,795
)
Income tax (benefit) provision
—

 
—

 
—

 
(439
)
Net income (loss) from discontinued operations
772

 
(518
)
 
1,956

 
(1,356
)
Net income (loss)
4

 
(3,142
)
 
455

 
(6,311
)
Accumulated undeclared dividends on preferred stock
(308
)
 
(262
)
 
(604
)
 
(524
)
Net loss allocable to common shareholders
$
(304
)
 
$
(3,404
)
 
$
(149
)
 
$
(6,835
)
Basic loss per common share:
 
 
 
 
 
 
 
Net loss from continuing operations
$
(0.06
)
 
$
(0.15
)
 
$
(0.11
)
 
$
(0.31
)
Net loss available to common shareholders
$
(0.02
)
 
$
(0.18
)
 
$
(0.01
)
 
$
(0.38
)
Diluted loss per common share:
 
 
 
 
 
 
 
Net loss from continuing operations
$
(0.06
)
 
$
(0.15
)
 
$
(0.11
)
 
$
(0.31
)
Net loss available to common shareholders
$
(0.02
)
 
$
(0.18
)
 
$
(0.01
)
 
$
(0.38
)
Weighted average number of common shares outstanding:
 
 
 
 
 
 
 
Basic
19,254,985

 
18,905,842

 
19,200,492

 
17,825,311

Diluted
19,254,985

 
18,905,842

 
19,200,492

 
17,825,311

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

4

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Dollars in thousands)
(Unaudited)
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
Net income (loss)
$
4

 
$
(3,142
)
 
$
455

 
$
(6,311
)
Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Change in unrealized gain (loss) on securities available for sale
406

 
(1,014
)
 
1,023

 
(1,643
)
Change in net unrealized gain and prior service benefit on supplemental executive retirement plan
—

 
—

 
—

 
20

Total comprehensive income (loss)
$
410

 
$
(4,156
)
 
$
1,478

 
$
(7,934
)
The accompanying notes are an integral part of these consolidated financial statements.


5

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(Shares and dollars in thousands)
(Unaudited)
For the Six Months Ended June 30, 2014
  
Series A, B, and C
Preferred stock
 
Common stock
 
Retained
earnings
(accumulated
deficit)
 
Accumulated
other
comprehensive
income (loss)
 
Total
Number
of shares
 
Amount
 
Number
of shares
 
Amount
 
Balance at December 31, 2013
130

 
$
10,565

 
19,135

 
$
128,877

 
$
(22,130
)
 
$
(2,154
)
 
$
115,158

Issuance of restricted stock, net
—

 
—

 
44

 
—

 
—

 
—

 
—

Series C Preferred Stock issued as a stock dividend on Series B Preferred Stock
6

 
544

 
—

 
—

 
(544
)
 
—

 
—

Common stock based compensation expense
—

 
—

 
—

 
540

 
—

 
—

 
540

Common stock options exercised
—

 
—

 
92

 
344

 
—

 
—

 
344

Net income
—

 
—

 
—

 
—

 
455

 
—

 
455

Change in accumulated other comprehensive income
—

 
—

 
—

 
—

 
—

 
1,023

 
1,023

Balance at June 30, 2014
136

 
$
11,109

 
19,265

 
$
129,761

 
$
(22,219
)
 
$
(1,131
)
 
$
117,520

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


6

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOW
(Dollars in thousands)
(Unaudited)
 
Six Months Ended June 30,
 
2014
 
2013
Cash Flows From Operating Activities:
 
 
 
Net income (loss)
$
455

 
$
(6,311
)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
 
 
 
Depreciation and amortization
296

 
280

Provision for loan and lease losses
1,050

 
1,150

Amortization of premium on securities
163

 
278

Net gains on sales of securities available for sale
—

 
(23
)
Net amortization of deferred fees and unearned income on loans
(160
)
 
(132
)
Net gain on sales of other real estate owned
—

 
(1
)
Net gain on sale of premises and equipment
(21
)
 
—

Net gain on sale of small business administration loans
(1,160
)
 
—

Small business administration loan originations
(14,815
)
 
—

Proceeds from sale of small business administration loans
16,001

 
—

Write down of other real estate owned
298

 
1,922

Stock-based compensation expense
540

 
355

Other
(89
)
 
174

Changes in operating assets and liabilities:
 
 
 
Net increase in accrued interest receivable
11

 
64

Net increase in other assets
(531
)
 
(3,765
)
Net decrease (increase) in deferred taxes
695

 
(587
)
Net increase in income taxes receivable
(23
)
 
(2,246
)
Net increase in accrued interest payable
329

 
223

Net decrease in other liabilities
(2,174
)
 
(3,060
)
Net cash provided by discontinued operations
9,223

 
45,137

Net cash provided by operating activities
10,088

 
33,458

Cash Flows From Investing Activities:
 
 
 
Net increase in interest-bearing time deposits with financial institutions
(500
)
 
—

Maturities of and principal payments received on securities available for sale and other stock
5,398

 
14,378

Proceeds from sale of securities available for sale and other stock
—

 
6,164

Proceeds from sale of other real estate owned
1,130

 
—

Capitalized cost of other real estate owned
(21
)
 
—

Net increase in loans
(34,956
)
 
(1,121
)
Purchases of premises and equipment
(288
)
 
(332
)
Proceeds from sale of premises and equipment
38

 
—

Net cash (used in) provided by investing activities
(29,199
)
 
19,089

Cash Flows From Financing Activities:
 
 
 
Proceeds from sale of common stock
—

 
14,999

Net increase (decrease) in deposits
39,069

 
(96,415
)
Net decrease in borrowings
(22,500
)
 
(10,000
)
Proceeds from exercise of common stock options
344

 
23

Net cash provided by (used in) financing activities
16,913

 
(91,393
)
Net increase in cash and cash equivalents
(2,198
)
 
(38,846
)
Cash and Cash Equivalents, beginning of period
106,940

 
128,208

Cash and Cash Equivalents, end of period
$
104,742

 
$
89,362

Supplementary Cash Flow Information:
 
 
 
Cash paid for interest on deposits and other borrowings
$
2,622

 
$
2,785

Cash paid for income taxes
$
—

 
$
—

Non-Cash Investing Activities:
 
 
 
Transfer of loans into other real estate owned
$
5,188

 
$
1,544

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

7


1. Nature of Business
Organization
Pacific Mercantile Bancorp (“PMBC”) is a bank holding company which, through its wholly owned subsidiary, Pacific Mercantile Bank (the “Bank”), is engaged in the commercial banking business in Southern California. PMBC is registered as a one bank holding company under the United States Bank Holding Company Act of 1956, as amended, and, as such, is regulated by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”) and the Federal Reserve Bank of San Francisco (“FRBSF”) under delegated authority from the Federal Reserve Board. Substantially all of our operations are conducted and substantially all of our assets are owned by the Bank, which accounts for substantially all of our consolidated revenues, expenses, and income. The Bank provides a full range of banking services to small and medium-size businesses, professionals and the general public in Orange, Los Angeles, San Bernardino and San Diego counties in Southern California and is subject to competition from other banks and financial institutions and from financial services organizations conducting operations in those same markets. The Bank is chartered by the California Department of Business Oversight under the Division of Financial Institutions and is a member of the FRBSF. In addition, the deposit accounts of the Bank’s customers are insured by the Federal Deposit Insurance Corporation up to the maximum amount allowed by law.
During the first quarter of 2013, PMBC organized a new wholly-owned subsidiary, PM Asset Resolution, Inc. ("PMAR"), for the purpose of purchasing certain non-performing loans and other real estate from the Bank and thereafter collecting on or disposing of those assets. During the fourth quarter of 2013, the Bank announced the closure of our mortgage banking business, which was substantially completed during the first half of 2014 and we expect will be concluded during the third quarter of 2014. The Bank operated a direct-to-consumer retail mortgage banking business, originating and funding residential mortgage loans and selling those loans, generally within the succeeding 30 days. Our mortgage banking operations are classified as discontinued operations within the consolidated financial statements and footnotes for all presented periods.
PMBC, the Bank and PMAR are sometimes referred to, together, on a consolidated basis, in this report as the “Company” or as “we”, “us” or “our”.

2. Significant Accounting Policies
Except as discussed below, our accounting policies are described in Note 2, Significant Accounting Policies of our audited consolidated financial statements for the year ended December 31, 2013 included in our Form 10-K.
Interim Consolidated Financial Statements Basis of Presentation
Our interim consolidated financial statements are prepared in accordance with the instructions of the U.S. Securities and Exchange Commission (the “SEC”) to Form 10-Q and in accordance with generally accepted accounting principles in effect in the United States (“GAAP”), on a basis consistent with prior periods. Our financial statements reflect all adjustments that are, in the opinion of management, necessary to present a fair statement of the results for the interim periods presented. The interim results are not necessarily indicative of operating results for the full year. The interim information should be read in conjunction with our audited consolidated financial statements in our Form 10-K.
Use of Estimates
The preparation of the financial statements in conformity with GAAP requires us to make certain estimates and assumptions that could affect the reported amounts of certain of our assets, liabilities, and contingencies at the date of the financial statements and the reported amounts of our revenues and expenses during the reporting periods. For the fiscal periods covered by this report, those estimates related primarily to our determinations of the allowance for loan and lease losses (“ALLL”), other real estate owned (“OREO”), the fair values of securities available for sale and mortgage loans held for sale (“LHFS”), repurchase reserves on LHFS, and the determination of reserves pertaining to deferred tax assets. If circumstances or financial trends on which those estimates were based were to change in the future or there were to occur any currently unanticipated events affecting the amounts of those estimates, our future financial position or results of operations could differ, possibly materially, from those expected at the current time.
Principles of Consolidation
Our consolidated financial statements for the three and six months ended June 30, 2014 and 2013 include the accounts of PMBC, the Bank and PMAR. All significant intercompany balances and transactions were eliminated in consolidation. 

8

Recent Accounting Pronouncements
In July 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2013-11, “Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists,” which amended its guidance on income taxes to eliminate diversity in the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. The amendments clarify whether unrecognized tax benefits should be presented as a liability on the balance sheet or as a reduction of a deferred tax asset. This guidance is effective for interim and annual periods beginning after December 15, 2013. Early adoption is permitted. We adopted this guidance on January 1, 2014, and it did not have any impact on our financial statement presentation.
In April 2014, the FASB issued ASU 2014-08, “Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity,” which amended its guidance on classification and reporting of discontinued operations. The amendments clarify when an entity should classify a component as discontinued operations, how to report the balances related to discontinued operations for prior periods, and additional disclosure requirements for discontinued operations. This guidance is effective for interim and annual periods beginning after December 15, 2014. Early adoption is permitted only for disposals which have not been previously reported. We will adopt this guidance on January 1, 2015 and do not expect it to have a material effect on our consolidated financial statements.
In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers (Topic 606),” which amended its guidance on revenue recognition to conform with international accounting guidance under the International Accounting Standards Board. The ASU provides a framework for addressing revenue recognition and replaces most existing revenue recognition guidance, as well as requires increased disclosure requirements. This guidance is effective for interim and annual periods beginning after December 15, 2016. Early adoption is not permitted. We will adopt this guidance on January 1, 2017. We are currently evaluating the expected impact on our consolidated financial statements.
In June 2014, the FASB issued ASU 2014-11, “Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period,” which amended its guidance on how to account for certain performance related share-based compensation plans. The amendments clarify the guidance on how to account for performance based awards when the requisite service period is met prior to potential performance targets being achieved. This guidance is effective for interim and annual periods beginning after December 15, 2015. Early adoption is permitted. We will adopt this guidance on January 1, 2016 and do not expect it to have a material effect on our consolidated financial statements.

3. Fair Value Measurements
Under FASB Accounting Standards Codification (“ASC”) 820-10, we group assets and liabilities 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:
Level 1
Valuation is based upon quoted prices for identical instruments traded in active markets.
 
 
Level 2
Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
 
 
Level 3
Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.
Risks with Fair Value Measurements
Fair value estimates are made at a discrete point in time based on relevant market information and other information about the financial instruments. Because no active market exists for a significant portion of our financial instruments, fair value estimates are based in large part on judgments we make primarily regarding current economic conditions, risk characteristics of various financial instruments, prepayment rates, and future expected loss experience. These estimates are subjective in nature and invariably involve some inherent uncertainties. Additionally, the occurrence of unexpected events or changes in circumstances can occur that could require us to make changes to our assumptions and which, in turn, could significantly affect and require us to make changes to our previous estimates of fair value.
In addition, the fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of existing and anticipated future customer relationships and the value of assets and liabilities that are not considered financial instruments, such as premises and equipment and OREO.
Measurement Methodology

9

Cash and Cash Equivalents. The fair value of cash and cash equivalents approximates its carrying value.
Interest-Bearing Deposits with Financial Institutions. The fair values of interest-bearing deposits maturing within ninety days approximate their carrying values.
FHLB and FRBSF Stock. The Bank is a member of the Federal Home Loan Bank of San Francisco (“FHLB”) and the FRBSF. As members, we are required to own stock of the FHLB and the FRBSF, the amount of which is based primarily on the level of our borrowings from those institutions. We also have the right to acquire additional shares of stock in either or both of the FHLB and the FRBSF; however, to date, we have not done so. The fair values of the FHLB and FRBSF stock are equal to their respective carrying amounts, are classified as restricted securities and are periodically evaluated for impairment based on our assessment of the ultimate recoverability of our investments in that stock. Any cash or stock dividends paid to us on such stock are reported as income.
Investment Securities Available for Sale. Fair value measurement for our investment securities available for sale is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 investment securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the- counter markets and money market funds. Level 2 investment securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.
Impaired Loans. Loans measured for impairment are measured at an observable market price (if available), or the fair value of the loan’s collateral (if the loan is collateral dependent). The fair value of an impaired loan may be estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an ALLL represent loans for which the fair value of the expected repayments or collateral exceeds the recorded investments in such loans. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the impaired loan at Level 2. When an appraised value is not available or we determine that the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the impaired loan at Level 3.
Loans. The fair value for loans with variable interest rates less a credit discount is the carrying amount. The fair value of fixed rate loans is derived by calculating the discounted value of future cash flows expected to be received by the various homogeneous categories of loans. All loans have been adjusted to reflect changes in credit risk. Changes are not recorded directly as an adjustment to current earnings or comprehensive income, but rather as an adjustment component in determining the overall adequacy of the loan loss reserve.
Other Real Estate Owned. OREO is adjusted to fair value, less estimated costs to sell, at the time the loans are transferred to other real estate owned. Subsequently, OREO is carried at the lower of carrying value or fair value less estimated costs to sell. Fair value is determined based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the foreclosed asset at Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the foreclosed asset at Level 3.
Mortgage Servicing Rights. Fair value measurement at December 31, 2013 for our mortgage servicing rights was measured using independent pricing models or other model-based valuation techniques which incorporated assumptions that market participants would use in estimating the fair value of servicing. These assumptions included estimates of prepayment speeds, discount rate, and prepayment and late fees, among other considerations. Mortgage servicing rights were considered a Level 3 measurement at December 31, 2013 and were included in Assets of discontinued operations in the accompanying consolidated statements of financial condition. The mortgage servicing rights were sold during the three months ended June 30, 2014.
Derivative Assets and Liabilities. We had no derivatives assets and liabilities as of June 30, 2014. Our derivative assets and liabilities were carried at fair value as required by GAAP and were accounted for as free standing derivatives at December 31, 2013. The derivative assets were interest rate lock commitments (“IRLCs”) with prospective residential mortgage borrowers whereby the interest rate on the loan was determined prior to funding and the borrowers had locked in that interest rate. These commitments were determined to be derivative instruments in accordance with GAAP. The derivative liabilities were hedging instruments (typically to-be-announced (“TBA”) securities) used to hedge the risk of fair value changes associated with changes in interest rates related to our mortgage loan origination operations. We hedged the period from the interest rate lock (assuming a fall-out factor) to the date of the loan sale. The estimated fair value was based on current market prices for similar assets plus a fall-out factor estimated by management and, accordingly, we had classified our IRLCs as Level 3 assets at December 31, 2013

10

and such assets were included in Assets of discontinued operations in the accompanying consolidated statements of financial condition. The valuation technique used for TBA's was based on pricing of the hedging instruments which were used to hedge the fair value changes associated with changes in interest rates related to our mortgage lending operations. The fair value of the hedging instruments was based on the actively quoted TBA Mortgage Backed Securities ("MBS") market using observable inputs related to the characteristics of the underlying MBS stratified by product, coupon and settlement date. TBA's were classified as Level 2 liabilities as of December 31, 2013. Our net derivatives were included within Assets of discontinued operations in the consolidated statements of financial condition as of December 31, 2013.

Deposits. Deposits are carried at historical cost. The carrying amounts of deposits from savings and money market accounts are deemed to approximate fair value as they either have no stated maturities or short-term maturities. Certificates of deposit is estimated utilizing discounted cash flow techniques. The interest rates applied are rates currently being offered for similar certificates of deposit.
Borrowings. The fair value of borrowings is the carrying amount for those borrowings that mature on a daily basis. The fair value of term borrowings is derived by calculating the discounted value of future cash flows expected to be paid out by the Company.
Junior Subordinated Debentures. The fair value of the junior subordinated debentures is based on quoted market prices of the underlying securities. These securities are variable rate in nature and reprice quarterly.
Commitments to Extend Credit and Standby Letters of Credit. The fair value of commitments to extend credit and standby letters of credit are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.
Interest Receivable and Interest Payable. The carrying amounts of our accrued interest receivable and accrued interest payable are deemed to approximate fair value.
Assets Recorded at Fair Value on a Recurring Basis
The following tables show the recorded amounts of assets and liabilities measured at fair value on a recurring basis at June 30, 2014 and December 31, 2013:
 
At June 30, 2014
(Dollars in thousands)
Total
 
Level 1
 
Level 2
 
Level 3
Assets and Liabilities at Fair Value:
 
 
 
 
 
 
 
Investment securities available for sale
 
 
 
 
 
 
 
Mortgage backed securities issued by U.S. agencies
$
55,603

 
$
—

 
$
55,603

 
$
—

Collateralized mortgage obligations issued by non-agency
889

 
—

 
889

 
—

Asset-backed security
1,503

 
—

 
—

 
1,503

Mutual funds
4,733

 
4,733

 
—

 
—

Total securities available for sale at fair value
$
62,728

 
$
4,733

 
$
56,492

 
$
1,503

 

11

 
At December 31, 2013
(Dollars in thousands)
Total
 
Level 1
 
Level 2
 
Level 3
Assets and Liabilities at Fair Value:
 
 
 
 
 
 
 
Investment securities available for sale
 
 
 
 
 
 
 
U.S. Treasury securities(1)
$
700

 
$
700

 
$
—

 
$
—

Mortgage backed securities issued by U.S. agencies
57,808

 
—

 
57,808

 
—

Collateralized mortgage obligations issued by non-agency
1,524

 
—

 
1,524

 
—

Asset-backed security
1,312

 
—

 
—

 
1,312

Mutual funds
4,645

 
4,645

 
—

 
—

Total securities available for sale at fair value
65,989

 
5,345

 
59,332

 
1,312

Other assets - Mortgage servicing rights
4,417

 
—

 
—

 
4,417

Derivative assets – IRLC’s
150

 
—

 
—

 
150

Total assets at fair value on recurring basis
$
70,556

 
$
5,345

 
$
59,332

 
$
5,879

Derivative liabilities – TBA securities
$
33

 
$
—

 
$
33

 
$
—

Total liabilities measured at fair value on a recurring basis
$
33

 
$
—

 
$
33

 
$
—

 
(1)
Our U.S. Treasury securities matured during the second quarter of 2014.

The changes in Level 3 assets measured at fair value on a recurring basis are summarized as follows for the six months ended June 30, 2014:
 
Asset Backed Securities
 
IRLC's
 
Mortgage Servicing Rights
 
Total
 
(Dollars in thousands)
Balance of recurring Level 3 instruments at January 1, 2014
$
1,312

 
$
150

 
$
4,417

 
$
5,879

Total gains or losses (realized/unrealized):
 
 
 
 
 
 
 
Included in earnings-realized
—

 
(150
)
 
930

 
780

Included in other comprehensive income
191

 
—

 
—

 
191

Purchases
—

 
—

 
—

 
—

Sales
—

 
—

 
(5,347
)
 
(5,347
)
Issuances
—

 
—

 
—

 
—

Settlements
—

 
—

 
—

 
—

Transfers in and/or out of Level 3
—

 
—

 
—

 
—

Balance of Level 3 assets at June 30, 2014
$
1,503

 
$
—

 
$
—

 
$
1,503


Assets Recorded at Fair Value on a Nonrecurring Basis
We may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with GAAP. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets. Information regarding assets measured at fair value on a nonrecurring basis is set forth in the table below.
 
At June 30, 2014
 
Total
 
Level 1
 
Level 2
 
Level 3
Assets at Fair Value:
(Dollars in thousands)
Impaired loans
$
22,889

 
$
—

 
$
—

 
$
22,889

Other real estate owned
16,072

 
—

 
16,072

 
—

Total
$
38,961

 
$
—

 
$
16,072

 
$
22,889

 
Significant Unobservable Inputs and Valuation Techniques of Level 3 Fair Value Measurements
For our fair value measurements classified in Level 3 of the fair value hierarchy as of June 30, 2014, a summary of the significant unobservable inputs and valuation techniques is as follows:

12

 
Fair Value Measurement as of June 30, 2014
 
Valuation Techniques
 
Unobservable Inputs
 
Range
 
Weighted Average
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
 
 
Asset-backed security
$
1,503

 
Third-Party Pricing
 
Marketability discount
 
N/A (1)
 
 
 
 
 
Illiquidity discount
 
N/A (1)
Impaired loans
22,889

 
Third-Party Pricing
 
Appraisals
 
N/A (2)
 
$
24,392

 
 
 
 
 
 
 
 
 
(1)
Information is unavailable as valuation was obtained from third-party pricing services.
(2)
We obtain appraisals for our various properties included within impaired loans which primarily rely upon market comparisons. These market comparisons support our assumption that the carrying value of the respective loans either requires or does not require additional impairment.
Fair Value Measurements for Other Financial Instruments
The table below provides estimated fair values and related carrying amounts of our financial instruments as of June 30, 2014 and December 31, 2013, excluding financial assets and liabilities which are recorded at fair value on a recurring basis.
 
Estimated Fair Value
At June 30, 2014
 
At December 31, 2013
Carrying Value
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Carrying Value
 
Total
 
Level 1
 
Level 2
 
Level 3
 
(Dollars in thousands)
Financial assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
104,742

 
$
104,742

 
$
104,742

 
$
—

 
$
—

 
$
106,940

 
$
106,940

 
106,940

 
—

 
—

Interest-bearing deposits with financial institutions
2,923

 
2,923

 
2,923

 
—

 
—

 
2,423

 
2,423

 
2,423

 
—

 
—

Federal Reserve Bank of San Francisco and Federal Home Loan Bank stock
8,058

 
8,058

 
8,058

 
—

 
—

 
8,531

 
8,531

 
8,531

 
—

 
—

Loans, net
793,820

 
792,757

 
—

 
—

 
792,757

 
765,426

 
767,893

 
—

 
—

 
767,893

Accrued interest receivable
2,006

 
2,006

 
2,006

 
—

 
—

 
2,017

 
2,017

 
2,017

 
—

 
—

Financial liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Noninterest bearing deposits
193,499

 
193,499

 
193,499

 
—

 
—

 
203,942

 
203,942

 
203,942

 
—

 
—

Interest-bearing deposits
625,795

 
619,458

 
—

 
619,458

 
—

 
576,283

 
568,258

 
—

 
568,258

 
—

Borrowings
47,500

 
47,449

 
—

 
47,449

 
—

 
70,000

 
70,000

 
—

 
70,000

 
—

Junior subordinated debentures
17,527

 
17,527

 
—

 
17,527

 
—

 
17,527

 
17,527

 
—

 
17,527

 
—

Accrued interest payable
2,614

 
2,614

 
2,614

 
—

 
—

 
2,285

 
2,285

 
2,285

 
—

 
—

Information Regarding Derivative Financial Instruments
The following table includes information for the derivative assets and liabilities for the periods presented:
 
 
 
 
 
Total Gains (Losses)
 
Notional Balance
 
Three Months Ended
 
Six Months Ended
 
June 30, 2014
 
December 31, 2013
 
June 30, 2014
 
June 30, 2013
 
June 30, 2014
 
June 30, 2013
 
(Dollars in thousands)
Derivative assets - IRLC’s
$
—

 
$
6,638

 
$
(44
)
 
$
(238
)
 
$
(150
)
 
$
(427
)
Derivative liabilities - TBAs
—

 
12,000

 
65

 
628

 
(28
)
 
698


4. Investments
Securities Available For Sale, at Fair Value
The following table sets forth the major components of securities available for sale and a compares the amortized costs and estimated fair market values of, and the gross unrealized gains and losses on, these securities at June 30, 2014 and December 31, 2013:

13

(Dollars in thousands)
June 30, 2014
 
December 31, 2013
Amortized
Cost
 
Gross Unrealized
 
Estimated
Fair Value
 
Amortized
Cost
 
Gross Unrealized
 
Estimated
Fair Value
Gain
 
Loss
 
Gain
 
Loss
 
Securities Available for Sale
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasury securities(1)
$
—

 
$
—

 
$
—

 
$
—

 
$
700

 
$
—

 
$
—

 
$
700

Mortgage backed securities issued by U.S. Agencies(2)
56,915

 
17

 
(1,329
)
 
55,603

 
60,514

 
13

 
(2,719
)
 
57,808

Collateralized mortgage obligations issued by non agencies(2)
899

 
—

 
(10
)
 
889

 
1,572

 
—

 
(48
)
 
1,524

Asset backed security(3)
2,101

 
—

 
(598
)
 
1,503

 
2,218

 
—

 
(906
)
 
1,312

Mutual funds(4)
4,733

 
—

 
—

 
4,733

 
4,645

 
—

 
—

 
4,645

Total
$
64,648

 
$
17

 
$
(1,937
)
 
$
62,728

 
$
69,649

 
$
13

 
$
(3,673
)
 
$
65,989

 
 
(1)
Our U.S. Treasury securities matured during the second quarter of 2014.
(2)
Secured by closed-end first liens on 1-4 family residential mortgages.
(3)
Comprised of a security that represents an interest in a pool of trust preferred securities issued by U.S.-based banks and insurance companies.
(4)
Consists primarily of mutual fund investments in closed-end first lien 1-4 family residential mortgages.
At June 30, 2014, U.S. agency mortgage backed securities with an aggregate fair market value of $4.3 million were pledged to secure repurchase agreements, local agency deposits and treasury, tax and loan accounts. At December 31, 2013, U.S. agency mortgage backed securities and collateralized mortgage obligations with an aggregate fair market value of $9.5 million were pledged to secure FHLB borrowings, repurchase agreements, local agency deposits and treasury, tax and loan accounts.
The amortized cost and estimated fair values of securities available for sale at June 30, 2014 and December 31, 2013 are shown in the tables below by contractual maturities taking into consideration historical prepayments based on the prior twelve months of principal payments. Expected maturities will differ from contractual maturities and historical prepayments, particularly with respect to collateralized mortgage obligations, primarily because prepayment rates are affected by changes in conditions in the interest rate market and, therefore, future prepayment rates may differ from historical prepayment rates.
 
At June 30, 2014 Maturing in
(Dollars in thousands)
One year
or less
 
Over one
year through
five years
 
Over five
years through
ten years
 
Over ten
Years
 
Total
Securities available for sale, amortized cost
$
6,703

 
$
28,099

 
$
19,259

 
$
10,587

 
$
64,648

Securities available for sale, estimated fair value
6,535

 
27,736

 
18,726

 
9,731

 
62,728

Weighted average yield
1.57
%
 
1.69
%
 
1.60
%
 
1.76
%
 
1.66
%
 
At December 31, 2013 Maturing in
(Dollars in thousands)
One year
or less
 
Over one
year through
five years
 
Over five
years through
ten years
 
Over ten
Years
 
Total
Securities available for sale, amortized cost
$
8,111

 
$
28,690

 
$
20,514

 
$
12,334

 
$
69,649

Securities available for sale, estimated fair value
7,816

 
27,664

 
19,586

 
10,923

 
65,989

Weighted average yield
1.52
%
 
1.70
%
 
1.60
%
 
1.34
%
 
1.59
%
 
We recognized gains on sales of securities available for sale of $23 thousand on sale proceeds of $6.2 million during the six months ended June 30, 2013. We had no sales of securities available for sale during the three and six months ended June 30, 2014 or during the three months ended June 30, 2013.
The tables below indicate, as of June 30, 2014 and December 31, 2013, the gross unrealized losses and fair values of our investments, aggregated by investment category, and length of time that the individual securities have been in a continuous unrealized loss position.

14

 
Securities with Unrealized Loss at June 30, 2014
 
Less than 12 months
 
12 months or more
 
Total
(Dollars in thousands)
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
Residential mortgage backed securities issued by U.S. Agencies
$
—

 
$
—

 
$
54,342

 
$
(1,329
)
 
$
54,342

 
$
(1,329
)
Residential collateralized mortgage obligations issued by non-agencies
—

 
—

 
889

 
(10
)
 
889

 
(10
)
Asset backed security
—

 
—

 
1,503

 
(598
)
 
1,503

 
(598
)
Total
$
—

 
$
—

 
$
56,734

 
$
(1,937
)
 
$
56,734

 
$
(1,937
)
  
Securities With Unrealized Loss at December 31, 2013
 
Less than 12 months
 
12 months or more
 
Total
(Dollars In thousands)
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
Residential mortgage backed securities issued by U.S. Agencies
$
25,808

 
$
(806
)
 
$
30,688

 
$
(1,913
)
 
$
56,496

 
$
(2,719
)
Residential collateralized mortgage obligations issued by non-agencies
586

 
(9
)
 
938

 
(39
)
 
1,524

 
(48
)
Asset-backed security
—

 
—

 
1,313

 
(906
)
 
1,313

 
(906
)
Total
$
26,394

 
$
(815
)
 
$
32,939

 
$
(2,858
)
 
$
59,333

 
$
(3,673
)
We regularly monitor investments for significant declines in fair value. We have determined that declines in the fair values of these investments below their respective amortized costs, as set forth in the tables above, are temporary because (i) those declines were due to interest rate changes and not to a deterioration in the creditworthiness of the issuers of those investment securities, and (ii) we have the ability to hold those securities until there is a recovery in their values or until their maturity.
We recognize other-than-temporary impairments (“OTTI”) to our available-for-sale debt securities in accordance with FASB ASC 320-10. When there are credit losses associated with, but we have no intention to sell, an impaired debt security, and it is more likely than not that we will not have to sell the security before recovery of its cost basis, we will separate the amount of impairment, or OTTI, between the amount that is credit related and the amount that is related to non-credit factors. Credit-related impairments are recognized in our consolidated statements of operations. Any non-credit-related impairments are recognized and reflected in other comprehensive income (loss) in our consolidated statements of financial condition.
Through the impairment assessment process, we determined that the available-for-sale securities discussed below were other-than-temporarily impaired at June 30, 2014. We recorded no impairment credit losses on available-for-sale securities in our consolidated statements of operations for the six months ended June 30, 2014 and 2013. The OTTI related to factors other than credit losses, in the aggregate amount of $0.6 million, and was recognized as other comprehensive loss in our accompanying consolidated statement of financial condition as of June 30, 2014.

The table below presents, for the six months ended June 30, 2014, a roll-forward of OTTI in those instances when a portion of the OTTI was attributable to non-credit related factors and, therefore, was recognized in other comprehensive loss:
(Dollars in thousands)
Gross Other-
Than-
Temporary
Impairments
 
Other-Than-
Temporary
Impairments
Included in Other
Comprehensive
Loss
 
Net Other-Than-
Temporary
Impairments
Included in
Retained  Earnings
(Deficit)
Balance – December 31, 2013
$
(1,459
)
 
$
(906
)
 
$
(553
)
Change in market value on a security for which an OTTI was previously recognized
308

 
308

 
—

Balance – June 30, 2014
$
(1,151
)
 
$
(598
)
 
$
(553
)
In determining the component of OTTI related to credit losses, we compare the amortized cost basis of each OTTI security to the present value of its expected cash flows, discounted using the effective interest rate implicit in the security at the date of acquisition.
As a part of our OTTI assessment process with respect to securities held for sale with unrealized losses, we consider available information about (i) the performance of the collateral underlying each such security, including any credit enhancements, (ii) historical prepayment speeds, (iii) delinquency and default rates, (iv) loss severities, (v) the age or “vintage” of the security,

15

and, (vi) any rating agency reports on the security. Significant judgments are required with respect to these and other factors in order to make a determination of the future cash flows that can be expected to be generated by the security.
Based on our OTTI assessment process, we determined that there is one asset-backed security in our portfolio of securities held for sale that was impaired as of June 30, 2014. This security is a multi-class, cash flow collateralized bond obligation backed by a pool of trust preferred securities issued by a diversified pool of 56 issuers that consisted of 45 U.S. depository institutions and 11 insurance companies at the time of the security’s issuance in November 2007. We purchased $3.0 million face amount of this security in November 2007 at a price of 95.21% for a total purchase price of $2.9 million, out of a total of $363 million of this security sold at the time of issuance. The security that we own (CUSIP 74042CAE8) is the mezzanine class B piece security with a variable interest rate of 3 month LIBOR plus 60 basis points, which had a rating of Aa2 and AA by Moody’s and Fitch, respectively, at the time of issuance in 2007.
As of June 30, 2014, the amortized cost of this security was $2.1 million with a fair value of $1.5 million, for an unrealized loss of approximately $0.6 million. As of June 30, 2014, the security had a Ca rating from Moody’s and a CCC rating from Fitch and had experienced $42.5 million in defaults (12.5% of total current collateral) and $23.0 million in deferring securities (6.7% of total current collateral) from issuance to June 30, 2014. We estimate that the security could experience another $94.0 million in defaults before the issuer would not receive all of the contractual cash flows under this security. This analysis is based on the following assumptions: future default rates of 3.4%, prepayment rates of 1% until maturity, and 15% recovery of future defaults.
 
We have made a determination that the remainder of our securities with respect to which there were unrealized losses as of June 30, 2014 are not other-than-temporarily impaired, because we have concluded that we have the ability to continue to hold those securities until their respective fair market values increase above their respective amortized costs or, if necessary, until their respective maturities. In reaching that conclusion we considered a number of factors and other information, which included: (i) the significance of each such security, (ii) the amount of the unrealized losses attributable to each such security, (iii) our liquidity position, (iv) the impact that retention of those securities could have on our capital position and (v) our evaluation of the expected future performance of these securities (based on the criteria discussed above).

Other Investments
Beginning in the fourth quarter of 2013, we had one investment in a limited partnership which is accounted for under the equity method of accounting and included within other assets on the consolidated statements of financial condition. As of June 30, 2014 and December 31, 2013, our other investment was as follows:
 
June 30, 2014
 
December 31, 2013
 
(Dollars in thousands)
Investment accounted for under the equity method
$
2,052

 
$
2,025


5. Loans and Allowance for Loan and Lease Losses
The loan portfolio consisted of the following at:
 
June 30, 2014
 
December 31, 2013
(Dollars in thousands)
Amount
 
Percent
 
Amount
 
Percent
Commercial loans
$
253,442

 
31.4
%
 
$
226,450

 
29.2
%
Commercial real estate loans – owner occupied
191,143

 
23.7
%
 
174,221

 
22.4
%
Commercial real estate loans – all other
178,562

 
22.1
%
 
177,884

 
22.9
%
Residential mortgage loans – multi-family
94,405

 
11.7
%
 
96,565

 
12.4
%
Residential mortgage loans – single family
72,919

 
9.0
%
 
75,660

 
9.7
%
Land development loans
9,966

 
1.2
%
 
18,458

 
2.4
%
Consumer loans
6,210

 
0.8
%
 
7,599

 
1.0
%
Gross loans
806,647

 
100.0
%
 
776,837

 
100.0
%
Deferred fee income, net
(247
)
 
 
 
(53
)
 
 
Allowance for loan and lease losses
(12,580
)
 
 
 
(11,358
)
 
 
Loans, net
$
793,820

 
 
 
$
765,426

 
 
At June 30, 2014 and December 31, 2013, real estate loans of approximately $222 million and $230 million, respectively, were pledged to secure borrowings obtained from the FHLB.

16

Allowance for Loan and Lease Losses
The ALLL represents our estimate of credit losses in our loan and lease portfolio that are probable and estimable at the balance sheet date. We employ economic models that are based on bank regulatory guidelines, industry standards and our own historical loan loss experience, as well as a number of more subjective qualitative factors, to determine both the sufficiency of the ALLL and the amount of the provisions that are required to be made for potential loan losses to increase or replenish the ALLL.
 
The ALLL is first determined by (i) analyzing all classified loans (graded as “Substandard” or “Doubtful” under our internal credit quality grading parameters) on non-accrual status for loss exposure and (ii) establishing specific reserves as needed. ASC 310-10 defines loan impairment as the existence of uncertainty concerning collection of all principal and interest in accordance with the contractual terms of a loan. For collateral dependent loans, impairment is typically measured by comparing the loan amount to the fair value of collateral, less estimated costs to sell, with any "shortfall" amount charged off. Other methods can be used in estimating impairment, including market price and the present value of expected future cash flows discounted at the loan’s original interest rate. We are an active lender with the U.S. Small Business Administration and many of the loans originated have a guaranteed percentage of the balances.  The ALLL reserves are calculated against the non-guaranteed loan balances. 
On a quarterly basis, we utilize a classification migration model and individual loan review analytical tools as starting points for determining the adequacy of the ALLL for homogenous pools of loans that are not subject to specific reserve allocations. Our loss migration analysis tracks a certain number of quarters of loan loss history and industry loss factors to determine historical losses by classification category for each loan type, except certain consumer loans. We then apply these calculated loss factors, together with qualitative factors based on external economic conditions and trends and internal assessments, to the outstanding loan balances in each homogenous group of loans, and then, using our internal credit quality grading parameters, we grade the loans as “Pass,” “Special Mention,” “Substandard” or “Doubtful”. We also conduct individual loan review analysis, as part of the ALLL allocation process, applying specific monitoring policies and procedures in analyzing the existing loan portfolio. This grading is based on the credit classifications of assets as prescribed by government regulations and industry standards and is separated into the following groups:
•
Pass: Loans classified as pass include current loans performing in accordance with contractual terms, installment/consumer loans that are not individually risk rated, and loans which exhibit certain risk factors that require greater than usual monitoring by management.
•
Special mention: Loans classified as special mention, while generally not delinquent, have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or in the Bank’s credit position at some future date.
•
Substandard: Loans classified as substandard have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. There is a distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.
•
Doubtful: Loans classified as doubtful have all the weaknesses inherent in a substandard loan, and may also be at delinquency status and have defined weaknesses based on currently existing facts, conditions and values making collection or liquidation in full highly questionable and improbable.

17

Set forth below is a summary of the activity in the ALLL during the three and six months ended June 30, 2014 and 2013:
(Dollars in thousands)
Commercial
 
Real  Estate
 
Land
Development
 
Consumer and
Single Family
Mortgages
 
Total
ALLL in the six months ended June 30, 2014:
 
 
 
 
 
 
 
 
 
Balance at beginning of period
$
5,812

 
$
4,517

 
$
165

 
$
864

 
$
11,358

Charge offs
(276
)
 
—

 
—

 
(102
)
 
(378
)
Recoveries
452

 
19

 
—

 
79

 
550

Provision
489

 
861

 
(80
)
 
(220
)
 
1,050

Balance at end of period
$
6,477

 
$
5,397

 
$
85

 
$
621

 
$
12,580

ALLL in the three months ended June 30, 2014:
 
 
 
 
 
 
 
 
 
Balance at beginning of period
$
5,988

 
$
5,039

 
$
154

 
$
759

 
$
11,940

Charge offs
(166
)
 
—

 
—

 
(2
)
 
(168
)
Recoveries
169

 
1

 
—

 
38

 
208

Provision
486

 
357

 
(69
)
 
(174
)
 
600

Balance at end of period
$
6,477

 
$
5,397

 
$
85

 
$
621

 
$
12,580

ALLL in the six months ended June 30, 2013:
 
 
 
 
 
 
 
 
 
Balance at beginning of period
$
6,340

 
$
3,487

 
$
248

 
$
806

 
$
10,881

Charge offs
(2,603
)
 
(308
)
 
(5
)
 
(2
)
 
(2,918
)
Recoveries
1,932

 
2

 
54

 
22

 
2,010

Provision
1,284

 
(327
)
 
—

 
193

 
1,150

Balance at end of period
$
6,953

 
$
2,854

 
$
297

 
$
1,019

 
$
11,123

ALLL in the three months ended June 30, 2013:
 
 
 
 
 
 
 
 
 
Balance at beginning of period
$
6,850

 
$
3,053

 
$
216

 
$
899

 
$
11,018

Charge offs
$
(1,433
)
 
$
—

 
$
—

 
$
—

 
$
(1,433
)
Recoveries
1,532

 
1

 
—

 
5

 
1,538

Provision
4

 
(200
)
 
81

 
115

 
—

Balance at end of period
$
6,953

 
$
2,854

 
$
297

 
$
1,019

 
$
11,123

Set forth below is information regarding loan balances and the related ALLL, by portfolio type, as of June 30, 2014 and December 31, 2013 (excluding LHFS).
(Dollars in thousands)
Commercial
 
Real  Estate
 
Land
Development
 
Consumer and
Single Family
Mortgages
 
Total
ALLL balance at June 30, 2014 related to:
 
 
 
 
 
 
 
 
 
Loans individually evaluated for impairment
$
1,820

 
$
—

 
$
—

 
$
—

 
$
1,820

Loans collectively evaluated for impairment
4,657

 
5,397

 
85

 
621

 
10,760

Total
$
6,477

 
$
5,397

 
$
85

 
$
621

 
$
12,580

Loans balance at June 30, 2014 related to:
 
 
 
 
 
 
 
 
 
Loans individually evaluated for impairment
$
9,111

 
$
9,429

 
$
368

 
$
2,931

 
$
21,839

Loans collectively evaluated for impairment
244,331

 
454,681

 
9,598

 
76,198

 
784,808

Total
$
253,442

 
$
464,110

 
$
9,966

 
$
79,129

 
$
806,647

ALLL Balance at December 31, 2013 related to:
 
 
 
 
 
 
 
 
 
Loans individually evaluated for impairment
$
—

 
$
—

 
$
—

 
$
—

 
$
—

Loans collectively evaluated for impairment
5,812

 
4,517

 
165

 
864

 
11,358

Total
$
5,812

 
$
4,517

 
$
165

 
$
864

 
$
11,358

Loans balance at December 31, 2013 related to:
 
 
 
 
 
 
 
 
 
Loans individually evaluated for impairment
$
10,484

 
$
8,451

 
$
391

 
$
4,834

 
$
24,160

Loans collectively evaluated for impairment
215,966

 
440,219

 
18,067

 
78,425

 
752,677

Total
$
226,450

 
$
448,670

 
$
18,458

 
$
83,259

 
$
776,837



18

Credit Quality
The amounts of nonperforming assets and delinquencies that occur within our loan portfolio factors in our evaluation of the adequacy of the ALLL.
The following table provides a summary of the delinquency status of loans by portfolio type at June 30, 2014 and December 31, 2013:
(Dollars in thousands)
30-59 Days Past Due
 
60-89 Days Past Due
 
90 Days and Greater
 
Total Past Due
 
Current
 
Total Loans Outstanding
 
Loans >90 Days and Accruing
At June 30, 2014
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
$
3,998

 
$
253

 
$
1,647

 
$
5,898

 
$
247,544

 
$
253,442

 
$
—

Commercial real estate loans – owner-occupied
485

 
—

 
—

 
485

 
190,658

 
191,143

 
—

Commercial real estate loans – all other
—

 
—

 
2,117

 
2,117

 
176,445

 
178,562

 
—

Residential mortgage loans – multi-family
—

 
—

 
—

 
—

 
94,405

 
94,405

 
—

Residential mortgage loans – single family
—

 
264

 
—

 
264

 
72,655

 
72,919

 
—

Land development loans
—

 
368

 
—

 
368

 
9,598

 
9,966

 
—

Consumer loans
—

 
—

 
—

 
—

 
6,210

 
6,210

 
—

Total
$
4,483

 
$
885

 
$
3,764

 
$
9,132

 
$
797,515

 
$
806,647

 
$
—

At December 31, 2013
 
Commercial loans
$
—

 
$
—

 
$
2,192

 
$
2,192

 
$
224,258

 
$
226,450

 
$
—

Commercial real estate loans – owner-occupied
—

 
—

 
—

 
—

 
174,221

 
174,221

 
—

Commercial real estate loans – all other
—

 
—

 
2,117

 
2,117

 
175,767

 
177,884

 
—

Residential mortgage loans – multi-family
—

 
—

 
—

 
—

 
96,565

 
96,565

 
—

Residential mortgage loans – single family
748

 
—

 
—

 
748

 
74,912

 
75,660

 
—

Land development loans
—

 
—

 
—

 
—

 
18,458

 
18,458

 
—

Consumer loans
450

 
—

 
—

 
450

 
7,149

 
7,599

 
—

Total
$
1,198

 
$
—

 
$
4,309

 
$
5,507

 
$
771,330

 
$
776,837

 
$
—

Generally, the accrual of interest on a loan is discontinued when principal or interest payments become more than 90 days past due, unless we believe that the loan is adequately collateralized and it is in the process of collection. There were no loans 90 days or more past due and still accruing interest at June 30, 2014 or December 31, 2013. In certain instances, when a loan is placed on non-accrual status, previously accrued but unpaid interest is reversed against current income. Subsequent collections of cash are applied as principal reductions when received, except when the ultimate collectability of principal is probable, in which case such payments are applied to accrued and unpaid interest, which is credited to income. Non-accrual loans may be restored to accrual status when principal and interest become current and full repayment becomes expected.
The following table provides information with respect to loans on nonaccrual status, by portfolio type, as of June 30, 2014 and December 31, 2013:
 
June 30, 2014
 
December 31, 2013
 
(Dollars in thousands)
Nonaccrual loans:
 
 
 
Commercial loans
$
5,044

 
$
5,371

Commercial real estate loans – owner occupied
2,735

 
1,773

Commercial real estate loans – all other
3,800

 
2,117

Residential mortgage loans – single family
66

 
1,874

Land development loans
—

 
391

Total
$
11,645

 
$
11,526


19

 We classify our loan portfolio using internal credit quality ratings. The following table provides a summary of loans by portfolio type and our internal credit quality ratings as of June 30, 2014 and December 31, 2013:
 
June 30, 2014
 
December 31, 2013
 
(Dollars in thousands)
Pass:
 
 
 
Commercial loans
$
232,471

 
$
212,938

Commercial real estate loans – owner occupied
185,404

 
167,947

Commercial real estate loans – all other
159,191

 
161,970

Residential mortgage loans – multi family
89,300

 
91,375

Residential mortgage loans – single family
71,158

 
73,786

Land development loans
7,816

 
10,047

Consumer loans
6,210

 
7,599

Total pass loans
$
751,550

 
$
725,662

Special Mention:
 
 
 
Commercial loans
$
10,731

 
$
52

Commercial real estate loans – all other
2,421

 
—

Residential mortgage loans – multi family
—

 
5,190

Residential mortgage loans – single family
425

 
—

Land development loans
1,782

 
—

Total special mention loans
$
15,359

 
$
5,242

Substandard:
 
 
 
Commercial loans
$
10,240

 
$
13,396

Commercial real estate loans – owner occupied
5,739

 
6,274

Commercial real estate loans – all other
16,950

 
15,914

Residential mortgage loans – multi family
5,105

 
—

Residential mortgage loans – single family
1,336

 
1,874

Land development loans
368

 
8,410

Total substandard loans
$
39,738

 
$
45,868

Doubtful:
 
 
 
Commercial loans
$
—

 
$
65

Total doubtful loans
$
—

 
$
65

Total Outstanding Loans, gross:
$
806,647

 
$
776,837

Impaired Loans
A loan generally is classified as impaired and placed on nonaccrual status when, in our opinion, principal or interest is not likely to be collected in accordance with the contractual terms of the loan agreement. We measure for impairments on a loan-by-loan basis, using either the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral if the loan is collateral dependent.
The following table sets forth information regarding impaired loans, at June 30, 2014 and December 31, 2013:
 
June 30, 2014
 
December 31, 2013
 
(Dollars in thousands)
Impaired loans:
 
Nonaccruing loans
$
8,235

 
$
5,590

Nonaccruing restructured loans
3,410

 
5,936

Accruing restructured loans (1)
11,244

 
12,634

Accruing impaired loans
—

 
—

Total impaired loans
$
22,889

 
$
24,160

Impaired loans less than 90 days delinquent and included in total impaired loans
$
19,125

 
$
21,968

 

20

(1)
See "Troubled Debt Restructurings" below for a description of accruing restructured loans at June 30, 2014 and December 31, 2013.
The table below contains additional information with respect to impaired loans, by portfolio type, as of June 30, 2014 and December 31, 2013:
 
June 30, 2014
 
December 31, 2013
 
Recorded Investment
 
Unpaid Principal Balance
 
Related Allowance (1)
 
Recorded Investment
 
Unpaid Principal Balance
 
Related Allowance (1)
 
(Dollars in thousands)
 
 
 
 
 
 
No allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
$
7,516

 
$
7,858

 
$
—

 
$
10,484

 
$
13,908

 
$
—

Commercial real estate loans – owner occupied
2,250

 
2,447

 
—

 
1,773

 
1,872

 
—

Commercial real estate loans – all other
6,810

 
6,843

 
—

 
6,678

 
6,711

 
—

Residential mortgage loans – multi-family
—

 
—

 
—

 
—

 
—

 
—

Residential mortgage loans – single family
2,996

 
3,208

 
—

 
4,834

 
5,263

 
—

Land development loans
368

 
401

 
—

 
391

 
409

 
—

Consumer loans
—

 
—

 
—

 
—

 
—

 
—

Total
19,940

 
20,757

 
—

 
24,160

 
28,163

 
—

With allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
$
2,464

 
$
2,741

 
$
1,361

 
$
—

 
$
—

 
$
—

Commercial real estate loans – owner occupied
485

 
485

 
459

 
—

 
—

 
—

Commercial real estate loans – all other
—

 
—

 
—

 
—

 
—

 
—

Residential mortgage loans – multi-family
—

 
—

 
—

 
—

 
—

 
—

Residential mortgage loans – single family
—

 
—

 
—

 
—

 
—

 
—

Land development loans
—

 
—

 
—

 
—

 
—

 
—

Consumer loans
—

 
—

 
—

 
—

 
—

 
—

Total
2,949

 
3,226

 
1,820

 
—

 
—

 
—

Total
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
$
9,980

 
$
10,599

 
$
1,361

 
$
10,484

 
$
13,908

 
$
—

Commercial real estate loans – owner occupied
2,735

 
2,932

 
459

 
1,773

 
1,872

 
—

Commercial real estate loans – all other
6,810

 
6,843

 
—

 
6,678

 
6,711

 
—

Residential mortgage loans – multi-family
—

 
—

 
—

 
—

 
—

 
—

Residential mortgage loans – single family
2,996

 
3,208

 
—

 
4,834

 
5,263

 
—

Land development loans
368

 
401

 
—

 
391

 
409

 
—

Consumer loans
—

 
—

 
—

 
—

 
—

 
—

Total
22,889

 
23,983

 
1,820

 
24,160

 
28,163

 
—

 
(1)
When the discounted cash flows, collateral value or market price equals or exceeds the recorded investment in the loan, then specific reserves are not required to be set aside for the loan within the ALLL. This typically occurs when the impaired loans have been partially charged-off and/or there have been interest payments received and applied to the balance of the principal outstanding.
 
At June 30, 2014 and December 31, 2013, there were $19.9 million and $24.2 million, respectively, of impaired loans for which no specific reserves had been allocated because these loans, in our judgment, were sufficiently collateralized. Of the impaired loans at June 30, 2014 for which no specific reserves were allocated, $15.8 million had been deemed impaired in the prior year.
Average balances and interest income recognized on impaired loans, by portfolio type, for the three and six months ended June 30, 2014 and 2013 were as follows:

21

 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
 
Average Balance
 
Interest Income Recognized
 
Average Balance
 
Interest Income Recognized
 
Average Balance
 
Interest Income Recognized
 
Average Balance
 
Interest Income Recognized
 
(Dollars in thousands)
No allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
$
7,420

 
$
54

 
$
10,866

 
$
54

 
$
8,441

 
$
168

 
$
9,762

 
$
104

Commercial real estate loans – owner occupied
2,002

 
—

 
4,487

 
14

 
1,926

 
22

 
4,059

 
28

Commercial real estate loans – all other
6,574

 
70

 
17,291

 
153

 
6,608

 
188

 
16,464

 
290

Residential mortgage loans – single family
3,075

 
30

 
834

 
—

 
3,661

 
60

 
819

 
—

Land development loans
374

 
—

 
157

 
—

 
380

 
—

 
243

 
15

Total
19,445

 
154

 
33,635

 
221

 
21,016

 
438

 
31,347

 
437

With allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
1,827

 
28

 
4,398

 
42

 
1,218

 
27

 
4,369

 
64

Commercial real estate loans – owner occupied
3,993

 
156

 
—

 
—

 
3,912

 
156

 
—

 
—

Total
5,820

 
184

 
4,398

 
42

 
5,130

 
183

 
4,369

 
64

Total
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
9,247

 
82

 
15,264

 
96

 
9,659

 
195

 
14,131

 
168

Commercial real estate loans – owner occupied
5,995

 
156

 
4,487

 
14

 
5,838

 
178

 
4,059

 
28

Commercial real estate loans – all other
6,574

 
70

 
17,291

 
153

 
6,608

 
188

 
16,464

 
290

Residential mortgage loans – single family
3,075

 
30

 
834

 
—

 
3,661

 
60

 
819

 
—

Land development loans
374

 
—

 
157

 
—

 
380

 
—

 
243

 
15

Total
$
25,265

 
$
338

 
$
38,033

 
$
263

 
$
26,146

 
$
621

 
$
35,716

 
$
501

The interest that would have been earned had the impaired loans remained current in accordance with their original terms was $142 thousand and $325 thousand during the three months ended June 30, 2014 and 2013, respectively. The interest that would have been earned had the impaired loans remained current in accordance with their original terms was $206 thousand and $555 thousand during the six months ended June 30, 2014 and 2013, respectively.
Troubled Debt Restructurings (“TDRs”)
Pursuant to the FASB's ASU No. 2011-2, A Creditor's Determination of whether a Restructuring is a Troubled Debt Restructuring, the Bank's TDRs totaled $14.7 million and $18.6 million at June 30, 2014 and December 31, 2013, respectively. TDRs consist of loans to which modifications have been made for the purpose of alleviating temporary impairments of the borrower's financial condition and cash flows. Those modifications have come in the forms of changes in amortization terms, reductions in interest rates, interest only payments and, in limited cases, concessions to outstanding loan balances. The modifications are made as part of workout plans we enter into with the borrower that are designed to provide a bridge for the borrower's cash flow shortfalls in the near term. If a borrower works through the near term issues, then in most cases, the original contractual terms of the borrower's loan will be reinstated.
Of the $14.7 million of TDRs outstanding at June 30, 2014, $11.2 million were performing in accordance with their terms and accruing interest, and $3.4 million were not. Our impairment analysis determined no specific reserves were required on the TDR balances outstanding at June 30, 2014.
The following table presents loans restructured as TDRs during the three and six months ended June 30, 2014 and 2013:

22

 
Three Months Ended
 
June 30, 2014
 
June 30, 2013
(Dollars in thousands)
Number of
Loans
 
Pre-Modification
Outstanding
Recorded
Investment
 
Post-Modification
Outstanding
Recorded
Investment
 
Number of
loans
 
Pre-Modification
Outstanding
Recorded
Investment
 
Post-Modification
Outstanding
Recorded
Investment
Performing
 
 
 
 
 
 
 
 
 
 
 
Commercial real estate – all other
—

 
$
—

 
$
—

 
1

 
$
613

 
$
607

 
—

 
—

 
—

 
1

 
613

 
607

Nonperforming
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
1

 
300

 
193

 
1

 
84

 
59

Land development loans
—

 
—

 
—

 
1

 
439

 
414

 
1

 
300

 
193

 
2

 
523

 
473

Total Troubled Debt Restructurings
1

 
$
300

 
$
193

 
3

 
$
1,136

 
$
1,080

 
Six Months Ended
 
June 30, 2014
 
June 30, 2013
(Dollars in thousands)
Number of
loans
 
Pre-Modification
Outstanding
Recorded
Investment
 
Post-Modification
Outstanding
Recorded
Investment
 
Number of
loans
 
Pre-Modification
Outstanding
Recorded
Investment
 
Post-Modification
Outstanding
Recorded
Investment
Performing
 
 
 
 
 
 
 
 
 
 
 
Commercial real estate – all other
—

 
$
—

 
$
—

 
1

 
$
613

 
$
607

 
—

 
—

 
—

 
1

 
613

 
607

Nonperforming
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
1

 
300

 
193

 
1

 
84

 
59

Land development loans
—

 
—

 
—

 
1

 
439

 
414

 
1

 
300

 
193

 
2

 
523

 
473

Total troubled debt restructurings
1

 
$
300

 
$
193

 
3

 
$
1,136

 
$
1,080

As of June 30, 2014, TDRs totaled $14.7 million as compared to $18.6 million at December 31, 2013.
During the three and six months ended June 30, 2014 and 2013, TDRs that were modified within the preceding 12-month period which subsequently defaulted were as follows:
 
Three Months Ended
 
Six Months Ended
 
June 30, 2014
 
June 30, 2013
 
June 30, 2014
 
June 30, 2013
 
Number of loans
 
Recorded Investment
 
Number of loans
 
Recorded Investment
 
Number of loans
 
Recorded Investment
 
Number of loans
 
Recorded Investment
 
(Dollars in thousands)
Commercial loans
—

 
$
—

 
1

 
$
519

 
—

 
$
—

 
2

 
$
1,494

Total
—

 
$
—

 
1

 
$
519

 
—

 
$
—

 
2

 
$
1,494


6. Income Taxes
For the three and six months ended June 30, 2014 and the three months ended June 30, 2013, we recorded no income tax provision. We recorded an income tax benefit from continuing operations of $1.5 million for the six months ended June 30, 2013. The tax benefit during the six months ended June 30, 2013 was primarily related to the release of the remainder of a valuation allowance in the first quarter of 2013, which we had established against our deferred tax asset by means of non-cash charges to the provision for income taxes prior to 2013. We generated net operating losses (“NOLs”) for the year ended December 31, 2013 which may be utilized against taxable income. The 2013 NOLs were subject to a valuation allowance. As a result of taxable income generated and the utilization of the NOLs subject to a valuation allowance during the three and six months ended June 30, 2014, we had no income tax provision and our net deferred tax asset at June 30, 2014 was $6.9 million, net of a valuation allowance of $11.8 million. This is a decrease of $0.7 million from the December 31, 2013 balance of $7.6 million, net of a valuation allowance of $12.5 million.

23

We file income tax returns with the U.S. federal government and the state of California. As of March 31, 2014, we were subject to examination by the Internal Revenue Service with respect to our U.S. federal tax returns for the 2010 to 2013 tax years and Franchise Tax Board for California state income tax returns for the 2009 to 2013 tax years. NOLs on our U.S. federal and California state income tax returns may be carried forward twenty years. As of June 30, 2014, we do not believe there will be any material adverse changes in our unrecognized tax benefits over the next 12 months.
Our policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of tax expense. We did not have any accrued interest or penalties associated with any unrecognized tax benefits, and no interest expense was recognized during the three and six months ended June 30, 2014 and 2013.
7. Stock-Based Employee Compensation Plans
In May 2010, our shareholders approved the adoption of our 2010 Equity Incentive Plan (the “2010 Incentive Plan”), which authorized and set aside a total of 400,000 shares of our common stock for issuance on the exercise of stock options or the grant of restricted stock or other equity incentives to our officers, and other key employees and directors. An additional 158,211 shares of common stock were also set aside which was equal to the total of the shares that were available for the grant of equity incentives under our shareholder-approved 2008 and 2004 Equity Incentive Plans (the "Previously Approved Plans") at the time of the adoption of the 2010 Incentive Plan. Options to purchase a total of 937,604 shares of our common stock granted under the Previously Approved Plans were outstanding at June 30, 2014. The 2010 Incentive Plan provides that if any of these outstanding options under the Previously Approved Plans expire or are terminated for any reason, then the number of shares that would become available for grants or awards of equity incentives under the 2010 Incentive Plan would be increased by an equivalent number of shares. At the Annual Shareholders meeting held in May 2013, our shareholders approved an additional 800,000 share increase in the maximum number of shares of our common stock that may be issued pursuant to grants or exercises of options or restricted shares or other equity incentives under the 2010 Incentive Plan. As a result, as of June 30, 2014, the maximum number of shares that were authorized for the grant of options or other equity incentives under the 2010 Incentive Plan totaled 2,295,815, or approximately 12% of the shares of our common stock then outstanding.
A stock option entitles the recipient to purchase shares of our common stock at a price per share that may not be less than 100% of the fair market value of the Company’s shares on the date the option is granted. Restricted shares may be granted at such purchase prices and on such other terms, including restrictions and Company repurchase or reacquisition rights, as are fixed by the Compensation Committee at the time rights to purchase such restricted shares are granted. Stock Appreciation Rights ("SARs") entitle the recipient to receive a cash payment in an amount equal to the difference between the fair market value of the Company’s shares on the date of vesting and a “base price” (which, in most cases, will be equal to the fair market value of the Company’s shares on the date the SAR is granted), subject to the right of the Company to make such payment in shares of its common stock at their then fair market value. Options, restricted shares and SARs may vest immediately or in installments over various periods generally ranging up to five years, subject to the recipient’s continued employment or service or the achievement of specified performance goals, as determined by the Compensation Committee at the time it grants or awards the options, the restricted shares or the SARs. Stock options and SARs may be granted for terms of up to 10 years after the date of grant, but will terminate sooner upon or shortly after a termination of service occurring prior to the expiration of the term of the option or SAR. The Company will become entitled to repurchase any unvested restricted shares, at the same price that was paid for the shares by the recipient, or to cancel those shares in the event of a termination of employment or service of the holder of such shares or if any performance goals specified in the award are not satisfied. To date, the Company has not granted any SARs.
Under FASB ASC 718-10, we are required to recognize, in our financial statements, the fair value of the options or any restricted shares that we grant as compensation cost over their respective service periods. The fair values of the options that were outstanding at June 30, 2014 under the 2010 Incentive Plan were estimated as of their respective dates of grant using the Black-Scholes option-pricing model. The Company under the 2010 Incentive Plan granted restricted stock for the benefit of its employees. These restricted shares vest over a period of three years. The recipients of restricted shares have the right to vote all shares subject to such grant and receive all dividends with respect to such shares whether or not the shares have vested. The recipients do not pay any cash consideration for the shares.
Stock Options
The table below summarizes the weighted average assumptions used to determine the fair values of the options granted during the following periods:

24

 
Three Months Ended June 30,
 
Six Months Ended June 30,
Assumptions with respect to:
2014(1)
 
2013
 
2014
 
2013
Expected volatility
—
%
 
43
%
 
44
%
 
43
%
Risk-free interest rate
—
%
 
1.77
%
 
2.08
%
 
1.77
%
Expected dividends
—
%
 
0.57
%
 
0.61
%
 
0.57
%
Expected term (years)
—

 
2.0-6.9

 
6.7 - 6.7

 
2.0-6.9

Weighted average fair value of options granted during period
$
—

 
$
1.91

 
$
2.75

 
$
1.91

 
(1)    We did not grant any options during the second quarter of 2014.
The following table summarizes the stock option activity under the Company’s equity incentive plans during the six months ended June 30, 2014 and 2013, respectively.
 
Number of
Shares
 
Weighted-
Average
Exercise
Price
Per Share
 
Number of
Shares
 
Weighted-
Average
Exercise
Price
Per Share
 
2014
 
2013
Outstanding – January 1,
1,821,000

 
$
6.88

 
1,566,965

 
$
6.90

Granted
41,892

 
6.18

 
214,000

 
6.05

Exercised
(92,200
)
 
3.74

 
(6,300
)
 
3.52

Forfeited/Canceled
(290,733
)
 
10.63

 
(244,600
)
 
6.60

Outstanding – June 30,
1,479,959

 
6.32

 
1,530,065

 
6.84

Options Exercisable – June 30,
779,465

 
$
6.47

 
980,789

 
$
7.52

Options Vested – June 30,
779,465

 
$
6.47

 
980,789

 
$
7.52

Options to purchase 27,200 and 92,200 shares of our common stock were exercised during the three and six months ended June 30, 2014, respectively. Options to purchase 200 and 6,300 shares of our common stock were exercised during the three and six months ended June 30, 2013, respectively. The aggregate intrinsic value of options exercised during the three months ended June 30, 2014 and 2013 was $58 thousand and $0, respectively. The aggregate intrinsic value of options exercised during the six months ended June 30, 2014 and 2013 was $232 thousand and $2 thousand, respectively. The fair values of options vested during the three months ended June 30, 2014 and 2013 was $144 thousand and $153 thousand, respectively. The fair values of options that vested during the six months ended June 30, 2014 and 2013 was $214 thousand and $271 thousand, respectively.
The following table provides additional information regarding the vested and unvested options that were outstanding at June 30, 2014.
Options Outstanding as of June 30, 2014
 
Options Exercisable
as of June 30, 2014(1)
 
Vested
 
Unvested
 
Weighted
Average
Exercise
Price
 
Weighted
Average
Remaining
Contractual
Life (Years)
 
Shares
 
Weighted
Average
Exercise Price
$2.97 – $5.99
507,997

 
81,737

 
$
4.23

 
6.80
 
507,997

 
$
4.14

$6.00 – $9.99
140,168

 
618,757

 
6.36

 
8.87
 
140,168

 
6.52

$10.00 – $12.99
5,000

 
—

 
12.02

 
0.80
 
5,000

 
12.02

$13.00 – $17.99
106,800

 
—

 
15.13

 
0.99
 
106,800

 
15.13

$18.00 – $18.84
19,500

 
—

 
18.06

 
1.59
 
19,500

 
18.06

 
779,465

 
700,494

 
$
6.32

 
7.35
 
779,465

 
$
6.47

 
(1)
The weighted average remaining contractual life of the options that were exercisable as of June 30, 2014 was 5.99 years.
The aggregate intrinsic value of options that were outstanding and exercisable under the 2010 Incentive Plan at June 30, 2014 and December 31, 2013 was $1.3 million and $1.2 million, respectively.
 
A summary of the status of the unvested options outstanding as of June 30, 2014, and changes in the weighted average grant date fair values of the unvested options during the three months ended June 30, 2014, are set forth in the following table.

25

 
Number of
Shares Subject
to Options
 
Weighted
Average
Grant Date
Fair Value
Unvested at December 31, 2013
785,566

 
$
2.57

Granted
41,892

 
2.75

Vested
(99,865
)
 
2.14

Forfeited/Canceled
(27,099
)
 
2.68

Unvested at June 30, 2014
700,494

 
2.63

At June 30, 2014, the weighted average period over which nonvested awards were expected to be recognized was 1.11 years.
Restricted Stock
We issued 43,608 shares of restricted stock under the 2010 Incentive Plan during the six months ended June 30, 2014, at a price of $6.29 that vest on an annual prorated basis over the next three years. The following table summarizes the activity related to restricted stock granted, vested and forfeited under our equity incentive plans during the six months ended June 30, 2014.
 
Number of Shares
 
Average Grant Date Fair Value
Outstanding at December 31, 2013
141,284

 
6.23

Granted
43,608

 
$
6.29

Vested
—

 
—

Forfeited
(6,286
)
 
6.21

Outstanding at June 30, 2014
178,606

 
$
6.25

Compensation Expense
We expect that the compensation expense that will be recognized during the periods presented below in respect of stock options and restricted stock outstanding at June 30, 2014, will be as follows:
 
Estimated Stock Based Compensation Expense Stock Options
 
Estimated Stock Based Compensation Expense Restricted Stock
 
Estimated Stock Based Compensation Expense Total
(Dollars in thousands)
 
 
 
 
 
For the years ending December 31,
 
 
 
 
 
Remainder of 2014
$
387,462

 
$
144,582

 
$
532,044

2015
550,116

 
289,165

 
839,281

2016
269,449

 
231,471

 
500,920

2017
35,770

 
7,570

 
43,340

2018 and beyond
26,553

 
—

 
26,553

 
$
1,269,350

 
$
672,788

 
$
1,942,138

The aggregate amounts of stock based compensation expense recognized in our consolidated statements of operations for the three months ended June 30, 2014 and 2013 were $260 thousand and $199 thousand, respectively, and for the six months ended June 30, 2014 and 2013 were $537 thousand and $354 thousand, respectively, in each case net of taxes.

8. Earnings Per Share (“EPS”)
Basic EPS excludes dilution and is computed by dividing net income or loss available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if stock options or other contracts to issue common stock were exercised or converted into common stock that would then share in our earnings.


26

The following table shows how we computed basic and diluted EPS for the three and six months ended June 30, 2014 and 2013. 
(In thousands, except per share data)
For the Three Months Ended June 30,
 
For the Six Months Ended June 30,
2014
 
2013
 
2014
 
2013
Numerator:
 
 
 
 
 
 
 
Net loss from continuing operations
$
(768
)
 
$
(2,624
)
 
$
(1,501
)
 
$
(4,955
)
Accumulated undeclared dividends on preferred stock
(308
)
 
(262
)
 
(604
)
 
(524
)
Numerator for basic and diluted net loss from continuing operations
(1,076
)
 
(2,886
)
 
(2,105
)
 
(5,479
)
Net income (loss) from discontinued operations
772

 
(518
)
 
1,956

 
(1,356
)
Numerator for basic and diluted net loss available to common shareholders
$
(304
)
 
$
(3,404
)
 
$
(149
)
 
$
(6,835
)
Denominator:
 
 
 
 
 
 
 
Basic weighted average outstanding shares of common stock
19,255

 
18,906

 
19,200

 
17,825

Dilutive effect of employee stock options and warrants
—

 
—

 
—

 
—

Diluted weighted average common stock and common stock equivalents
19,255

 
18,906

 
19,200

 
17,825

Basic (loss) income per common share:
 
 
 
 
 
 
 
Net loss from continuing operations
$
(0.06
)
 
$
(0.15
)
 
$
(0.11
)
 
$
(0.31
)
Net income (loss) from discontinued operations
$
0.04

 
$
(0.03
)
 
$
0.10

 
$
(0.07
)
Net loss available to common shareholders
$
(0.02
)
 
$
(0.18
)
 
$
(0.01
)
 
$
(0.38
)
Diluted (loss) income per common share:
 
 
 
 
 
 
 
Net loss from continuing operations
$
(0.06
)
 
$
(0.15
)
 
$
(0.11
)
 
$
(0.31
)
Net income (loss) from discontinued operations
$
0.04

 
$
(0.03
)
 
$
0.10

 
$
(0.07
)
Net loss available to common shareholders
$
(0.02
)
 
$
(0.18
)
 
$
(0.01
)
 
$
(0.38
)
The weighted average shares that have an antidilutive effect in the calculation of diluted net loss per share and have been excluded from the computations above were as follows:
 
For the Three Months Ended June 30,
 
For the Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
Stock options(1)
1,519,378

 
1,504,073

 
1,591,697

 
1,520,020

Shares subject to stock purchase warrants(2)
761,278

 
761,278

 
761,278

 
761,278

 
(1)
Stock options were excluded from the computation of diluted earnings per common share for the three and six months ended June 30, 2014 and June 30, 2013 as we reported a net loss from continuing operations.
(2)
Stock purchase warrants were excluded from the computation of diluted earnings per common share for the three and six months ended June 30, 2014 and 2013 because the exercisability of those warrants is conditioned on the happening of certain future events.


27

9. Shareholders’ Equity
Accumulated Other Comprehensive Loss
Accumulated other comprehensive loss as of June 30, 2014 and December 31, 2013 was as follows:
 
Unrealized Gain (Loss) on Securities Available-for-Sale, net of tax
 
Unrealized Gain (Loss) on Supplemental Executive Plan Expense, net
 
Accumulated Other Comprehensive Income, Net
 
(Dollars in thousands)
Ending balance as of December 31, 2012
$
(545
)
 
$
(20
)
 
$
(565
)
Other comprehensive loss before reclassifications, net of tax benefit of $1,141 thousand (1)
(1,635
)
 
—

 
(1,635
)
Amounts reclassified from accumulated other comprehensive loss, net of tax provision of $18 thousand and tax provision of $10 thousand, respectively (2)
26

 
20

 
46

Other comprehensive (loss) income, net of tax benefit of $1,123 thousand and tax expense $10 thousand, respectively
(1,609
)
 
20

 
(1,589
)
Ending balance as of December 31, 2013
$
(2,154
)
 
$
—

 
$
(2,154
)
Other comprehensive income before reclassifications, net of tax benefit of $715 thousand (1)
1,023

 
—

 
1,023

Amounts reclassified from accumulated other comprehensive income, net of tax
—

 
—

 
—

Other comprehensive income, net of tax benefit of $715 thousand
1,023

 
—

 
1,023

Ending balance as of June 30, 2014
$
(1,131
)
 
$
—

 
$
(1,131
)
 
(1)
Tax impact included in Deferred tax assets.
(2)
Gross amounts related to Unrealized Gain (Loss) on Securities Available-for-Sale, net of tax are included in Net gains on sale of securities available for sale. Gross amounts related to Unrealized Gain (Loss) on Supplemental Executive Plan Expense, net are included in Salaries and employee benefits. Related tax impact amounts are included in Income tax provision (benefit).

10. Commitments and Contingencies
Repurchase Reserves
We have historically maintained reserves for possible repurchases that we may have been required to make of certain of the mortgage loans which we sold as a result of deficiencies or defects that may be found to exist in such loans. Our repurchase reserve also covered returns of any premiums earned and administrative fees pertaining to the repurchase of mortgage loans that did not meet investor guidelines, including potential loss of advances on Veterans Affairs or Federal Housing Authority Ginnie Mae loans.  As a result of our exit from the mortgage banking business and no longer being subject to potential loss for anything other than mortgage fraud, we have undertaken an analysis of our accrual. Our analysis assumes that the repurchase liability exposure will decrease over time as mortgage loans are paid off and as we are no longer originating new mortgage loans. Additionally, with the sale of the mortgage servicing rights during April 2014, the increased exposure loss for the servicing of Ginnie Mae loans which we were accruing for was eliminated, resulting in further reversal of the accrual. As a result of our review, we reversed $1.5 million of our reserve during the current period. We repurchased $1.3 million of loans during the six months ended June 30, 2014 by adjusting the gains on sale recorded for these loans. No loans were repurchased during the three months ended June 30, 2014 or during the three and six months ended June 30, 2013. The following table sets forth information, at June 30, 2014 and December 31, 2013, with respect to such reserves:
 
June 30, 2014
 
December 31, 2013
 
(Dollars in thousands)
Beginning balance
$
1,883

 
$
906

(Recovery of)/Provision for repurchases
(1,453
)
 
1,041

Settlements
—

 
(64
)
Total repurchases reserve
$
430

 
$
1,883

Commitments

28

To meet the financing needs of our customers in the normal course of business, we are a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated financial statements. At June 30, 2014 and December 31, 2013, we were committed to fund certain loans including letters of credit amounting to approximately $130 million and $138 million, respectively. The contractual amounts of a credit-related financial instrument, such as a commitment to extend credit, a credit-card arrangement or a letter of credit, represent the amount of potential accounting loss should the commitment be fully drawn upon, the customer were to default, and the value of any existing collateral securing the customer’s payment obligation becomes worthless. The loss reserve for unfunded loan commitments was $225,000 at both June 30, 2014 and December 31, 2013.
As a result, we use the same credit policies in making commitments to extend credit and conditional obligations as we do for on-balance sheet instruments. Commitments generally have fixed expiration dates; however, since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis, using the same credit underwriting standards that are employed in making commercial loans. The amount of collateral obtained, if any, upon an extension of credit is based on our evaluation of the creditworthiness of the customer. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, residential real estate and income-producing commercial properties.
Litigation, Claims and Assessments
We are a defendant in or a party to a number of legal actions or proceedings that arise in the ordinary course of business. In some of these actions and proceedings, claims for monetary damages are asserted against us.
In accordance with applicable accounting guidance, we assess the likelihood of any loss or exposure with respect to lawsuits and other proceedings that are pending against us. We establish an accrued liability for lawsuits or other legal proceedings when they present loss contingencies that are both probable and estimable. Where a loss is not probable but it is reasonably possible or where a loss in excess of an amount accrued is reasonably possible, we disclose an estimate of the amount of the loss or range of possible losses for the claim if a reasonable estimate can be made, unless the amount of reasonably possible losses with respect to the matter is not material to our financial condition, results of operations or cash flows. We estimate any potential loss based upon currently available information and significant judgments and a variety of assumptions, and known and unknown uncertainties. Moreover, the facts and circumstances on which such estimates are based will change over time. Therefore, the amount of any losses we might incur in any lawsuits or other legal proceedings may exceed amounts which we had accrued based on our estimates and those estimates do not represent the maximum loss exposure that we may have in connection with any lawsuits or other legal proceedings.
Based on our evaluation of the lawsuits and other proceedings that were pending against us as of June 30, 2014, the outcomes in those suits or other proceedings are not expected to have, either individually or in the aggregate, a material adverse effect on our consolidated financial position, results of operations or cash flows. However, in light of the inherent uncertainties involved, some of which are beyond our control, and the very large or indeterminate damages often sought in such legal actions or proceedings, an adverse outcome in one or more of these suits or proceedings could be material to our financial position, results of operations or cash flows for any particular reporting period.

11. Discontinued Operations
During the fourth quarter of 2013, the Bank announced its decision to exit the mortgage banking business. As of June 30, 2014, we are no longer involved in the origination, selling and servicing of mortgage loans. The remaining wind down of the mortgage banking business is expected to be complete during the third quarter of 2014. Accordingly, all income and expense related to the mortgage banking business have been removed from continuing operations and are included in the consolidated statements of operations under the caption "Income (loss) from discontinued operations."
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
 
(Dollars in thousands)
Revenues(1)
$
(249
)
 
$
1,812

 
$
1,518

 
$
3,732

Pre-tax income (loss)
$
772

 
$
(518
)
 
$
1,956

 
$
(1,795
)
 
 
(1)
Net interest income plus noninterest income.

29

We established a reserve of $3.1 million in December 2013 for our estimated cost of discontinuing the mortgage banking business, which is included in our loss from discontinued operations in our statement of operations. This reserve primarily included severance and fees related to contract and lease terminations. Assets related to discontinued operations primarily consist of mortgage loans held for sale (see below), mortgage servicing rights (see below), fixed assets, and our derivative financial instruments (see Fair Value Measurements footnote above for more information regarding our derivatives). As of June 30, 2014, $1.0 million of the reserve remained outstanding.
Mortgage Loans Held for Sale
A summary of the unpaid principal balances of LHFS, by type, is presented below:
 
June 30, 2014
 
December 31, 2013
 
(Dollars in thousands)
Government
$
—

 
$
2,616

Conventional
—

 
3,138

Jumbo
—

 
1,177

Fair value adjustment
—

 
(15
)
Total LHFS at fair value(1)
$
—

 
$
6,916

 
 
(1)    We had no LHFS as of June 30, 2014.
Gains on LHFS for the three and six months ended June 30, 2014 and 2013 were as follows:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
 
 
 
 
 
(Dollars in thousands)
Gain on sale of mortgage loans
$
47

 
$
5,333

 
$
394

 
$
1,424

Net loan servicing
91

 
494

 
312

 
296

Unrealized gains (losses) from derivative financial statements
240

 
393

 
—

 
584

Realized gains (losses) from derivative financial instruments
36

 
519

 
(219
)
 
367

Mark to market (loss) gain on LHFS
(248
)
 
(2,192
)
 
(166
)
 
(610
)
Direct origination (expenses) fees, net
(8
)
 
(1,943
)
 
(109
)
 
(964
)
Provision for repurchases
1,470

 
(83
)
 
1,453

 
(32
)
Total gain on LHFS
$
1,628

 
$
2,521

 
$
1,665

 
$
1,065

Mortgage Servicing Rights
We sometimes retained mortgage servicing rights on mortgage loans that we sold. Such rights represented the net positive cash flows generated from the servicing of such mortgage loans and we recognized such rights as assets on our statements of financial condition based on their estimated fair values. We received servicing fees, less any subservicing costs, on the unpaid principal balances of such mortgage loans. Those fees were collected from the monthly payments made by the mortgagors or from the proceeds of the sale or foreclosure and liquidation of the underlying real property collateralizing the loans. We also generally received various mortgagor-contracted fees, such as late charges, collateral reconveyance charges and nonsufficient fund fees. In addition, we generally were entitled to retain interest earned on funds held pending remittance (or float) related to the collection of principal, interest, taxes and insurance payments on the mortgage loans which we serviced.
In April 2014, we sold the entire portfolio of mortgage servicing rights on loans with an unpaid principal balance of $498.9 million as of April 30, 2014 in two separate transactions for a total of $5.5 million. During the first quarter of 2014, we recorded an increase in the fair value of the mortgage servicing rights of $1.2 million, which was included in income from discontinued operations. The final settlement during May 2014 resulted in a reversal of $257 thousand of the previous increase in fair value during the three months ended June 30, 2014. For the six months ended June 30, 2014, we recognized a gain on the sale of the mortgage servicing rights of $930 thousand.
As of June 30, 2014 and December 31, 2013, mortgage servicing rights totaled $0 and $4.4 million, respectively. At December 31, 2013, the mortgage servicing rights were included in Assets of discontinued operations in the accompanying consolidated statements of financial condition.
The Bank accounts for mortgage servicing rights at fair value with changes in fair value recorded in income from discontinued operations in the consolidated statements of operations. The table below presents the activity for mortgage servicing rights for the three and six months ended June 30, 2014 and 2013.

30

Rollforward of Fair Value of Mortgage Servicing Rights
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(Dollars in thousands)
 
2014
 
2013
 
2014
 
2013
Balance, beginning of period
 
$
5,604

 
$
3,264

 
$
4,417

 
$
2,801

Additions
 
—

 
168

 
60

 
593

Payoffs
 
—

 
(125
)
 
(31
)
 
(245
)
Impact due to changes in Constant Prepayment Rate (“CPR”)
 
—

 
422

 
—

 
798

Changes in fair value resulting from valuation inputs or assumptions
 
(257
)
 
94

 
901

 
(124
)
Sale of mortgage servicing rights portfolio
 
(5,347
)
 
—

 
(5,347
)
 
—

Balance, end of period
 
$
—

 
$
3,823

 
$
—

 
$
3,823

Rollforward of Unpaid Principal Balance of Mortgage Servicing Portfolio
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(Dollars in thousands)
 
2014
 
2013
 
2014
 
2013
Balance, beginning of period
 
$
506,583

 
$
491,629

 
$
506,664

 
$
457,062

Additions
 
—

 
24,236

 
5,420

 
82,807

Payoffs
 
—

 
(28,004
)
 
(2,765
)
 
(49,819
)
Impact due to changes in CPR
 
—

 
(1,779
)
 
—

 
(3,968
)
Changes in fair value resulting from valuation inputs or assumptions
 
—

 
—

 
(2,736
)
 
—

Sale of mortgage servicing rights portfolio
 
(506,583
)
 
—

 
(506,583
)
 
—

Balance, end of period
 
$
—

 
$
486,082

 
$
—

 
$
486,082

The following table sets forth the principal amounts of the mortgage loans we were servicing, categorized by type of loan, at June 30, 2014 and June 30, 2013:
 
Unpaid Principal Balance as of
(Dollars in thousands)
June 30, 2014
 
December 31, 2013
Government
$
—

 
$
404,432

Conventional
—

 
102,232

Total loans serviced
$
—

 
$
506,664


12. Business Segment Information
We have one reportable business segment, commercial banking. The commercial banking segment provides small and medium-size businesses, professional firms and individuals with a diversified range of products and services such as various types of deposit accounts, various types of commercial and consumer loans, cash management services, and online banking services. We also have one non-reportable segment, discontinued operations, which is comprised of our mortgage banking business. Our mortgage banking business originated mortgage loans that, for the most part, were resold within 30 days to long-term investors in the secondary residential mortgage market.
Since our operating segment derives all of its revenues from interest and noninterest income and interest expense constitutes its most significant expense, this segment, as well as our discontinued operations, are reported below using net interest income (interest income less interest expense) and noninterest income (primarily net gains on sales of SBA loans and fee income). We do not allocate general and administrative expenses or income taxes to our operating segment.

31

The following table sets forth information regarding the net interest income and noninterest income for our commercial banking and discontinued operations segments, respectively, for the three and six months ended June 30, 2014 and 2013.
(Dollars in thousands)
Commercial
 
Other
 
Total from continuing operations
 
Discontinued Operations
 
Total including discontinued operations
Net interest income for the three months ended June 30,
 
 
 
 
 
 
 
 
 
2014
$
7,698

 
$
(72
)
 
$
7,626

 
$
3

 
$
7,629

2013
$
7,443

 
$
(72
)
 
$
7,371

 
$
69

 
$
7,440

Noninterest income for the three months ended June 30,
 
 
 
 
 
 
 
 
 
2014
$
984

 
$
225

 
$
1,209

 
$
(254
)
 
$
955

2013
$
(342
)
 
$
68

 
$
(274
)
 
$
1,719

 
$
1,445

Net interest income for the six months ended June 30,
 
2014
$
15,539

 
$
(69
)
 
$
15,470

 
$
77

 
$
15,547

2013
$
14,706

 
$
(173
)
 
$
14,533

 
$
262

 
$
14,795

Noninterest income for the six months ended June 30,
 
 
 
 
 
 
 
 
 
2014
$
2,162

 
$
341

 
$
2,503

 
$
1,435

 
$
3,938

2013
$
104

 
$
67

 
$
171

 
$
3,407

 
$
3,578

Segment Assets at:
 
 
 
 
 
 
 
 
 
June 30, 2014
$
997,280

 
$
13,423

 
$
1,010,703

 
$
1,297

 
$
1,012,000

December 31, 2013
$
968,507

 
$
15,887

 
$
984,394

 
$
12,189

 
$
996,583


ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward Looking Statements
Statements contained in this Quarterly Report on Form 10-Q (this “Report”) that are not historical facts or that discuss our expectations, beliefs or views regarding our future operations or future financial performance, or financial or other trends in our business or in the markets in which we operate, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “estimate,” “project,” "forecast," or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could,” or “may.” The information contained in such forward-looking statements is based on current information available to us and on assumptions that we make about future economic and market conditions and other events over which we do not have control. In addition, our business and the markets in which we operate are subject to a number of risks and uncertainties. Such risks and uncertainties, and the occurrence of events in the future or changes in circumstances that had not been anticipated, could cause our financial condition or actual operating results in the future to differ materially from our expected financial condition or operating results that are set forth in the forward-looking statements contained in this Report and could, therefore, also affect the price performance of our shares.
In addition to the risk of incurring loan losses, which is an inherent risk of the banking business, these risks and uncertainties include, but are not limited to, the following: the risk that the economic recovery in the United States, which is still relatively fragile, will be adversely affected by domestic or international economic conditions, which could cause us to incur additional loan losses and adversely affect our results of operations in the future; uncertainties and risks with respect to the effects that our compliance with the written agreement (the “FRBSF Agreement”) with the Federal Reserve Bank of San Francisco (the “FRBSF”) will have on our business and results of operations because, among other things, the FRBSF Agreement imposes restrictions on our operations and our ability to grow our banking franchise, and the risk of potential future supervisory action against us or the Bank (as defined below) by the FRBSF if we are unable to meet the requirements of the FRBSF Agreement; the risk that our results of operations in the future will continue to be adversely affected by our exit from the wholesale and residential mortgage lending businesses and the risk that our commercial banking business will not generate the additional revenues needed to fully offset the decline in our mortgage banking revenues within the next two to three years; the risk that our interest margins and, therefore, our net interest income will be adversely affected by changes in prevailing interest rates; the risk that we will not succeed in further reducing our remaining nonperforming assets, in which event we would face the prospect of further loan charge-offs and write-downs of assets; the risk that we will not be able to manage our interest rate risks effectively, in which event our operating results could be harmed; the prospect that government regulation of banking and other financial services organizations will increase, causing our costs of doing business to increase and restricting our ability to take advantage of business and growth opportunities; the risk that our efforts to develop a robust commercial banking platform and a productive small business administration (“SBA”)

32

lending group may not succeed; and the risk that we may be unable to realize our expected level of increasing deposit inflows. Additional information regarding these and other risks and uncertainties to which our business is subject is contained in our Annual Report on Form 10-K for the year ended December 31, 2013 (the “2013 Form 10-K”) that we filed with the Securities and Exchange Commission (“SEC”) on March 14, 2014, and readers of this Report are urged to review the additional information contained in that report, and in any subsequent Quarterly Report on Form 10-Q that we file with the SEC. We urge you to read those risk factors in conjunction with your review of the following discussion and analysis of our results of operations for the three and six months ended, and our financial condition at, June 30, 2014.
Due to the risks and uncertainties we face, readers are cautioned not to place undue reliance on the forward-looking statements contained in this Report, which speak only as of the date of this Report, or to make predictions about future performance based solely on historical financial performance. We also disclaim any obligation to update forward-looking statements contained in this Report as a result of new information, future events or otherwise, except as may otherwise be required by law.

Overview
The following discussion presents information about our consolidated results of operations, financial condition, liquidity and capital resources and should be read in conjunction with our consolidated financial statements and the notes thereto included in Item 1 above of this Report.
Our principal operating subsidiary is Pacific Mercantile Bank (the “Bank”), which is a California state chartered bank. The Bank accounts for substantially all of our consolidated revenues, expenses and income and our consolidated assets and liabilities. Accordingly, the following discussion focuses primarily on the Bank’s results of operations and financial condition.
As of June 30, 2014, our total assets, net loans and total deposits were $1.0 billion, $794 million and $819 million, respectively.
The Bank, which is headquartered in Orange County, California, approximately 40 miles south of Los Angeles, conducts a commercial banking business in Orange, Los Angeles, San Bernardino and San Diego counties in Southern California. The Bank is also a member of the Federal Reserve System and its deposits are insured, to the maximum extent permitted by law, by the Federal Deposit Insurance Corporation (the “FDIC”). For the six months ended June 30, 2014 and 2013, we operated as one reportable segment, Commercial Banking, and one non-reportable segment, Discontinued Operations.
Unless the context otherwise requires, the “Company,” “we,” “our,” “ours,” and “us” refer to Pacific Mercantile Bancorp and its consolidated subsidiaries.

Current Developments
During the fourth quarter of 2013, we announced our decision to exit the mortgage banking business. We have made substantial progress in our efforts to wind down the mortgage division. During the first quarter of 2014, all of the loan applications that were in process at the time of the announcement to discontinue mortgage lending were funded, closed by the applicant, or denied. At June 30, 2014, the Bank only had 3 remaining employees in the mortgage division, down from 77 employees at December 31, 2013, and is no longer involved in the origination, selling and servicing of mortgage loans. In April 2014, the Bank also finalized arrangements to sell its portfolio of mortgage servicing rights in two separate transactions, which closed on April 30, 2014 and are described in more detail above in Item 1 of this Report under Note 11, Discontinued Operations. The remaining wind down of the mortgage banking business is expected to be complete during the third quarter of 2014.
The Company has also furthered its efforts in laying the foundation for a full-fledged Asset Based Lending ("ABL") Group that was begun in 2013. The ABL Group will originate loans primarily secured by general corporate assets with a borrowing formula primarily based on accounts receivables. In the first half of 2014, the ABL Group developed a pipeline of potential relationships that included an ABL credit facility along with products and services to meet the customers' depository and cash management needs. The Bank commenced with some of these relationships during the second quarter of 2014 with the funding of the ABL facilities.
The Company continued to expand its offerings through the SBA Programs and during the six months ended June 30, 2014 funded $19.7 million in loans through the 7(a) Program and sold $14.8 million of the guaranteed portion of those loans, which resulted in a $1.2 million gain during the six months ended June 30, 2014. The Company plans to continue its efforts to originate and sell SBA 7(a) loans.
Results of Operations
Discontinued Operations

33

In connection with our exit from the mortgage banking business described above, the revenues and expenses of our mortgage banking division have been classified as discontinued operations for all periods presented. As a result, all comparisons below reflect results from continuing operations. Income from discontinued operations was $0.8 million and $2.0 million for the three and six months ended June 30, 2014, respectively, while our loss from discontinued operations was $0.5 million and $1.4 million for the three and six months ended June 30, 2013, respectively. During the six months ended June 30, 2014, we recorded a gain on the sale of the mortgage servicing rights that we sold in April 2014, which is included in income from discontinued operations in the consolidated statements of operations. This compares to a loss from the mortgage banking operations prior to the decision to discontinue the mortgage banking business. For additional information, see Note 11, Discontinued Operations, included in Item 1 of this Report.
Operating Results for the Three and Six Months Ended June 30, 2014 and 2013     
Our operating results for the three and six months ended June 30, 2014, compared to June 30, 2013, were as follows:
 
Three Months Ended June 30,
 
2014 vs. 2013
% Change
 
Six Months Ended June 30,
 
2014 vs. 2013
% Change
 
2014
 
2013
 
 
2014
 
2013
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
 
Interest income
9,134

 
8,728

 
4.7
 %
 
18,421

 
17,478

 
5.4
 %
Interest expense
1,508

 
1,357

 
11.1
 %
 
2,951

 
2,945

 
0.2
 %
Provision for loan and lease losses
600

 
—

 
100.0
 %
 
1,050

 
1,150

 
(8.7
)%
Non-interest income
1,209

 
(274
)
 
(541.2
)%
 
2,503

 
171

 
1,363.7
 %
Non-interest expense
9,003

 
9,721

 
(7.4
)%
 
18,424

 
19,999

 
(7.9
)%
Income tax provision (benefit)
—

 
—

 
—
 %
 
—

 
(1,490
)
 
(100.0
)%
Net (loss) income from continuing operations
(768
)
 
(2,624
)
 
(70.7
)%
 
(1,501
)
 
(4,955
)
 
(69.7
)%
Net income (loss) from discontinued operations
772

 
(518
)
 
(249.0
)%
 
1,956

 
(1,356
)
 
(244.2
)%
Net income (loss)
4

 
(3,142
)
 
(100.1
)%
 
455

 
(6,311
)
 
(107.2
)%
Interest Income
Three Months Ended June 30, 2014 and 2013
Total interest income increased 4.7% to $9.1 million for the three months ended June 30, 2014 from $8.7 million for the three months ended June 30, 2013, with an average yield on interest-earning assets of 3.70% for the three months ended June 30, 2014 compared to 3.82% for the three months ended June 30, 2013. This increase was primarily due to an increase in interest income on loans during the three months ended June 30, 2014 compared to the same prior year period due to an increase in average loan balances, partially offset by a decline in the average yield. During the three months ended June 30, 2014 and 2013, interest income on loans was $8.7 million and $8.3 million, respectively, yielding 4.40% and 4.65% on average loan balances of $787.9 million and $712.5 million, respectively. The increase in the average loan balances is attributable to an increase in loan demand. The decrease in average loan yield is primarily attributable to the actions of the Board of Governors of the Federal Reserve System (“Federal Reserve Board”) to keep short-term interest rates low.
During the three months ended June 30, 2014 and 2013, interest income from our securities available-for-sale and stock, was $403 thousand and $387 thousand, respectively, yielding 2.25% and 1.86% on average balances of $71.9 million and $83.4 million, respectively. The average securities balances decreased as a result of sales and maturities of, and payments on, securities which we did not fully replace due to liquidity needs. The investment yield increase is primarily due to lower premium amortization attributable to slower projected prepayment speeds on our securities available-for-sale, returning our prepayment speed to a more historically normal level as compared to the accelerated prepayment speed seen in the prior year. Interest income from our short-term investments, including our federal funds sold and interest-bearing deposits, was $79 thousand and $75 thousand for the three months ended June 30, 2014 and 2013, respectively, yielding 0.24% and 0.25% on average balances of $130.1 million and $120.0 million, respectively. The average balances of short-term investments increased as a result of an increase in our funds held at the FRBSF. As a result, total interest income on investments increased slightly for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013.
Six Months Ended June 30, 2014 and 2013
Total interest income increased 5.4% to $18.4 million for the six months ended June 30, 2014 from $17.5 million for the six months ended June 30, 2013, with an average yield on interest-earning assets of 3.78% for the six months ended June 30, 2014 compared to 3.75% for the six months ended June 30, 2013. This increase was primarily due to an increase in interest income on loans during the six months ended June 30, 2014 compared to the same prior year period due to an increase in average loan balances, partially offset by a decline in the average yield. During the six months ended June 30, 2014 and 2013, interest income

34

on loans was $17.4 million and $16.6 million, respectively, yielding 4.49% and 4.66% on average loan balances of $783.6 million and $716.7 million, respectively. The increase in the average loan balances is attributable to an increase in loan demand. The decrease in loan yield is primarily attributable to the actions of the Federal Reserve Board to keep short-term interest rates low.
During the six months ended June 30, 2014 and 2013, interest income from our securities available-for-sale and stock, was $821 thousand and $757 thousand, respectively, yielding 2.27% and 1.75% on average balances of $72.8 million and $87.2 million, respectively. The average securities balances decreased as a result of sales and maturities of, and payments on, securities which we did not fully replace due to liquidity needs. The investment yield increase is primarily due to lower premium amortization attributable to slower projected prepayment speeds on our securities available-for-sale, returning our prepayment speed to a more historically normal level as compared to the accelerated prepayment speed seen in the prior year. Interest income from our short-term investments, including our federal funds sold and interest-bearing deposits, was $155 thousand and $170 thousand for the six months ended June 30, 2014 and 2013, respectively, yielding 0.25% and 0.25% on average balances of $126.3 million and $136.6 million, respectively. The decrease in interest income from our short-term investments was primarily attributable to a decrease in the average loan balances during the six months ended June 30, 2014 as compared to the six months ended June 30, 2013. As a result, total interest income on investments increased slightly for the six months ended June 30, 2014 and 2013.
Interest Expense
Three Months Ended June 30, 2014 and 2013
Total interest expense increased 11.1% to $1.5 million for the three months ended June 30, 2014 from $1.4 million for the three months ended June 30, 2013. The increase was primarily due to an increase in average interest-bearing liabilities of $713.5 million and $638.3 million at June 30, 2014 and 2013, respectively, yielding a cost of funds of 0.85% and 0.85%, respectively, which consisted of deposits, borrowings and junior subordinated debentures. Interest expense on our certificates of deposit for the three months ended June 30, 2014 and 2013, was $1.1 million and $1.0 million, respectively, yielding 0.95% and 1.02% on average balances of $454.0 million and $382.9 million, respectively. The increase in interest expense of $151 thousand, or 11.1%, was also due to an increase in the volume of certificates of deposit partially offset by a decrease in the rates of interest paid on certificates of deposit.
Six Months Ended June 30, 2014 and 2013
Total interest expense increased 0.2% to $3.0 million for the six months ended June 30, 2014 from $2.9 million for the six months ended June 30, 2013. The increase was primarily due to an increase in average interest-bearing liabilities of $711.4 million and $667.7 million at June 30, 2014 and 2013, respectively, yielding a cost of funds of 0.84% and 0.89%, respectively, which consisted of deposits, borrowings and junior subordinated debentures. Interest expense on our certificates of deposit for the six months ended June 30, 2014 and 2013, was $2.1 million and $2.2 million, respectively, yielding 0.97% and 1.09% on average balances of $439.9 million and $405.2 million, respectively. The increase in interest expense was also due to an increase in the volume of certificates of deposit partially offset by a decrease in the rates of interest paid on certificates of deposit.
Net Interest Margin
One of the principal determinants of a bank’s income is its net interest income, which is the difference between (i) the interest that a bank earns on loans, investment securities and other interest earning assets, on the one hand, and (ii) its interest expense, which consists primarily of the interest it must pay to attract and retain deposits and the interest that it pays on borrowings and other interest-bearing liabilities, on the other hand. As a general rule, all other things being equal, the greater the difference or "spread" between the amount of our interest income and the amount of our interest expense, the greater will be our net income; whereas, a decline in that difference or "spread" will generally result in a decline in our net income.
A bank’s interest income and interest expense are affected by a number of factors, some of which are outside of its control, including national and local economic conditions and the monetary policies of the Federal Reserve Board which affect interest rates, competition in the market place for loans and deposits, the demand for loans and the ability of borrowers to meet their loan payment obligations. Net interest income, when expressed as a percentage of total average interest earning assets, is a banking organization’s “net interest margin.”
The following tables set forth information regarding our average balance sheet, yields on interest earning assets, interest expense on interest-bearing liabilities, the interest rate spread and the interest rate margin for the three and six months ended June 30, 2014 and 2013. Average balances are calculated based on average daily balances.

35

 
Three Months Ended June 30,
 
2014
 
2013
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
(Dollars in thousands)
Interest earning assets
 
 
 
 
 
 
 
 
 
 
 
Short-term investments(1)
$
130,146

 
$
79

 
0.24
%
 
$
120,012

 
$
75

 
0.25
%
Securities available for sale and stock(2)
71,928

 
403

 
2.25
%
 
83,375

 
387

 
1.86
%
Loans(3)
787,882

 
8,652

 
4.40
%
 
712,525

 
8,266

 
4.65
%
Total interest-earning assets
989,956

 
9,134

 
3.70
%
 
915,912

 
8,728

 
3.82
%
Interest-bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing checking accounts
$
35,457

 
$
25

 
0.28
%
 
$
32,735

 
$
22

 
0.27
%
Money market and savings accounts
154,591

 
119

 
0.31
%
 
160,124

 
151

 
0.38
%
Certificates of deposit
454,041

 
1,081

 
0.95
%
 
382,935

 
975

 
1.02
%
Other borrowings
51,911

 
129

 
1.00
%
 
45,011

 
71

 
0.63
%
Junior subordinated debentures
17,527

 
154

 
3.52
%
 
17,527

 
138

 
3.16
%
Total interest bearing liabilities
713,527

 
1,508

 
0.85
%
 
638,332

 
1,357

 
0.85
%
Net interest income
 
 
$
7,626

 
 
 
 
 
$
7,371

 
 
Net interest income/spread
 
 
 
 
2.85
%
 
 
 
 
 
2.97
%
Net interest margin
 
 
 
 
3.09
%
 
 
 
 
 
3.23
%
 
Six Months Ended June 30,
 
2014
 
2013
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
(Dollars in thousands)
Interest earning assets
 
 
 
 
 
 
 
 
 
 
 
Short-term investments(1)
$
126,255

 
$
155

 
0.25
%
 
$
136,619

 
$
170

 
0.25
%
Securities available for sale and stock(2)
72,827

 
821

 
2.27
%
 
87,150

 
757

 
1.75
%
Loans(3)
783,559

 
17,445

 
4.49
%
 
716,723

 
16,551

 
4.66
%
Total interest-earning assets
982,641

 
18,421

 
3.78
%
 
940,492

 
17,478

 
3.75
%
Interest-bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing checking accounts
$
34,682

 
$
49

 
0.28
%
 
$
32,980

 
$
43

 
0.26
%
Money market and savings accounts
158,789

 
250

 
0.32
%
 
164,218

 
349

 
0.43
%
Certificates of deposit
439,855

 
2,111

 
0.97
%
 
405,188

 
2,181

 
1.09
%
Other borrowings
60,565

 
282

 
0.94
%
 
47,713

 
103

 
0.44
%
Junior subordinated debentures
17,527

 
259

 
2.98
%
 
17,604

 
269

 
3.08
%
Total interest bearing liabilities
711,418

 
2,951

 
0.84
%
 
667,703

 
2,945

 
0.89
%
Net interest income
 
 
$
15,470

 
 
 
 
 
$
14,533

 
 
Net interest income/spread
 
 
 
 
2.94
%
 
 
 
 
 
2.86
%
Net interest margin
 
 
 
 
3.17
%
 
 
 
 
 
3.12
%
 
(1)
Short-term investments consist of federal funds sold and interest bearing deposits that we maintain at other financial institutions.
(2)
Stock consists of Federal Home Loan Bank of San Francisco (“FHLB”) stock and FRBSF stock.
(3)
Loans include the average balance of nonaccrual loans.
The following table sets forth changes in interest income, including loan fees, and interest paid in each of the six months ended June 30, 2014 and 2013 and the extent to which those changes were attributable to changes in (i) the volumes of or in the rates of interest earned on interest-earning assets and (ii) the volumes of or in the rates of interest paid on our interest-bearing liabilities.
 

36

 
Three Months Ended June 30, 2014 Compared to
Three Months Ended June 30, 2013 Increase (Decrease) due to Changes in
 
Six Months Ended June 30, 2014 Compared to
Six Months Ended June 30, 2013 Increase (Decrease) due to Changes in
 
Volume
 
Rates
 
Total
Increase
(Decrease)
 
Volume
 
Rates
 
Total
Increase
(Decrease)
 
(Dollars in thousands)
Interest income
 
 
 
 
 
 
 
 
 
 
 
Short-term investments(1)
$
6

 
$
(2
)
 
$
4

 
$
(13
)
 
$
(2
)
 
$
(15
)
Securities available for sale and stock(2)
(58
)
 
74

 
16

 
(138
)
 
202

 
64

Loans
843

 
(457
)
 
386

 
1,503

 
(609
)
 
894

Total earning assets
791

 
(385
)
 
406

 
1,352

 
(409
)
 
943

Interest expense
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing checking accounts
2

 
1

 
3

 
2

 
4

 
6

Money market and savings accounts
(5
)
 
(27
)
 
(32
)
 
(11
)
 
(88
)
 
(99
)
Certificates of deposit
172

 
(66
)
 
106

 
178

 
(248
)
 
(70
)
Borrowings
12

 
46

 
58

 
34

 
145

 
179

Junior subordinated debentures
—

 
16

 
16

 
(1
)
 
(9
)
 
(10
)
Total interest-bearing liabilities
181

 
(30
)
 
151

 
202

 
(196
)
 
6

Net interest income
$
610

 
$
(355
)
 
$
255

 
$
1,150

 
$
(213
)
 
$
937

 
(1)
Short-term investments consist of federal funds sold and interest bearing deposits that we maintain at financial institutions.
(2)
Stock consists of FHLB stock and FRBSF stock.
Provision for Loan and Lease Losses
We maintain reserves to provide for loan losses that occur in the ordinary course of the banking business. When it is determined that the payment in full of a loan has become unlikely, the carrying value of the loan is reduced ("written down") to what management believes is its realizable value or, if it is determined that a loan no longer has any realizable value, the carrying value of the loan is written off in its entirety (a loan "charge-off"). Loan charge-offs and write-downs are charged against our allowance for loan and lease losses (“ALLL”). The amount of the ALLL is increased periodically to replenish the ALLL after it has been reduced due to loan write-downs or charge-offs. The ALLL also is increased or decreased periodically to reflect increases or decreases in the volume of outstanding loans and to take account of changes in the risk of potential loan losses due to a deterioration or improvement in the condition of borrowers or in the value of properties securing non-performing loans or adverse changes or improvements in economic conditions. Increases in the ALLL are made through a charge, recorded as an expense in the statement of operations, referred to as the "provision for loan and lease losses." Recoveries of loans previously charged-off are added back to and, therefore, to that extent increase the ALLL and reduce the amount of the provision for loan and lease losses that might otherwise have had to be made to replenish or increase the ALLL.
We employ economic models that are based on bank regulatory guidelines, industry standards and our own historical loan loss experience, as well as a number of more subjective qualitative factors, to determine both the sufficiency of the ALLL and the amount of the provisions that we believe need to be made for potential loan losses to increase or replenish the ALLL. However, those determinations involve judgments and assumptions about trends in current economic conditions and other events that can affect the ability of borrowers to meet their loan obligations to us and a weighting among the quantitative and qualitative factors we consider in determining the amount of the ALLL. Moreover, the duration and anticipated effects of prevailing economic conditions or trends can be uncertain and can be affected by a number of risks and circumstances that are outside of our ability to control. If changes in economic or market conditions or unexpected subsequent events or changes in circumstances were to occur, or if changes were made to bank regulatory guidelines or industry standards that are used to assess the sufficiency of the ALLL, it could become necessary for us to record additional, and possibly significant, charges to increase the ALLL, which would have the effect of reducing our income or causing us to incur losses.
In addition, the FRBSF and the California Department of Business Oversight (“CDBO”), as an integral part of their examination processes, periodically review the adequacy of our ALLL. These agencies may require us to make additional provisions for possible loan losses, over and above the provisions that we have already made, the effect of which would be to reduce our income or increase any losses we might incur.
During the three and six months ended June 30, 2014, we recorded a provision for loan and lease losses of $600 thousand and $1.1 million, respectively, as compared to $0 and $1.2 million recorded during the three and six months ended June 30, 2013,

37

respectively. The provision for loan and lease losses increased $600 thousand, or 100.0%, for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013, primarily as a result of an increase in loan balances by $28.0 million for the three months ended June 30, 2014 compared to $14.3 million for the three months ended June 30, 2013. The provision for loan and lease losses decreased $100 thousand, or 8.7%, for the six months ended June 30, 2014 as compared to the six months ended June 30, 2013, primarily as a result of net recoveries of $172 thousand for the six months ended June 30, 2014, along with increased loan balances of $29.8 million in the first half of 2014 compared to net charge-offs of $908 thousand during the six months ended June 30, 2013 and a decrease in loan balances of $1.4 million for the same period.
See "—Financial Condition—Nonperforming Assets and the Allowance for Loan and Lease Losses" below in this Item 2 for additional information regarding the ALLL.
Noninterest Income
The following table identifies the components of and the percentage changes in noninterest income during the three and six months ended June 30, 2014 and 2013: 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
Amount
 
Amount
 
Percentage
Change
 
Amount
 
Amount
 
Percentage
Change
 
2014
 
2013
 
2014 vs. 2013
 
2014
 
2013
 
2014 vs. 2013
 
 
 
 
 
 
 
(Dollars in thousands)
Service fees on deposits and other banking services
218

 
196

 
11.2
 %
 
426

 
392

 
8.7
 %
Net gains on sale of securities available for sale
—

 
—

 
—
 %
 
—

 
23

 
(100.0
)%
Net gain on sale of small business administration loans
474

 
—

 
100.0
 %
 
1,160

 
—

 
100.0
 %
Net loss on sale of other real estate owned
—

 
—

 
—
 %
 
—

 
(9
)
 
(100.0
)%
Income from other real estate owned
225

 
1

 
22,400.0
 %
 
341

 
68

 
401.5
 %
Other noninterest income (loss)
292

 
(471
)
 
(162.0
)%
 
576

 
(303
)
 
(290.1
)%
Total noninterest income
$
1,209

 
$
(274
)
 
(541.2
)%
 
$
2,503

 
$
171

 
1,363.7
 %
Three Months Ended June 30, 2014 and 2013
Noninterest income increased by $1.5 million for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013 primarily as a result of:
•
A net gain of $474 thousand on sales of commercial SBA loans for the three months ended June 30, 2014 as compared to no sales of SBA loans during the prior year period;
•
A $224 thousand increase in income from properties acquired by or in lieu of loan foreclosures (commonly referred to as other real estate owned or “OREO”); and
•
No sales of loans in the current period as compared to a net loss on the sale of loans of $576 thousand for the three months ended June 30, 2013 included within other noninterest income (loss).
Six Months Ended June 30, 2014 and 2013
Noninterest income increased $2.3 million for the six months ended June 30, 2014 as compared to the six months ended June 30, 2013, primarily as a result of:
•
A net gain of $1.2 million on sales of SBA loans for the six months ended June 30, 2014 as compared to no sales of SBA loans during the prior year period;
•
An increase of $273 thousand in income from OREO; and
•
No sales of loans in the current period as compared to a net loss on the sale of loans of $485 thousand for the three months ended June 30, 2013 included within other noninterest income (loss).
Noninterest Expense
The following table sets forth the principal components and the amounts of, and the percentage changes in, noninterest expense during the three and six months ended June 30, 2014 and 2013.

38

 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014 vs. 2013
 
2014
 
2013
 
2014 vs. 2013
 
Amount
 
Amount
 
Percent Change
 
Amount
 
Amount
 
Percent Change
 
 
 
 
 
 
 
(Dollars in thousands)
Salaries and employee benefits
$
5,420

 
$
5,150

 
5.2
 %
 
$
11,023

 
$
9,516

 
15.8
 %
Occupancy
610

 
597

 
2.2
 %
 
1,198

 
1,086

 
10.3
 %
Equipment and depreciation
363

 
392

 
(7.4
)%
 
732

 
818

 
(10.5
)%
Data processing
200

 
199

 
0.5
 %
 
451

 
398

 
13.3
 %
FDIC expense
359

 
547

 
(34.4
)%
 
653

 
1,092

 
(40.2
)%
Other real estate owned expense
538

 
1,245

 
(56.8
)%
 
1,398

 
3,362

 
(58.4
)%
Professional fees
490

 
845

 
(42.0
)%
 
1,064

 
2,211

 
(51.9
)%
(Recovery of) provision for contingencies
175

 
(279
)
 
(162.7
)%
 
175

 
(539
)
 
(132.5
)%
Business development
169

 
327

 
(48.3
)%
 
338

 
534

 
(36.7
)%
Loan related expense
129

 
80

 
61.3
 %
 
216

 
220

 
(1.8
)%
Insurance
141

 
147

 
(4.1
)%
 
278

 
294

 
(5.4
)%
Other operating expenses (1)
409

 
471

 
(13.2
)%
 
898

 
1,007

 
(10.8
)%
Total noninterest expense
$
9,003

 
$
9,721

 
(7.4
)%
 
$
18,424

 
$
19,999

 
(7.9
)%
 
(1)
Other operating expenses primarily consist of telephone, investor relations, promotional, regulatory expenses, and correspondent bank fees.
Three Months Ended June 30, 2014 and 2013
During the three months ended June 30, 2014, noninterest expense decreased by $718 thousand, or 7.4%, to $9.0 million from $9.7 million for the three months ended June 30, 2013, primarily as a result of:
•
A decrease of $707 thousand in OREO expenses related to the reduction of older OREO that incurred more expenses to maintain and resolve in the second quarter of 2013, partially offset by newer OREO taken in collection of debts that have not incurred the same level of expense to maintain and resolve during the second quarter of 2014;
•
A decrease of $355 thousand in professional fees related to decreased legal expenses due to the settlement of certain lawsuits and other disputes and a decline in nonperforming loans; partially offset by
•
An increase of $270 thousand in salaries and employee benefits related to the hiring of a new CEO and other key employees in 2013, increases in health care insurance costs, and increases in workers' compensation premiums.
Six Months Ended June 30, 2014 and 2013
During the six months ended June 30, 2014, noninterest expense decreased by $1.6 million, or 7.9%, to $18.4 million from $20.0 million for the six months ended June 30, 2013, primarily as a result of:
•
A decrease of $2.0 million in OREO expenses related to the reduction of older OREO that incurred more expenses to maintain and resolve in the first half of 2013, partially offset by newer OREO taken in collection of debts that have not incurred the same level of expense to maintain and resolve during the first half of 2014;
•
A decrease of $1.1 million in professional fees related to decreased legal expenses due to the settlement of certain lawsuits and other disputes and a decline in nonperforming loans; partially offset by
•
An increase of $1.5 million in salaries and employee benefits related to the hiring of a new CEO and other key employees in 2013, increases in health care insurance costs, and increases in workers' compensation premiums.
Provision for (Benefit from ) Income Tax
Three Months Ended June 30, 2014 and 2013    
For the three months ended June 30, 2014 and 2013, we recorded no income tax provision. There was no income tax provision during the three months ended June 30, 2013 as a result of a net operating loss for the quarter. We generated net operating losses (“NOLs”) for the year ended December 31, 2013 which may be utilized against taxable income. The 2013 NOLs were subject to a valuation allowance. As a result of taxable income generated and the utilization of the NOLs subject to a valuation allowance during the three months ended June 30, 2014, we had no income tax provision.
Six Months Ended June 30, 2014 and 2013

39

For the six months ended June 30, 2014, we recorded no income tax provision and we recorded an income tax benefit of $1.5 million for the six months ended June 30, 2013. The tax benefit during the six months ended June 30, 2013 was primarily related to the release of the remainder of a valuation allowance, which we had established against our deferred tax asset by means of non-cash charges to the provision for income taxes prior to 2013. We generated net operating losses (“NOLs”) for the year ended December 31, 2013 which may be utilized against taxable income. The 2013 NOLs were subject to a valuation allowance. As a result of taxable income generated and the utilization of the NOLs subject to a valuation allowance during the six months ended June 30, 2014, we had no income tax provision.
Financial Condition
Assets
Our total assets increased by $15 million to $1.0 billion at June 30, 2014 from $997 million at December 31, 2013. The following table sets forth the composition of our interest earning assets at:
 
June 30, 2014
 
December 31, 2013
 
(Dollars in thousands)
Interest-bearing deposits with financial institutions (1)
$
90,441

 
$
93,451

Interest-bearing time deposits with financial institutions
2,923

 
2,423

Federal Reserve Bank of San Francisco and Federal Home Loan Bank Stock, at cost
8,058

 
8,531

Securities available for sale, at fair value
62,728

 
65,989

Loans (net of allowances of $12,580 and $11,358, respectively)
793,820

 
765,426

 
(1)
Includes interest-earning balances maintained at the FRBSF.
Investment Portfolio
Securities Available for Sale. Securities that we intend to hold for an indefinite period of time, but which may be sold in response to changes in liquidity needs, in interest rates, or in prepayment risks or other similar factors, are classified as “securities available for sale”. Such securities are recorded on our balance sheet at their respective fair values and increases or decreases in those values are recorded as unrealized gains or losses, respectively, and are reported as other comprehensive income (loss) on our accompanying consolidated statements of financial condition, rather than included in or deducted from our earnings.
The following is a summary of the major components of securities available for sale and a comparison of the amortized cost, estimated fair values and the gross unrealized gains and losses attributable to those securities, as of June 30, 2014 and December 31, 2013:
(Dollars in thousands)
Amortized Cost
 
Gross
Unrealized Gain
 
Gross
Unrealized Loss
 
Estimated
Fair Value
Securities available for sale at June 30, 2014:
 
 
 
 
 
 
 
Mortgage backed securities issued by U.S. Agencies
$
56,915

 
$
17

 
$
(1,329
)
 
$
55,603

Collateralized mortgage obligations issued by non agencies
899

 
—

 
(10
)
 
889

Asset backed security
2,101

 
—

 
(598
)
 
1,503

Mutual funds
4,733

 
—

 
—

 
4,733

Total securities available for sale
$
64,648

 
$
17

 
$
(1,937
)
 
$
62,728

Securities available for sale at December 31, 2013:
 
 
 
 
 
 
 
U.S. Treasury securities
$
700

 
$
—

 
$
—

 
$
700

Mortgage backed securities issued by U.S. Agencies
60,514

 
13

 
(2,719
)
 
57,808

Collateralized mortgage obligations issued by non agencies
1,572

 
—

 
(48
)
 
1,524

Asset backed security
2,218

 
—

 
(906
)
 
1,312

Mutual funds
4,645

 
—

 
—

 
4,645

Total securities available for sale
$
69,649

 
$
13

 
$
(3,673
)
 
$
65,989

The amortized cost of securities available for sale at June 30, 2014 is shown in the table below by contractual maturities taking into consideration historical prepayments based on the prior twelve months of principal payments. Expected maturities will differ from contractual maturities and historical prepayments, particularly with respect to collateralized mortgage obligations, primarily because prepayment rates are affected by changes in conditions in the interest rate market and, therefore, future prepayment rates may differ from historical prepayment rates.

40

 
June 30, 2014 Maturing in
 
One year or less
 
Over one year through five years
 
Over five years through ten years
 
Over ten years
 
Total
(Dollars in thousands)
Amortized Cost
 
Weighted
Average
Yield
 
Amortized Cost
 
Weighted
Average
Yield
 
Amortized Cost
 
Weighted
Average
Yield
 
Amortized Cost
 
Weighted
Average
Yield
 
Amortized Cost
 
Weighted
Average
Yield
Securities available for sale:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Mortgage-backed securities issued by U.S. Agencies
$
6,703

 
1.57
%
 
$
22,467

 
1.57
%
 
$
19,259

 
1.60
%
 
$
8,486

 
1.63
%
 
$
56,915

 
1.59
%
Non-agency collateralized mortgage obligations
—

 
—

 
899

 
2.92
%
 
—

 
—

 
—

 
—

 
899

 
2.92
%
Asset backed securities
—

 
—

 
—

 
—
%
 
—

 
—

 
2,101

 
2.28
%
 
2,101

 
2.28
%
Mutual funds
—

 
—

 
4,733

 
2.00
%
 
—

 
—

 
—

 
—

 
4,733

 
2.00
%
Total Securities Available for sale
$
6,703

 
1.57
%
 
$
28,099

 
1.69
%
 
$
19,259

 
1.60
%
 
$
10,587

 
1.76
%
 
$
64,648

 
1.66
%

Loans
The following table sets forth the composition, by loan category, of our loan portfolio at June 30, 2014 and December 31, 2013:
 
June 30, 2014
 
December 31, 2013
 
Amount
 
Percent
 
Amount
 
Percent
 
(Dollars in thousands)
Commercial loans
$
253,442

 
31.4
%
 
$
226,450

 
29.2
%
Commercial real estate loans – owner occupied
191,143

 
23.7
%
 
174,221

 
22.4
%
Commercial real estate loans – all other
178,562

 
22.1
%
 
177,884

 
22.9
%
Residential mortgage loans – multi-family
94,405

 
11.7
%
 
96,565

 
12.4
%
Residential mortgage loans – single family
72,919

 
9.0
%
 
75,660

 
9.7
%
Land development loans
9,966

 
1.2
%
 
18,458

 
2.4
%
Consumer loans
6,210

 
0.8
%
 
7,599

 
1.0
%
Gross loans
806,647

 
100.0
%
 
776,837

 
100.0
%
Deferred fee costs (income), net
(247
)
 
 
 
(53
)
 
 
Allowance for loan and lease losses
(12,580
)
 
 
 
(11,358
)
 
 
Loans, net
$
793,820

 
 
 
$
765,426

 
 
Commercial loans are loans to businesses to finance capital purchases or improvements, or to provide cash flow for operations. Real estate and residential mortgage loans are loans secured by trust deeds on real properties, including commercial properties and single family and multi-family residences. Construction loans are interim loans to finance specific construction projects. Consumer loans include installment loans to consumers.
The following table sets forth the maturity distribution of our loan portfolio (excluding single and multi-family residential mortgage loans and consumer loans) at June 30, 2014:
 
June 30, 2014
 
One Year
or Less
 
Over One
Year
Through
Five Years
 
Over Five
Years
 
Total
 
(Dollars in thousands)
Real estate loans(1)
 
 
 
 
 
 
 
Floating rate
$
43,713

 
$
44,984

 
$
121,883

 
$
210,580

Fixed rate
22,876

 
76,421

 
69,794

 
169,091

Commercial loans
 
 
 
 
 
 
 
Floating rate
38,891

 
21,601

 
4,482

 
64,974

Fixed rate
132,108

 
51,222

 
5,138

 
188,468

Total
$
237,588

 
$
194,228

 
$
201,297

 
$
633,113


41

 
(1)
Does not include mortgage loans on single or multi-family residences or consumer loans, which totaled $167.3 million and $6.2 million, respectively, at June 30, 2014.
Nonperforming Assets and Allowance for Loan and Lease Losses
Nonperforming Assets. Non-performing loans consist of (i) loans on non-accrual status which are loans on which the accrual of interest has been discontinued and include restructured loans when there has not been a history of past performance on debt service in accordance with the contractual terms of the restructured loans, and (ii) loans 90 days or more past due and still accruing interest. Non-performing assets are comprised of non-performing loans and OREO, which consists of real properties which we have acquired by or in lieu of foreclosure and which we intend to offer for sale.
Loans are placed on non-accrual status when, in our opinion, the full timely collection of principal or interest is in doubt. Generally, the accrual of interest is discontinued when principal or interest payments become more than 90 days past due, unless we believe the loan is adequately collateralized and the loan is in the process of collection. However, in certain instances, we may place a particular loan on non-accrual status earlier, depending upon the individual circumstances involved in that loan’s delinquency. When a loan is placed on non-accrual status, previously accrued but unpaid interest is reversed against current income. Subsequent collections of unpaid amounts on such a loan are applied to reduce principal when received, except when the ultimate collectability of principal is probable, in which case such payments are applied to interest and are credited to income. Non-accrual loans may be restored to accrual status if and when principal and interest become current and full repayment is expected. Interest income is recognized on the accrual basis for impaired loans which, based on our non-accrual policy, do not require non-accrual treatment.
The following table sets forth information regarding our nonperforming assets, as well as information regarding restructured loans, at June 30, 2014 and December 31, 2013:
 
At June 30, 2014
 
At December 31, 2013
 
(Dollars in thousands)
Nonaccrual loans:
 
 
 
Commercial loans
$
5,044

 
$
5,371

Commercial real estate
6,535

 
3,890

Residential real estate
66

 
1,874

Land development
—

 
391

Total nonaccrual loans
$
11,645

 
$
11,526

Loans past due 90 days and still accruing interest:
 
 
 
Total loans past due 90 days and still accruing interest
$
—

 
$
—

Other real estate owned (OREO):
 
 
 
Commercial real estate
$
14,480

 
$
9,569

Residential real estate
962

 
2,092

Construction and land development
630

 
630

Total other real estate owned
$
16,072

 
$
12,291

Other nonperforming assets:
 
 
 
Asset backed security
—

 
1,312

Total other nonperforming assets
$
—

 
$
1,312

Total nonperforming assets
$
27,717

 
$
25,129

Restructured loans:
 
 
 
Accruing loans
$
11,244

 
$
12,634

Nonaccruing loans (included in nonaccrual loans above)
3,410

 
5,936

Total restructured loans
$
14,654

 
$
18,570

As the above table indicates, total nonperforming assets increased by approximately $2.6 million, or 10.3%, to $27.7 million as of June 30, 2014 from $25.1 million as of December 31, 2013, primarily due to a $5.2 million commercial real estate property added to OREO from the foreclosure of a commercial loan, partially offset by $1.1 million of OREO sales from residential real estate and returning a $1.3 million asset backed security to accrual status from nonaccrual status.
Information Regarding Impaired Loans. At June 30, 2014, loans deemed impaired totaled $22.9 million as compared to $24.2 million at December 31, 2013. We had an average investment in impaired loans of $26.1 million for the six months ended June 30, 2014 as compared to $35.7 million for the year ended December 31, 2013. The interest that would have been earned

42

during the six months ended June 30, 2014 had the nonaccruing impaired loans remained current in accordance with their original terms was approximately $206 thousand.
The following table sets forth the amount of impaired loans to which a portion of the ALLL has been specifically allocated, and the aggregate amount so allocated, in accordance with Accounting Standards Codification (“ASC”) 310-10, and the amount of the ALLL and the amount of impaired loans for which no such allocations were made, in each case at June 30, 2014 and December 31, 2013:
 
June 30, 2014
 
December 31, 2013
 
Loans
 
Reserves for
Loan Losses
 
% of
Reserves to
Loans
 
Loans
 
Reserves for
Loan Losses
 
% of
Reserves to
Loans
 
(Dollars in thousands)
Impaired loans with specific reserves
$
2,949

 
$
1,820

 
61.7
%
 
$
—

 
$
—

 
—
%
Impaired loans without specific reserves
19,940

 
—

 
—

 
24,160

 
—

 
—

Total impaired loans
$
22,889

 
$
1,820

 
8.0
%
 
$
24,160

 
$
—

 
—
%
The $1.3 million decrease in impaired loans to $22.9 million at June 30, 2014 from $24.2 million at December 31, 2013 was primarily attributable to the foreclosure and transfer to OREO on a $1.8 million nonaccrual loan. Accruing restructured loans were comprised of a number of loans performing in accordance with modified terms, which included lowering of interest rates, deferral of payments, or modifications to payment terms. Based on an internal analysis, using the current estimated fair values of the collateral or the discounted present values of the future estimated cash flows of the impaired loans, we concluded that, at June 30, 2014, $1.8 million of specific reserves were required on eight impaired loans and that all remaining impaired loans were well secured and adequately collateralized with no specific reserves required.
Allowance for Loan and Lease Losses. The ALLL totaled $12.6 million, representing 1.56% of loans outstanding, at June 30, 2014, as compared to $11.4 million, or 1.46% of loans outstanding, at December 31, 2013.
The adequacy of the ALLL is determined through periodic evaluations of the loan portfolio and other factors that can reasonably be expected to affect the ability of borrowers to meet their loan obligations. Those factors are inherently subjective as the process for determining the adequacy of the ALLL involves some significant estimates and assumptions about such matters such as (i) economic conditions and trends and the amounts and timing of expected future cash flows of borrowers which can affect their ability to meet their loan obligations to us, (ii) the fair value of the collateral securing non-performing loans, (iii) estimates of losses that we may incur on non-performing loans, which are determined on the basis of historical loss experience and industry loss factors and bank regulatory guidelines, which are subject to change, and (iv) various qualitative factors. Since those factors are subject to changes in economic and other conditions and changes in regulatory guidelines or other circumstances over which we have no control, the amount of the ALLL may prove to be insufficient to cover all of the loan losses we might incur in the future. In such an event, it may become necessary for us to increase the ALLL from time to time to maintain its adequacy. Such increases are effectuated by means of a charge to income, referred to as the “provision for loan and lease losses”, in our statements of our operations. See “—Results of Operations— Provision for Loan and Lease Losses, above in this Item 2.
The amount of the ALLL is first determined by assigning reserve ratios for all loans. All non-accrual loans and other loans classified as “Special Mention,” “Substandard” or “Doubtful” (“classified loans” or “classification categories”) and not fully collateralized are then assigned specific reserves within the ALLL, with greater reserve allocations made to loans deemed to be of a higher risk. These ratios are determined based on prior loss history and industry guidelines and loss factors, by type of loan, adjusted for current economic factors and current economic trends. Refer to Note 5, Loans and Allowance for Loan and Lease Losses for definitions related to our credit quality indicators stated above.
On a quarterly basis, we utilize a classification migration model and individual loan review analytical tools as starting points for determining the adequacy of the ALLL. Our loss migration analysis tracks a certain number of quarters of loan loss history and industry loss factors to determine historical losses by classification category for each loan type, except certain loans (automobile, mortgage and credit cards), which are analyzed as homogeneous loan pools. These calculated loss factors are then applied to outstanding loan balances. We also conduct individual loan review analysis, as part of the ALLL allocation process, applying specific monitoring policies and procedures in analyzing the existing loan portfolio.
In determining whether and the extent to which we will make adjustments to our loan loss migration model for purposes of determining the ALLL, we also consider a number of qualitative factors that can affect the performance and the collectability of the loans in our loan portfolio. Such qualitative factors include:
•
The effects of changes that we may make in our loan policies or underwriting standards on the quality of the loans and the risks in our loan portfolios;

43

•
Trends and changes in local, regional and national economic conditions, as well as changes in industry specific conditions, and any other reasonably foreseeable events that could affect the performance or the collectability of the loans in our loan portfolios;
•
Material changes that may occur in the mix or in the volume of the loans in our loan portfolios that could alter, whether positively or negatively, the risk profile of those portfolios;
•
Changes in management or loan personnel or other circumstances that could, either positively or negatively, impact the application of our loan underwriting standards, the monitoring of nonperforming loans or our loan collection efforts;
•
Changes in the concentration of risk in the loan portfolio; and
•
External factors that, in addition to economic conditions, can affect the ability of borrowers to meet their loan obligations, such as fires, earthquakes and terrorist attacks.
Determining the effects that these qualitative factors may have on the performance of each category of loans in our loan portfolio requires numerous judgments, assumptions and estimates about conditions, trends and events which may subsequently prove to have been incorrect due to circumstances outside of our control. Moreover, the effects of qualitative factors such as these on the performance of our loan portfolios are often difficult to quantify. As a result, we may sustain loan losses in any particular period that are sizable in relation to the ALLL or that may even exceed the ALLL.
In response to the economic recession, which resulted in increased and relatively persistent high rates of unemployment, and the credit crisis that has led to a severe tightening in the availability of credit, preventing borrowers from refinancing their loans, we (i) implemented more stringent loan underwriting standards, (ii) strengthened loan underwriting and approval processes, and (iii) added personnel with experience in addressing problem assets.
Set forth below is information regarding loan balances and the related ALLL, by portfolio type, for the six months ended June 30, 2014 and 2013 (excluding mortgage loans held for sale).
(Dollars in thousands)
Commercial
 
Real  Estate
 
Land
Development
 
Consumer and
Single Family
Mortgages
 
Total
ALLL for the six months ended June 30, 2014:
 
 
 
 
 
 
 
 
 
Balance at beginning of year
$
5,812

 
$
4,517

 
$
165

 
$
864

 
$
11,358

Charge offs
(276
)
 
—

 
—

 
(102
)
 
(378
)
Recoveries
452

 
19

 
—

 
79

 
550

Provision
489

 
861

 
(80
)
 
(220
)
 
1,050

Balance at end of year
$
6,477

 
$
5,397

 
$
85

 
$
621

 
$
12,580

Ratio of net charge-offs to average loans outstanding (annualized)
 
 
 
 
 
 
 
 
(0.04
)%
ALLL for the six months ended June 30, 2013:
 
 
 
 
 
 
 
 
 
Balance at beginning of year
$
6,340

 
$
3,487

 
$
248

 
$
806

 
$
10,881

Charge offs
(2,603
)
 
(308
)
 
(5
)
 
(2
)
 
(2,918
)
Recoveries
1,932

 
2

 
54

 
22

 
2,010

Provision
1,284

 
(327
)
 
—

 
193

 
1,150

Balance at end of year
$
6,953

 
$
2,854

 
$
297

 
$
1,019

 
$
11,123

Ratio of net charge-offs to average loans outstanding (annualized)
 
 
 
 
 
 
 
 
0.25
 %
The ALLL increased $1.2 million from December 31, 2013 to June 30, 2014 as a result of net loan growth of $29.8 million in the first half of 2014 and an increase in specific reserves of $1.8 million on our impaired loans. The decrease in the provision for loan and lease losses from June 30, 2013 to June 30, 2014 was primarily the result of net recoveries of $172 thousand for the six months ended June 30, 2014 compared to net charge-offs of $908 thousand during the six months ended June 30, 2013.
We classify our loan portfolios using internal credit quality ratings. The credit quality table in Note 5, Loans and Allowance for Loan and Lease Losses above in Item 1, provides a summary of loans by portfolio type and our internal credit quality ratings as of June 30, 2014 and December 31, 2013. Loans totaled approximately $806.6 million at June 30, 2014, an increase of $29.8 million from $776.8 million at December 31, 2013. The disaggregation of the loan portfolio by risk rating in the credit quality table located in Note 5 reflects the following changes that occurred between June 30, 2014 and December 31, 2013:

44

•
Loans rated "Pass" totaled $751.6 million, an increase of $25.9 million from $725.7 million at December 31, 2013. The increase was primarily attributable to new loan growth in commercial loans of $27.0 million and commercial real estate loans – owner occupied of $16.9 million, partially offset by the downgrade to "Special Mention" of $15.4 million in loans and "Substandard" of $3.6 million in loans.
•
Loans rated "Special Mention" totaled $15.4 million, an increase of $10.1 million from $5.2 million at December 31, 2013. The increase was primarily the result of $15.4 million downgraded from "Pass", which included a $12.9 million commercial loan relationship, partially offset by the downgrade to "Substandard" of a $5.1 million residential mortgage loan – multi family relationship in current status.
•
Loans rated "Substandard" totaled $39.7 million, a decrease of $6.1 million from $45.9 million at December 31, 2013. This decrease was primarily the result of principal payments of $12.1 million and the foreclosure and transfer to OREO of a $1.8 million commercial loan, partially offset by approximately $8.8 million in loans downgraded to "Substandard".
We use a rolling twelve quarter loss migration analysis to determine the loss factors we will apply to each of the above-described loan classification categories. We previously used an eight quarter loss migration analysis through December 2013.  The economic cycle has improved based on delinquency balances due to the drop in impaired loan balances over the past few years.  Management decided an eight quarter loss migration cycle may overweight the benefits of an improving economic cycle and revisited the general reserve factors as part of its normal review of the ALLL, resulting in an increased look-back period. As a result, for purposes of determining applicable loss factors at June 30, 2014, our migration analysis covered the period from June 30, 2011 to June 30, 2014. That migration analysis resulted in modest increases to the loss factors of our June 30, 2014 ALLL analysis, which we believe was consistent with and reasonably reflects current economic conditions and the risks that were inherent in our loan portfolio at June 30, 2014.
The table below sets forth loan delinquencies, by quarter, from June 30, 2014 to June 30, 2013.
 
June 30, 2014
 
March 31, 2014
 
December 31, 2013
 
September 30, 2013
 
June 30, 2013
Loans Delinquent:
(Dollars in thousands)
90 days or more:
 
 
 
 
 
 
 
 
 
Commercial loans
$
1,647

 
$
266

 
$
2,192

 
$
1,402

 
$
756

Commercial real estate
2,117

 
2,117

 
2,117

 
2,117

 
2,117

 
3,764

 
2,383

 
4,309

 
3,519

 
2,873

30-89 days:
 
 
 
 
 
 
 
 
 
Commercial loans
4,251

 
1,416

 
—

 
4,977

 
4,592

Commercial real estate
485

 
—

 
—

 
—

 
4,792

Residential mortgages
264

 
137

 
748

 
—

 
—

Land development loans
368

 
—

 
—

 
—

 
—

Consumer loans
—

 
—

 
450

 
—

 
—

 
5,368

 
1,553

 
1,198

 
4,977

 
9,384

Total Past Due(1):
$
9,132

 
$
3,936

 
$
5,507

 
$
8,496

 
$
12,257

 
(1)
Past due balances include nonaccrual loans.
As the above table indicates, total past due loans increased by $3.6 million, to $9.1 million at June 30, 2014 from $5.5 million at December 31, 2013. Loans past due 90 days or more decreased by $0.5 million, to $3.8 million at June 30, 2014, from $4.3 million at December 31, 2013.
Loans 30-89 days past due increased by $4.2 million to $5.4 million at June 30, 2014 from $1.2 million at December 31, 2013, primarily due to a matured commercial loan relationship of $3.1 million, which is well secured and due to be paid off.
Deposits
Average Balances of and Average Interest Rates Paid on Deposits
Set forth below are the average amounts of, and the average rates paid on, deposits for the six months ended June 30, 2014 and year ended December 31, 2013:

45

 
Six Months Ended June 30, 2014
 
Year Ended December 31, 2013
 
Average
Balance
 
Average
Rate
 
Average
Balance
 
Average
Rate
 
(Dollars in thousands)
Noninterest bearing demand deposits
$
188,862

 
—

 
$
188,696

 
—

Interest-bearing checking accounts
34,682

 
0.28
%
 
33,447

 
0.28
%
Money market and savings deposits
158,789

 
0.32
%
 
155,352

 
0.36
%
Time deposits(1)
439,855

 
0.97
%
 
354,720

 
1.06
%
Total deposits
$
822,188

 
0.59
%
 
$
732,215

 
0.60
%
 
 
(1)
Comprised of time certificates of deposit in denominations of less than and more than $100,000.
Deposit Totals
Deposits totaled $819.3 million at June 30, 2014 as compared to $780.2 million at December 31, 2013. The following table provides information regarding the mix of our deposits at June 30, 2014 and December 31, 2013:
 
At June 30, 2014
 
At December 31, 2013
 
Amounts
 
% of Total Deposits
 
Amounts
 
% of Total Deposits
 
(Dollars in thousands)
Core deposits
 
 
 
 
 
 
 
Noninterest bearing demand deposits
$
193,499

 
23.6
%
 
$
203,942

 
26.1
%
Savings and other interest-bearing transaction deposits
175,944

 
21.5
%
 
197,614

 
25.3
%
Time deposits
449,851

 
54.9
%
 
378,669

 
48.5
%
Total deposits
$
819,294

 
100.0
%
 
$
780,225

 
100.0
%
At June 30, 2014, noninterest-bearing deposits totaled $193.5 million, or 23.6% of total deposits, as compared to $203.9 million, or 26.1% of total deposits at December 31, 2013. Certificates of deposit in denominations of $100,000 or more, on which we pay higher rates of interest than on other deposits, aggregated $397.2 million, or 48.5%, of total deposits at June 30, 2014, as compared to $327.6 million, or 42.0%, of total deposits at December 31, 2013.
Set forth below is a maturity schedule of domestic time certificates of deposit outstanding at June 30, 2014 and December 31, 2013:
 
June 30, 2014
 
December 31, 2013
Maturities
Certificates of
Deposit Under
$ 100,000
 
Certificates of
Deposit $100,000
or more
 
Certificates of
Deposit Under
$100,000
 
Certificates of
Deposit $100,000
or more
 
(Dollars in thousands)
Three months or less
$
10,209

 
$
51,966

 
$
19,581

 
$
90,694

Over three and through six months
10,648

 
117,524

 
7,359

 
36,946

Over six and through twelve months
22,366

 
139,426

 
17,735

 
149,919

Over twelve months
9,429

 
88,283

 
6,354

 
50,081

Total
$
52,652

 
$
397,199

 
$
51,029

 
$
327,640



Liquidity
We actively manage our liquidity needs to ensure that sufficient funds are available to meet our needs for cash, including to fund new loans to and deposit withdrawals by our customers. We project the future sources and uses of funds and maintain liquid funds for unanticipated events. Our primary sources of cash include cash we have on deposit at other financial institutions, payments from borrowers on their loans, proceeds from sales or maturities of securities held for sale, sales of residential mortgage loans, increases in deposits and increases in borrowings principally from the FHLB. The primary uses of cash include funding new loans and making advances on existing lines of credit, purchasing investments, including securities available for sale, funding new residential mortgage loans, funding deposit withdrawals and paying operating expenses. We maintain funds in overnight federal funds and other short-term investments to provide for short-term liquidity needs. We also have obtained credit lines from

46

the FHLB and other financial institutions to meet any additional liquidity requirements we might have. See "—Contractual Obligations—Borrowings" below for additional information related to our borrowings from the FHLB.
Our liquid assets, which included cash and due from banks, federal funds sold, interest earning deposits that we maintain with financial institutions and unpledged securities available for sale (excluding FRBSF and FHLB stock) totaled $147.7 million, which represented 15% of total assets, at June 30, 2014. We believe that our cash and cash equivalent resources, together with available borrowings under our credit facilities, will be sufficient to meet normal operating requirements for at least the next twelve months, including to enable us to meet any increase in deposit withdrawals that might occur in the foreseeable future.
Cash Flow Provided by (Used in) Operating Activities. During the six months ended June 30, 2014, operating activities provided net cash of $10.1 million, comprised primarily of $9.2 million provided by our discontinued operations and our net income of $0.5 million. During the six months ended June 30, 2013, operating activities provided net cash of $33.5 million, comprised primarily of $45.1 million provided by our discontinued operations, partially offset by our net loss of $6.3 million.
Cash Flow (Used in) Provided by Investing Activities. During the six months ended June 30, 2014, investing activities used net cash of $29.2 million, primarily attributable to $35.0 million used to fund an increase in loans, partially offset by $4.9 million and $0.5 million of cash from maturities of and principal payments on securities available for sale and FRBSF and FHLB stock, respectively, and $1.1 million of proceeds from sales of OREO. During the six months ended June 30, 2013, investing activities provided net cash of $19.1 million, primarily comprised of $6.2 million from sales of securities available for sale, $14.4 million of cash from maturities and principal payments on securities available for sale, partially offset by $1.1 million used to fund an increase in loans.
Cash Flow Used in Financing Activities. During the six months ended June 30, 2014, financing activities provided net cash of $16.9 million, consisting primarily of a $49.5 million net increase in interest bearing deposits, which resulted primarily from a decision to increase the rates of interest we pay on our certificates of deposit in order to decrease our loan-to-deposit ratio and increase our liquidity, partially offset by a $22.5 million decrease in borrowings, and a decrease in noninterest bearing deposits of $10.4 million. During the six months ended June 30, 2013, financing activities used net cash of $91.4 million, consisting primarily of a $96.4 million net decrease in deposits as a result of a decision to decrease the rates paid on certificates of deposit in order to decrease our cost of funds, and a $10.0 million decrease in borrowings, partially offset by net proceeds of $15.0 million from a private placement of shares of our common stock in March 2013.
Ratio of Loans to Deposits. The relationship between gross loans and total deposits can provide a useful measure of a bank’s liquidity. Since repayment of loans tends to be less predictable than the maturity of investments and other liquid resources, the higher the loan-to-deposit ratio the less liquid are our assets. On the other hand, since we realize greater yields on loans than we do on investments, a lower loan-to-deposit ratio can adversely affect interest income and earnings. As a result, our goal is to achieve a loan-to-deposit ratio that appropriately balances the requirements of liquidity and the need to generate a fair return on our assets. At June 30, 2014 and December 31, 2013, the loan-to-deposit ratio was 98% and 100%, respectively.
Capital Resources
Regulatory Capital Requirements Applicable to Banking Institutions
Under federal banking regulations that apply to all United States based bank holding companies and federally insured banks, the Company (on a consolidated basis) and the Bank (on a stand-alone basis) must meet specific capital adequacy requirements that, for the most part, involve quantitative measures, primarily in terms of the ratios of their capital to their assets, liabilities, and certain off-balance sheet items, calculated under regulatory accounting practices. Under those regulations, each bank holding company must meet a minimum capital ratio and each federally insured bank is determined by its primary federal bank regulatory agency to come within one of the following capital adequacy categories on the basis of its capital ratios:
•
well capitalized
•
adequately capitalized
•
undercapitalized
•
significantly undercapitalized; or
•
critically undercapitalized
Certain qualitative assessments also are made by a banking institution’s primary federal regulatory agency that could lead the agency to determine that the banking institution should be assigned to a lower capital category than the one indicated by the quantitative measures used to assess the institution’s capital adequacy. At each successive lower capital category, a banking institution is subject to greater operating restrictions and increased regulatory supervision by its federal bank regulatory agency.
The following table sets forth the capital and capital ratios of the Company (on a consolidated basis) and the Bank (on a stand-alone basis) at June 30, 2014, as compared to the respective regulatory requirements applicable to them.

47

 
 
 
 
 
 
Applicable Federal Regulatory Requirement
 
 
 
For Capital
Adequacy Purposes
 
To be Categorized As
Well Capital
 
Amount
 
Ratio
 
Amount
 
Ratio
 
Amount
 
Ratio
 
(Dollars in thousands)
Total Capital to Risk Weighted Assets:
 
 
 
 
 
 
 
 
 
 
 
Company
$
139,842

 
17.1
%
 
$
65,579

 
At least 8.0
 
N/A

 
N/A
Bank
119,796

 
14.9
%
 
64,529

 
At least 8.0
 
$
80,661

 
At least 10.0
Tier 1 Capital to Risk Weighted Assets:
 
 
 
 
 
 
 
 
 
 
 
Company
$
129,559

 
15.8
%
 
$
32,789

 
At least 4.0
 
N/A

 
N/A
Bank
109,675

 
13.6
%
 
32,264

 
At least 4.0
 
$
48,397

 
At least 6.0
Tier 1 Capital to Average Assets:
 
 
 
 
 
 
 
 
 
 
 
Company
$
129,559

 
12.6
%
 
$
41,062

 
At least 4.0
 
N/A

 
N/A
Bank
109,675

 
10.8
%
 
40,661

 
At least 4.0
 
$
50,826

 
At least 5.0
At June 30, 2014 the Bank (on a stand-alone basis) continued to qualify as a well-capitalized institution, and the Company continued to exceed the minimum required capital ratios applicable to it, under the capital adequacy guidelines described above.
The consolidated total capital and Tier 1 capital of the Company at June 30, 2014 includes an aggregate of $17.0 million principal amount of the $17.5 million of junior subordinated debentures that we issued in 2002 and 2004. See “—Contractual Obligations—Junior Subordinated Debentures” below for additional information. We contributed the net proceeds from the sales of the junior subordinated debentures to the Bank over the nine year period ended June 30, 2014, thereby providing it with additional cash to fund the growth of its banking operations and, at the same time, to increase its total capital and Tier 1 capital.
Capital and Other Requirements under FRBSF Agreement and CDBO Order
On August 31, 2010, the Company and the Bank entered into the FRBSF Agreement with FRBSF. On the same date, the Bank consented to the issuance of a regulatory order by the CDBO (the “CDBO Order”).
On October 31, 2013, the CDBO terminated the CDBO Order after concluding that the Bank had substantially complied with its terms.
The principal purposes of the FRBSF Agreement, which constitutes formal supervisory action by the FRBSF, were to require us to adopt and implement formal plans and take certain actions, as well as to continue to implement other measures that we previously adopted, to address the adverse consequences that the economic recession has had on the performance of our loan portfolio and our operating results, to improve our operating results, and to increase our capital to strengthen our ability to weather any further adverse economic conditions that might arise in the future.
The FRBSF Agreement requires the Boards of Directors of the Company and the Bank to prepare and submit written plans to the FRBSF to address the following matters: (i) strengthening board oversight of the management operations of the Bank; (ii) strengthening credit risk management practices; (iii) improving credit administration policies and procedures; (iv) improving the Bank’s position with respect to problem assets; (v) maintaining adequate reserves for loan losses in accordance with applicable supervisory guidelines; (vi) improving the capital position of the Bank and of the Company; (vii) improving the Bank’s earnings through the formulation, adoption and implementation of a new strategic plan, and (viii) submitting a satisfactory funding contingency plan for the Bank that would identify available sources of liquidity and a plan for dealing with adverse economic and market conditions. The Company may not declare or pay cash dividends, repurchase any of its shares, make payments on its trust preferred securities or incur or guarantee any debt, without the prior approval of the FRBSF. As a result of these prohibitions, the Company has not made interest payments on the junior subordinated debentures issued in 2002 and 2004. See “—Contractual Obligations—Junior Subordinated Debentures” below for additional information.
The Company and the Bank have made substantial progress with respect to several of the requirements imposed by the FRBSF Agreement, including a requirement, achieved in August 2011, that the Bank raise additional capital to increase its ratio of adjusted tangible shareholders’ equity-to-tangible assets to 9.00%. The Company is committed to achieving all of the requirements on a timely basis. Formal termination of the FRBSF Agreement requires an express determination by the FRBSF to the effect that substantial compliance with all of the provisions have been achieved. A failure by the Company or the Bank to meet any of those remaining requirements could be deemed by the FRBSF to be conducting business in an unsafe manner which could subject the Company or the Bank to further regulatory enforcement action. See “Risks and uncertainties posed by the FRBSF Agreement to which we and the Bank are subject” under Item 1A “Risk Factors” in Part I of our 2013 Form 10-K.

48

Dividend Policy and Share Repurchase Programs.
It is, and since the beginning of 2009 it has been, the policy of the Boards of Directors of the Company and the Bank to preserve cash to enhance our capital positions and the Bank's liquidity. Moreover, since mid-2009, bank regulatory restrictions, including those under the FRBSF Agreement, have precluded the Company and the Bank from paying cash dividends, and we have been precluded from repurchasing our shares, without the prior approval of the FRBSF. Accordingly, we do not expect to pay dividends or make share repurchases for the foreseeable future.
The principal source of cash available to a bank holding company consists of cash dividends from its bank subsidiaries. There are currently several restrictions on the Bank’s ability to pay us cash dividends in addition to the FRBSF Agreement discussed above. Government regulations, including the laws of the State of California, as they pertain to the payment of cash dividends by California state chartered banks, also limit the amount of funds that the Bank is permitted to dividend to us. Further, Section 23(a) of the Federal Reserve Act limits the amounts that a bank may loan to its bank holding company to an aggregate of no more than 10% of the bank subsidiary’s capital surplus and retained earnings and requires that such loans be secured by specified assets of the bank holding company. See Note 15, Shareholders’ Equity in the notes to our consolidated financial statements in Part II of our 2013 Form 10-K for more detail regarding the restrictions on dividends and inter-company transactions. While restrictions on the payment of dividends from the Bank to us exist, there are no restrictions on the dividends that may be paid to us by PM Asset Resolution, Inc. (“PMAR”), a wholly owned subsidiary we organized during the first quarter of 2013 for the purpose of purchasing certain non-performing loans and other real estate from the Bank and thereafter collecting or disposing of those assets. PMAR has approximately $16.2 million in assets which are in the process of being liquidated and could provide us with additional cash if required. In addition, we currently have sufficient cash on hand to meet our cash obligations. As a result, we do not expect that these restrictions will impact our ability to meet our cash obligations.

Off Balance Sheet Arrangements
Loan Commitments and Standby Letters of Credit. To meet the financing needs of our customers in the normal course of business, we are a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. At June 30, 2014 and December 31, 2013, we were committed to fund certain loans including letters of credit amounting to approximately $130 million and $138 million, respectively.
Commitments to extend credit and standby letters of credit generally have fixed expiration dates or other termination clauses and the customer may be required to pay a fee and meet other conditions in order to draw on those commitments or standby letters of credit. We expect, based on historical experience, that many of the commitments will expire without being drawn upon and, therefore, the total commitment amounts do not necessarily represent future cash requirements.
To varying degrees, commitments to extend credit involve elements of credit and interest rate risk for us that are in excess of the amounts recognized in our balance sheets. Our maximum exposure to credit loss in the event of nonperformance by the customers to whom such commitments are made could potentially be equal to the amount of those commitments. As a result, before making such a commitment to a customer, we evaluate the customer’s creditworthiness using the same underwriting standards that we would apply if we were approving loans to the customer. In addition, we often require the customer to secure its payment obligations for amounts drawn on such commitments with collateral such as accounts receivable, inventory, property, plant and equipment, income-producing commercial properties, residential properties and properties under construction. As a consequence, our exposure to credit and interest rate risk on such commitments is not different in character or amount than risks inherent in the outstanding loans in our loan portfolio.
Standby letters of credit are conditional commitments issued by the Bank to guarantee a payment obligation of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers.
Contractual Obligations
Borrowings. As of June 30, 2014, we had $17.5 million of outstanding short-term borrowings and $30.0 million of outstanding long-term borrowings that we had obtained from the FHLB. The table below sets forth the amounts of, the interest rates we pay on and the maturity dates of these FHLB borrowings. These borrowings had a weighted-average annualized interest rate of 0.70% for the year ended June 30, 2014.

49

Principal
Amounts
 
Interest
Rate
 
Maturity Dates
 
Principal
Amounts
 
Interest
Rate
 
Maturity Dates
(Dollars in thousands)
$
3,000

 
0.64
%
 
September 26, 2014
 
$
5,000

 
0.61
%
 
September 18, 2015
5,000

 
0.35
%
 
October 9, 2014
 
5,000

 
0.57
%
 
September 30, 2015
4,500

 
0.78
%
 
March 26, 2015
 
5,000

 
1.08
%
 
September 19, 2016
5,000

 
0.76
%
 
March 30, 2015
 
5,000

 
0.96
%
 
September 30, 2016
10,000

 
0.61
%
 
August 31, 2015
 
 
 
 
 
 
At June 30, 2014, $441.9 million of residential mortgage and other real estate secured loans were pledged to secure these FHLB borrowings.
The highest amount of borrowings outstanding at any month-end during the six months ended June 30, 2014 was $70 million, which consisted of borrowings from the FHLB. By comparison, the highest amount of borrowings outstanding at any month end in 2013 consisted of $85 million of borrowings from the FHLB.
Junior Subordinated Debentures. Pursuant to rulings of the Federal Reserve Board, bank holding companies were permitted to issue long term subordinated debt instruments that, subject to certain conditions, would qualify as and, therefore, augment capital for regulatory purposes. At June 30, 2014, we had outstanding approximately $17.5 million principal amount of 30-year junior subordinated floating rate debentures (the “Debentures”), of which $17.0 million qualified as Tier 1 capital for regulatory purposes as of June 30, 2014.
Set forth below is certain information regarding the Debentures:
Original Issue Dates
Principal Amount
 
Interest Rates
 
Maturity Dates
September 2002
$
7,217

 
LIBOR plus 3.40%
 
September 2032
October 2004
10,310

 
LIBOR plus 2.00%
 
October 2034
Total
$
17,527

 
 
 
 
 
 
(1)
Subject to the receipt of prior regulatory approval, we may redeem the Debentures, in whole or in part, without premium or penalty, at any time prior to maturity.
As previously reported, since July 2009 we have been required to obtain the prior approval of the FRBSF to make interest payments on the Debentures. During the years ended June 30, 2014 and 2013, we were unable to obtain regulatory approvals to pay, and it became necessary for us to defer, quarterly interest payments on the Debentures. We cannot predict when the FRBSF will approve our resumption of such interest payments and until such approval can be obtained it will be necessary for us to continue deferring interest payments on the Debentures. Since we have the right, under the terms of the Debentures, to defer interest payments for up to twenty (20) consecutive quarters, the deferrals of interest payments to date have not constituted, and any future deferrals of interest payments through January 2015 will not constitute, a default under or with respect to the Debentures. However, if by that date we have not been able to obtain regulatory approval to pay all of the deferred interest payments, we would then be in default under the Debentures, in which case the entire $17.5 million principal amount of, and accrued but unpaid interest on, the Debentures could be declared immediately due and payable. For additional information regarding the restrictions on the payment by us of interest on the Debentures, as well as other regulatory restrictions that apply to us and the Bank under a regulatory agreement entered into with the FRBSF, see “Capital Resources” above in this section of this Report and “Supervision and Regulation” in Item 1 and “Risk Factors” in Item 1A in Part I of our 2013 Form 10-K.

Critical Accounting Policies
Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) and general practices in the banking industry. Certain of those accounting policies are considered critical accounting policies, because they require us to make assumptions and judgments regarding circumstances or trends that could affect the carrying value of our material assets, such as, for example, assumptions regarding economic conditions or trends that could impact our ability to fully collect our loans or ultimately realize the carrying value of certain of our other assets, such as securities available for sale and our deferred tax asset. Those assumptions and judgments are based on current information available to us regarding those economic conditions or trends or other circumstances. If adverse changes were to occur in the conditions, trends or other events on which our assumptions or judgments had been based, then under GAAP it could become necessary for us to reduce the carrying values of any affected assets on our balance sheet. In addition, because reductions in the carrying value of assets are sometimes effectuated by or require charges to income, such reductions also may have the effect of reducing our income.

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There have been no significant changes during the six months ended June 30, 2014 to the items that we disclosed as our critical accounting policies and estimates in Critical Accounting Policies within Management's Discussion and Analysis of Financial Condition and Results of Operations included in our 2013 Form 10-K.

ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As a smaller reporting company as defined in Item 10 of Regulation S-K, we are not required to provide the information required by this item.

ITEM 4.     CONTROLS AND PROCEDURES

Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, our management recognized that any system of controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, as ours are designed to do, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As required by SEC rules, an evaluation was performed under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer of the effectiveness, as of June 30, 2014, of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act). Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of June 30, 2014, the Company’s disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed in the reports that we file under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.
Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting during the three months ended June 30, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS
We are subject to legal actions that arise from time to time in the ordinary course of our business. Currently, neither we nor any of our subsidiaries is a party to, and none of our or our subsidiaries' property is the subject of, any material legal proceeding.

ITEM 1A. RISK FACTORS
There have been no material changes in our assessment of our risk factors from those set forth in our 2013 Form 10-K.

ITEM 5. OTHER INFORMATION
On August 8, 2014, Andrew M. Phillips resigned from both the Company and Bank Boards of Directors.

ITEM 6. EXHIBITS
(a) Exhibits
The Index to Exhibits attached hereto is incorporated by reference.

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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on August 8, 2014.
 
PACIFIC MERCANTILE BANCORP
 
 
By:
 
/S/   STEVEN K. BUSTER   
 
 
Steven K. Buster
 
 
President and Chief Executive Officer
PACIFIC MERCANTILE BANCORP
 
 
By:
 
/S/   CURT A. CHRISTIANSSEN
 
 
Curt A. Christianssen
 
 
Interim Chief Financial Officer


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EXHIBIT INDEX
Exhibit No.
 
Description of Exhibit
 
 
 
 
3.1
 
Articles of Incorporation of Pacific Mercantile Bancorp (Incorporated by reference to the same numbered exhibit to the Company's Registration Statement (No. 333-33452) on Form S-1 filed with the Commission on June 14, 2000.)
 
 
 
3.2
 
Certificate of Amendment of Articles of Incorporation of Pacific Mercantile Bancorp (Incorporated by reference to Exhibit 3.1 to the Quarterly Report on Form 10-Q dated August 14, 2001.)
 
 
 
3.3
 
Certificate of Amendment of Articles of Incorporation of Pacific Mercantile Bancorp (Incorporated by reference to Exhibit 3.1 to the Current Report on Form 8-K dated January 26, 2012 and filed with the Commission on February 1, 2012.)
 
 
 
3.4
 
Certificate of Determination of Rights, Preferences, Privileges and Restrictions of Series A Convertible 10% Cumulative Preferred Stock of Pacific Mercantile Bancorp. (Incorporated by reference to Exhibit 3.1 to the Current Report on Form 8-K (No. 000-30777) dated October 6, 2010.)
 
 
 
3.5
 
Certificate of Amendment of Certificate of Determination of Rights, Preferences, Privileges and Restrictions of the Series A Convertible 10% Cumulative Preferred Stock of Pacific Mercantile Bancorp. (Incorporated by reference to Exhibit 3.2 to the Current Report on Form 8-K dated January 26, 2012 and filed with the Commission on February 1, 2012.)
 
 
 
3.6
 
Certificate of Determination of Rights, Preferences, Privileges and Restrictions of the Series B Convertible 8.4% Noncumulative Preferred Stock of Pacific Mercantile Bancorp. (Incorporated by reference to Exhibit 3.1 to the Current Report on Form 8-K (No. 000-30777) dated August 22, 2011.)
 
 
 
3.7
 
Certificate of Determination of Rights, Preferences, Privileges and Restrictions of the Series C 8.4% Noncumulative Preferred Stock of Pacific Mercantile Bancorp. (Incorporated by reference to Exhibit 3.2 to the Current Report on Form 8-K (No. 000-30777) dated August 22, 2011.)
 
 
 
3.8
 
Pacific Mercantile Bancorp Bylaws, Amended and Restated as of December 17, 2007. (Incorporated by reference to the same numbered exhibit to the Company's Current Report on Form 8-K (No. 000-30777) dated December 18, 2007.)
 
 
 
31.1
 
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
31.2
 
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
 
32.1
 
Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
32.2
 
Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
Exhibit 101.INS
 
XBRL Instance Document
 
 
Exhibit 101.SCH
 
XBRL Taxonomy Extension Schema Document
 
 
Exhibit 101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
Exhibit 101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document
 
 
Exhibit 101.LAB
 
XBRL Taxonomy Extension Labels Linkbase Document
 
 
Exhibit 101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document



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