ITEM 1. BUSINESS
Forward-Looking Statements
In addition to historical information, this discussion and analysis includes certain forward-looking statements that are subject to risks and uncertainties and include information about possible or assumed future results of operations. Many possible events or factors could affect the future financial results and performance of the Company. This could cause results or performance to differ materially from those expressed in our forward-looking statements. Words such as “expects”, “anticipates”, “believes”, “estimates”, “intends”, “plans”, “assumes”, “projects”, “predicts”, “forecasts”, variations of such words and other similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in, or implied by, such forward-looking statements.
Readers of the Company’s Annual Report and Form 10-K should not rely solely on forward looking statements and should consider all uncertainties and risks discussed under "ITEM 7 - -MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS-Critical Accounting Policies and Estimates” and “-Risk Factors” on pages 40 through 41, and pages 53 through 55, respectively, of the Company's 2005 Annual Report to Shareholders, as well as elsewhere throughout this report. These statements are representative only on the date hereof, and the Company undertakes no obligation to update any forward-looking statements made. Some possible events or factors that could occur that may cause differences from expected results include the following: the Company’s loan growth is dependent on economic conditions, as well as various discretionary factors, such as decisions to sell, or purchase certain loans or loan portfolios; or sell or buy participations of loans; the quality and adequacy of management of the borrower, developments in the industry the borrower is involved in, product and geographic concentrations and the mix of the loan portfolio. The rate of charge-offs and provision expense can be affected by local, regional and international economic and market conditions, concentrations of borrowers, industries, products and geographical conditions, the mix of the loan portfolio and management’s judgements regarding the collectibility of loans. Liquidity requirements may change as a result of fluctuations in assets and liabilities and off-balance sheet exposures, which will impact the capital and debt financing needs of the Company and the mix of funding sources. Decisions to purchase, hold, or sell securities are also dependent on liquidity requirements and market volatility, as well as on and off-balance sheet positions. Factors that may impact interest rate risk include local, regional and international economic conditions, levels, mix, maturities, yields or rates of assets and liabilities and the wholesale and retail funding sources of the Company. The Company is also exposed to the potential of losses arising from adverse changes in market rates and prices which can adversely impact the value of financial products, including securities, loans, and deposits. In addition, the banking industry in general is subject to various monetary and fiscal policies and regulations, which include those determined by the Federal Reserve Board, the Federal Deposit Insurance Corporation and state regulators, whose policies and regulations could affect the Company’s results.
Other factors that may cause actual results to differ from the forward-looking statements include the following: competition with other local and regional banks, savings and loan associations, credit unions and other non-bank financial institutions, such as investment banking firms, investment advisory firms, brokerage firms, mutual funds and insurance companies, as well as other entities which offer financial services; interest rate, market and monetary fluctuations; inflation; market volatility; general economic conditions; introduction and acceptance of new banking-related products, services and enhancements; fee pricing strategies, mergers and acquisitions and their integration into the Company; civil disturbances or terrorist threats or acts, or apprehension about the possible future occurrences or acts of this type; outbreak or escalation of hostilities in which the United States is involved, any declaration of war by the U.S. Congress or any other national or international calamity, crisis or emergency; changes in laws and regulations; recently issued accounting pronouncements; government policies, regulations, and their enforcement (including Bank Secrecy Act-related matters, taxing statutes and regulations); restrictions on dividends that our subsidiaries are allowed to pay to us; the ability to satisfy requirements related to the Sarbanes-Oxley Act and other regulation on internal control; and management’s ability to manage these and other risks.
General Development of the Company
General
Capital Corp of the West (the “Company”) is a bank holding company incorporated under the laws of the State of California on April 26, 1995. On November 1, 1995, the Company became registered as a bank holding company and is the holder of all of the capital stock of County Bank (the “Bank”). The Company's primary asset is the Bank and the Bank is the Company's primary source of income. As of February 1, 2006, the Company had outstanding 10,575,361 shares of Common Stock, no par value, held by approximately 2,700 shareholders. There were no preferred shares outstanding at February 1, 2006. The Company has one wholly-owned inactive nonbank subsidiary, Capital West Group (“CWG”) at December 31, 2005. The Bank has three wholly-owned subsidiaries, Merced Area Investment & Development, Inc. (“MAID”), County Asset Advisors (“CAA”) and County Investment Trust (“REIT”). CAA is currently inactive. All references herein to the Company includes direct subsidiaries of the Company as well as the Bank and the Bank's subsidiaries, unless the context otherwise requires.
Information about Commercial Banking & General Business of the Company and its Subsidiaries
The Bank was organized on August 1, 1977, as County Bank of Merced, a California state banking corporation. The Bank commenced operations in 1977. In November 1992, the Bank changed its legal name to County Bank. The Bank's deposits are insured by the Federal Deposit Insurance Corporation ("FDIC"), up to applicable limits. The Bank is a member of the Federal Reserve System.
Industry & Market Area
The Bank engages in general commercial banking business primarily in Fresno, Madera, Mariposa, Merced, Sacramento, San Francisco, San Joaquin, Stanislaus, and Tuolomne counties. The Bank has twenty-two full service branch offices; two of which are located in Merced with the branch located in downtown Merced currently serving as both a branch and as administrative headquarters. There are offices in Atwater, Hilmar, Los Banos, Sacramento, Sonora, Stockton, two offices in Modesto and two offices in Turlock. In 1997, the Bank also opened an office in Madera and purchased three branch offices from Bank of America in Livingston, Dos Palos and Mariposa. During 1999, the Bank opened its first office in Fresno, and in 2000 expanded its presence in Fresno by adding an additional office. On January 18, 2001 the Bank opened a loan production office in San Francisco that during 2001 was converted into a full service branch. During 2003 and 2004, the Bank added one full service branch facility in Fresno each year. During 2005 the Bank opened a loan production office in Sacramento which was converted into a full service branch and opened a full service branch in Clovis. The Bank’s administrative headquarters also provides accommodations for the activities of MAID, the Bank's wholly-owned real estate subsidiary.
(See "ITEM 2. PROPERTIES")
Competition
The Company's primary market area consists of Fresno, Madera, Mariposa, Merced, Sacramento, San Francisco, San Joaquin, Stanislaus, and Tuolumne counties and nearby communities. The banking business in California generally, and specifically in the Company's primary market area, is highly competitive with respect to both loans and deposits. The banking business is dominated by a relatively small number of major banks which have many offices operating over wide geographic areas. Many of the major commercial banks offer certain services (such as international, trust and securities brokerage services) which are not offered directly by the Company or through its correspondent banks. By virtue of their greater total capitalization, such banks have substantially higher lending limits than the Company and substantial advertising and promotional budgets.
Smaller independent financial institutions, savings and loans and credit unions also serve as competition in our service area. In the past, the Bank's principal competi-tors for deposits and loans have been other banks (particu-larly major banks), savings and loan associations and credit unions. To a lesser extent, competition was also provided by thrift and loans, mortgage brokerage companies and insurance companies. Other institutions, such as brokerage houses, credit card companies, and even retail establishments offer investment vehicles, such as money-market funds, which also compete with banks. The direction of federal legislation in recent years seems to favor competition between different types of financial institu-tions and to foster new entrants into the financial services market, and it is anticipated that this trend will continue.
To compete effectively in our service area, the Bank relies upon specialized services, responsive handling of customer needs, local promotional activity, and personal contacts by its officers, directors and staff. For customers whose loan demands exceed the Bank's lending limits, the Bank seeks to arrange funding for such loans on a par-tici-pation basis with its correspondent banks or other independent commercial banks. The Bank also assists customers requiring services not offered by the Bank to obtain such services from its correspondent banks.
See also the discussion under “Regulation and Supervision - Financial Services Modernization Legislation.”
Bank's Services and Markets
Bank
The Bank conducts a general commercial banking business including the acceptance of demand (includes interest bearing), savings and time deposits. The Bank also offers commercial, agriculture, real estate, personal, home improvement, home mortgage, automobile, credit card and other installment and term loans. The Bank offers travelers' checks, safe deposit boxes, banking-by-mail, drive-up facilities, 24-hour automated teller machines, trust services, and other customary banking services to its customers.
The five general areas in which the Bank has directed its lendable assets are (i) real estate mortgage loans, (ii) commercial loans, (iii) agricultural loans, (iv) real estate construction loans, and (v) consumer loans. As of December 31, 2005, these five categories accounted for approximately 44%, 25%, 7%, 16% and 8%, respectively, of the Bank's loan portfolio.
In 1994, the Bank organized a department to originate loans within the underwriting standards of the Small Business Administration ("SBA"). The Bank originates, packages and subsequently sells these loans in the secondary market and retains servicing rights on these loans.
The Bank's deposits are attracted primarily from individuals and small and medium-sized business-related sources. The Bank also attracts some deposits from municipalities and other governmental agencies and entities. In connection with the deposits of municipalities or other governmental agencies, the Bank is generally required to pledge securities to secure such deposits, except when the depositor signs a waiver with respect to the first $100,000 of such deposits, which amount is insured by the FDIC.
The principal sources of the Bank's revenues are (i) interest and fees on loans, (ii) interest on investment securities (principally U.S. government agency securities, mortgage-backed securities, collateralized mortgage obligations, municipal and corporate bonds), and (iii) service charges on deposit accounts and other noninterest income. For the year ended December 31, 2005, these sources comprised approximately 72%, 18%, and 10% respectively, of the Bank's total interest and noninterest income.
Most of the Bank's business originates from individuals, businesses and professional firms located in its service area. The Bank is not dependent upon a single customer or group of related customers for a material portion of its deposits, nor is a material portion of the Bank's loans concentrated within a single industry or group of related industries. The quality of Bank assets and Bank earnings could be adversely affected by a downturn in the local economy, including the agricultural sector.
Bank's Real Estate Subsidiary (MAID)
California state-chartered banks previously were allowed, under state law, to engage in real estate development activities either directly or through investment in a wholly-owned subsidiary. Pursuant to this authorization, the Bank established MAID, its wholly-owned subsidiary, as a California corporation on February 18, 1987. MAID engaged in real estate development activities for approximately seven years.
Federal law now precludes banks from engaging in real estate development. At December 31, 2005, MAID held no real estate investments for sale. The last remaining real estate parcel held by MAID was sold during 2000. MAID does not currently intend to purchase or develop any new investment properties for sale or lease. During 2005, MAID owned, operated, and maintained the County Bank Merced downtown branch and County Bank administration building. MAID may only serve as owner for additional branch premise properties in the future. The state regulatory charter for MAID was changed in 2001 to only allow MAID to invest in additional branch premises property.
County Investment Trust (REIT)
The County Investment Trust is a real estate investment trust that invests in loan participations serviced by the Bank. The REIT provides the Bank with another vehicle in which business may be conducted and equity capital could be raised. While the Bank owns 100% of the common equity of the REIT, approximately 120 officers and employees of the Bank own a minority interest in the REIT in the aggregate amount of $31,000.
Employees
As of December 31, 2005, the Company employed a total of 370 full-time equivalent employees. The Company believes that employee relations are excellent.
Seasonal Trends in the Company's Business
Although the Company does experience some immaterial seasonal trends in deposit growth and funding of its agricultural and construction loan portfolios, in general the Company's business is not seasonal.
Operations in Foreign Countries
The Company conducts no operations in any foreign country.
Other Financial Information:
Recently Issued Accounting Standards
In December 2004, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 123 (Revised 2004), Share-Based Payment. The statement requires that compensation cost relating to share-based payment transactions be recognized in financial statements and that this cost be measured based on the fair value of the equity or liability instruments issued. SFAS No. 123 (Revised 2004) covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. The Company adopted SFAS No 123 (Revised 2004) on January 1, 2006 which becomes effective for accounting periods beginning January 1, 2006. The Company is currently evaluating the impact the adoption of the standard will have on the Company's results of operations. The impact on prior years is discussed in Note 1 under the section titled “Stock Option Plan”.
In May 2005, the FASB issued SFAS No. 154 Accounting Changes and Error Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3. The Statement requires retrospective application to prior periods’ financial statements of voluntary changes in accounting principle, unless it is impracticable to determine either the period - specific effects of the cumulative effect of the change. When it is impracticable to determine the period - specific effects of an accounting change on one or more individual prior periods presented, the new accounting principle is to be applied to the balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable, with a corresponding adjustment made to the opening balance of retained earnings or other components of equity for that period. If it is impracticable to determine the cumulative effect of applying a change in accounting principle, the new accounting principle is to be applied prospectively from the earliest date practicable. If retrospective application for all periods is impracticable, the method used to report the change and the reason that retrospective application is impracticable are to be disclosed. The Company adopted SFAS No. 154 on December 15, 2005. The Company does not expect the adoption of SFAS No. 154 to have a significant effect on the Company’s Consolidated Financial Statements.
REGULATION AND SUPERVISION
REGULATORY ENVIRONMENT
The banking and financial services industry is heavily regulated. Regulations, statutes and policies affecting the industry are frequently under review by Congress and state legislatures, and by the federal and state agencies charged with supervisory and examination authority over banking institutions. Changes in the banking and financial services industry can be expected to occur in the future. These changes may create new competitors in geographic and product markets which have historically been limited by law to bank institutions, such as the Bank. Changes in the regulation, statutes or policies that impact the Company and the Bank cannot necessarily be predicted and may have a material effect on their business and earnings.
The operations of bank holding companies and their subsidiaries are affected by the regulatory oversight and the credit and monetary policies of the Federal Reserve Board (FRB). An important function of the FRB is to regulate the national supply of bank credit. Among the instruments of monetary policy used by the FRB to implement its objectives are open market operations in U.S. government securities, changes in the discount rate on bank borrowings and changes in reserve requirements on bank deposits. These instruments of monetary policy are used in varying combinations to influence the overall level of bank loans, investments and deposits, the interest rates charged on loans and paid for deposits, the price of the dollar in foreign exchange markets, and the level of inflation. The credit and monetary policies of the FRB will continue to have a significant effect on the Bank and on the Company.
Set forth below is a summary of significant statutes, regulations and policies that apply to the operation of banking institutions. This summary is qualified in its entirety by reference to the full text of such statutes, regulations and policies.
BANK HOLDING COMPANY ACT
The Company is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (“BHCA”). As a bank holding company, Capital Corp is subject to examination by the FRB. Pursuant to the BHCA, Capital Corp is also subject to limitations on the kinds of businesses in which it can engage directly or through subsidiaries. It may, of course, manage or control banks. Generally, however, it is prohibited, with certain exceptions, from acquiring direct or indirect ownership or control of more than five percent of any class of voting shares of an entity engaged in nonbanking activities, unless the FRB finds such activities to be "so closely related to banking" as to be deemed "a proper incident thereto" within the meaning of the BHCA. As a bank holding company, the Company may not acquire more than five percent of the voting shares of any domestic bank without the prior approval of (or, for “well managed” companies, prior written notice to) the FRB.
The BHCA includes minimum capital requirements for bank holding companies. See section titled “Regulation and Supervision - Regulatory Capital Requirements”. Regulations and policies of the FRB also require a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. It is the FRB's policy that a bank holding company should stand ready to use available resources to provide adequate capital funds to a subsidiary bank during periods of financial stress or adversity and that it should maintain the financial flexibility and capital-raising capacity needed to obtain additional resources for assisting the subsidiary bank. Under certain conditions, the FRB may conclude that certain actions of a bank holding company, such as the payment of a cash dividend, would constitute an unsafe and unsound banking practice.
COUNTY BANK
County Bank is a California state-licensed bank. The Bank is a member of the Federal Reserve System. The Bank’s deposits are insured by the Federal Deposit Insurance Corporation (FDIC) and thus is subject to the rules and regulations of the FDIC pertaining to deposit insurance, including deposit insurance assessments. The Bank is subject to regulation and supervision by the FRB and the California Department of Financial Institutions (the "Department" or “DFI”). Applicable federal and state regulations address many aspects of the Bank's business and activities, including investments, loans, borrowings, transactions with affiliates, branching, reporting and other areas. County Bank may acquire other banks or branches of other banks with the approval of the FRB and the Department. County Bank is subject to examination by both the FRB and the Department.
DIVIDENDS
The Company may make a distribution to its shareholders if the corporation's retained earnings equal at least the amount of the proposed distribution. In the event sufficient retained earnings are not available for the proposed distribution, the Company may nevertheless make a distribution to its shareholders if, after giving effect to the distribution, the Company's assets equal at least 125% of its liabilities and certain other conditions are met. Since the 125% ratio translates into a minimum capital ratio of 20%, most bank holding companies, including the Company, based on its current capital ratios, are unable to satisfy this second test.
The primary source of funds for payment of dividends by the Company to its shareholders is the receipt of dividends from the Bank. The Bank’s ability to pay dividends to the Company is limited by applicable state and federal law. A California state-licensed bank may not make a cash distribution to its shareholders in excess of the lesser of: (i) the bank's retained earnings, or (ii) the bank's net income for its last three fiscal years, less the amount of any distributions made by the bank to its shareholders during such period. However, with the approval of the Commissioner of Financial Institutions (the "Commissioner"), a California state-licensed bank may pay dividends in an amount not to exceed the greater of (i) the bank's retained earnings, (ii) its net income for its last fiscal year, or (iii) its net income for the current fiscal year.
The FRB, FDIC and the Commissioner have authority to prohibit a bank from engaging in practices which are considered to be unsafe and unsound. Depending on the financial condition of the Bank and upon other factors, the FRB or the Commissioner could determine that payment of dividends or other payments by the Bank might constitute an unsafe or unsound practice. Finally, any dividend that would cause a bank’s capital to fall below required regulatory capital levels could also be prohibited.
REGULATORY CAPITAL REQUIREMENTS
The Company and the Bank are both required to maintain a minimum risk-based capital ratio of 8% (at least 4% in the form of Tier 1 capital) of risk-weighted assets and off-balance sheet items. "Tier 1" capital consists of common equity, non-cumulative perpetual preferred stock and minority interests in the equity accounts of consolidated subsidiaries, and excludes goodwill. "Tier 2" capital consists of cumulative perpetual preferred stock, limited-life preferred stock, mandatory convertible securities, subordinated debt and (subject to a limit of 1.25% of risk-weighted assets) general loan loss reserves. In calculating the relevant ratio, a bank's assets and off-balance sheet commitments are risk-weighted; thus, for example, loans are included at 100% of their book value while assets considered less risky are included at a percentage of their book value (20%, for example, for interbank obligations, and 0% for vault cash and U.S. Government securities).
The Company and the Bank are also subject to leverage capital ratio guidelines. The leverage ratio guidelines require maintenance of a minimum ratio of 3% Tier capital to total assets for the most highly rated organizations. Institutions that are less highly rated, anticipating significant growth or subject to other significant risks will be required to maintain capital levels ranging from 1% to 2% above the 3% minimum.
Federal regulation has established five tiers of capital measurement, ranging from "well capitalized" to "critically undercapitalized." Federal bank regulatory authorities are required to take prompt corrective action with respect to inadequately capitalized banks. If a bank does not meet the minimum capital requirements set by its regulators, the regulators are compelled to take certain actions, which may include a prohibition on the payment of dividends to a parent holding company and requiring adoption of an acceptable plan to restore capital to an acceptable level. Failure to comply will result in further sanctions, which may include orders to raise capital, merge with another institution, restrict transactions with affiliates, limit asset growth or reduce asset size, divest certain investments and /or elect new directors. It is the Company’s intention to maintain risk-based capital ratios for itself and for the Bank at above the minimum for the "well capitalized" level (6% Tier 1 risk-based; 10% total risk-based) and to maintain the leverage capital ratio for County Bank above the 5% minimum for "well-capitalized" banks. At December 31, 2005, the Company's leverage, Tier 1 risk-based and total risk-based capital ratios were 8.57%, 10.01% and 11.13%, and the Bank's leverage, Tier 1 risk-based and total risk-based capital ratios were 7.80%, 9.12% and 10.24%. No assurance can be given that the Company or the Bank will be able to maintain capital ratios in the "well capitalized" level in the future.
Prompt Corrective Action
The FDIC has authority: (a) to request that an institution’s primary regulatory agency take enforcement action against it based upon an examination by the FDIC or the agency, (b) if no action is taken within 60 days and the FDIC determines that the institution is in an unsafe and unsound condition or that failure to take the action will result in continuance of unsafe and unsound practices, to order that action be taken against the institution, and (c) to exercise this enforcement authority under “exigent circumstances” merely upon notification to the institution’s primary regulatory agency. This authority gives the FDIC the same enforcement powers with respect to any institution and its subsidiaries and affiliates as the primary regulatory agency has with respect to those entities.
An undercapitalized institution is required to submit an acceptable capital restoration plan to its primary federal bank regulatory agency. The plan must specify (a) the steps the institution will take to become adequately capitalized, (b) the capital levels to be attained each year, (c) how the institution will comply with any regulatory sanctions then in effect against the institution and (d) the types and levels of activities in which the institution will engage. The banking agency may not accept a capital restoration plan unless the agency determines, among other things, that the plan “is based on realistic assumptions, and is likely to succeed in restoring the institution’s capital” and “would not appreciably increase the risk to which the institution is exposed.” A requisite element of an acceptable capital restoration plan for an undercapitalized institution is a guaranty by its parent holding company that the institution will comply with the capital restoration plan. Liability with respect to this guaranty is limited to the lesser of (i) 5% of the institution’s assets at the time when it becomes undercapitalized and (ii) the amount necessary to bring the institution into capital compliance with applicable capital standards as of the time when the institution fails to comply with the plan. The guaranty liability is limited to companies controlling the undercapitalized institution and does not affect other affiliates. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to priority of payment over the claims of other creditors, including the holders of the company’s long-term debt.
The Federal Deposit Insurance Corporation Improvement Act (“FDICIA”) provides that the appropriate federal regulatory agency must require an insured depository institution that is significantly undercapitalized, or that is undercapitalized and either fails to submit an acceptable capital restoration plan within the time period allowed by regulation or fails in any material respect to implement a capital restoration plan accepted by the appropriate federal banking agency, to take one or more of the following actions: (a) sell enough shares, including voting shares, to become adequately capitalized; (b) merge with (or be sold to) another institution (or holding company), but only if grounds exist for appointing a conservator or receiver; (c) restrict specified transactions with banking affiliates as if the “sister bank” exception to the requirements of Section 23A of the Federal Reserve Act did not exist; (d) otherwise restrict transactions with bank or nonbank affiliates; (e) restrict interest rates that the institution pays on deposits to “prevailing rates” in the institution’s “region”; (f) restrict asset growth or reduce total assets; (g) alter, reduce or terminate activities; (h) hold a new election of directors; (i) dismiss any director or senior executive officer who held office for more than 180 days immediately before the institution became undercapitalized, provided that in requiring dismissal of a director or senior executive officer, the agency must comply with procedural requirements, including the opportunity for an appeal in which the director or officer will have the burden of proving his or her value to the institution; (j) employ “qualified” senior executive officers; (k) cease accepting deposits from correspondent depository institutions; (l) divest nondepository affiliates which pose a danger to the institution; (m) be divested by a parent holding company; and (n) take any other action which the agency determines would better carry out the purposes of the prompt corrective action provisions.
In addition to the foregoing sanctions, without the prior approval of the appropriate federal banking agency, a significantly undercapitalized institution may not pay any bonus to any senior executive officer or increase the rate of compensation for a senior executive officer without regulatory approval. If an undercapitalized institution has failed to submit or implement an acceptable capital restoration plan the appropriate federal banking agency is not permitted to approve the payment of a bonus to a senior executive officer. Not later than 90 days after an institution becomes critically undercapitalized, the institution’s primary federal bank regulatory agency must appoint a receiver or a conservator, unless the agency, with the concurrence of the FDIC, determines that the purposes of the prompt corrective action provisions would be better served by another course of action. Any alternative determination must be documented by the agency and reassessed on a periodic basis. Notwithstanding the foregoing, a receiver must be appointed after 270 days unless the FDIC determines that the institution has positive net worth, is in compliance with a capital plan, is profitable or has a sustainable upward trend in earnings, and is reducing its ratio of non-performing loans to total loans, and unless the head of the appropriate federal banking agency and the chairperson of the FDIC certify that the institution is viable and not expected to fail.
The FDIC is required, by regulation or order, to restrict the activities of critically undercapitalized institutions. The restrictions must include prohibitions on the institution’s doing any of the following without prior FDIC approval: entering into any material transactions not in the usual course of business, extending credit for any highly leveraged transaction; engaging in any “covered transaction” (as defined in Section 23A of the Federal Reserve Act) with an affiliate; paying “excessive compensation or bonuses”; and paying interest on “new or renewed liabilities” that would increase the institution’s average cost of funds to a level significantly exceeding prevailing rates in the market.
Federal Reserve Borrowings
A Federal Reserve Bank may not make advances to an undercapitalized institution for more than 60 days in any 120-day period without a viability certification by a federal bank regulatory agency or by the Chairman of the FRB after an examination by the FRB. If an institution is deemed critically undercapitalized, an extension of Federal Reserve Bank credit cannot continue for five days without demand for payment unless the Federal Reserve Bank is willing to accept responsibility for any resulting loss to the FDIC. As a practical matter, this provision is likely to mean that Federal Reserve Bank credit will not be extended beyond the limitations in this provision.
Acquisitions of Control
Under applicable federal and state laws, it is unlawful for a person to purchase or otherwise acquire beneficial ownership of shares of common or preferred stock of the Bank, without the prior approval of the Commissioner and a notice of non-disapproval from the FDIC, if the acquisition would give the person, or any group of persons acting together (a “Group”), control of the Bank. The applicable government regulations defined “control” for these purposes to mean the direct or indirect power (i) to vote 25% or more of the Bank’s outstanding shares, or (ii) to direct or cause the direction of the management and policies of the Bank, whether through ownership of voting securities, by contract or otherwise; provided that no individual will be deemed to control the Bank solely on accord of being a director, officer or employee of the Bank. Persons who directly or indirectly own or control 10% or more of a Bank’s outstanding shares are presumed to control the bank.
Consumer Laws and Regulations
In addition to the other laws and regulations discussed in this Offering Circular, the Bank must also comply with consumer laws and regulations that are designed to protect consumers in transactions with banks. While the list is not exhaustive, these laws and regulations include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, and the Fair Housing Act, among others. These laws and regulations mandate disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits or making loans. The Bank must comply with the applicable provisions of these consumer protection laws and regulations as part of its ongoing regulatory compliance and customer relations efforts.
Exposure to and Management of Risk
The federal banking agencies examine banks and bank holding companies with respect to their exposure to and management of different categories of risk. Categories of risk identified by the agencies include legal risk, operational risk, market risk, credit risk, interest rate risk, price risk, foreign exchange risk, transaction risk, compliance risk, strategic risk, credit risk, liquidity risk, and reputation risk. This examination approach causes bank regulators to focus on risk management procedures, rather than simply examining every asset and transaction. This approach supplements rather than replaces existing rating systems based on the evaluation of an institution’s capital, assets, management, earnings and liquidity. It is not clear what effect, if any, this examination approach will have on the Bank.
Safety and Soundness Standards
Federal banking regulators have adopted a Safety and Soundness Rule and Interagency Guidelines Prescribing Standards for Safety and Soundness (the “Guidelines”). The Guidelines create standards for a wide range of operational and managerial matters including (a) internal controls, information systems, and internal audit systems; (b) loan documentation; (c) credit underwriting; (d) interest rate exposure; (e) asset growth; (f) compensation and benefits; and (g) asset quality and earnings.
The Community Development Act required the agencies to prescribe standards prohibiting as an unsafe and unsound practice the payment of excessive compensation that could result in material financial loss to an institution, and to specify when compensation, fees or benefits become excessive. The Guidelines characterize compensation as excessive if it is unreasonable or disproportionate to the services actually performed by the executive officer, employee, director or principal shareholder being compensated.
Federal regulators have stated that the Guidelines are meant to be flexible and general enough to allow each institution to develop its own systems for compliance. With the exception of the standards for compensation and benefits, a failure to comply with the Guidelines’ standards does not necessarily constitute an unsafe and unsound practice or condition. On the other hand, an institution in conformance with the standards may still be found to be engaged in an unsafe and unsound practice or to be in an unsafe and unsound condition.
Although meant to be flexible, an institution that falls short of the Guidelines’ standards may be requested to submit a compliance plan or be subjected to regulatory enforcement actions. Generally, the federal banking agencies will request a compliance plan if an institution’s failure to meet one or more of the standards is of sufficient severity to threaten the safe and sound operation of the institution. An institution must file a compliance plan within 30 days of request by its primary federal regulator, which is the FDIC in the case of the Bank. The Guidelines provide for prior notice of and an opportunity to respond to the agency’s proposed order. An enforcement action may be commenced if, after being notified that it is in violation of a safety and soundness standard, the institution fails to submit an acceptable compliance plan or fails in any material respect to implement an accepted plan. The Federal Deposit Insurance Act provides the agencies with a wide range of enforcement powers. An agency may, for example, obtain an enforceable cease and desist order in the United States District Court, or may assess civil money penalties against an institution or its affiliated parties.
Legislation and Proposed Changes
From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial institutions. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial institutions are frequently made in Congress, in the California legislature and before various bank regulatory agencies. For example, from time to time Congress has considered various proposals to eliminate the federal thrift charter, create a uniform financial institutions charter, conform holding company regulation, and abolish the Office of Thrift Supervision. Typically, the intent of this type of legislation is to strengthen the banking industry, even if it may on occasion prove to be a burden on management’s plans. No prediction can be made as to the likelihood of any major changes or the impact that new laws or regulations might have on the Bank.
LIMITATIONS ON ACTIVITIES
On December 15, 2005 the Federal Reserve Bank of San Francisco (“FRBSF”) lifted the written agreement (“Agreement”) that was entered into on October 26, 2004 with County Bank. Under the Agreement, the Bank, among other actions taken, (i) developed a written program designed to improve the Bank's system of internal controls to ensure compliance with applicable provisions of the Bank Secrecy Act; (ii) developed an enhanced written customer due diligence program designed to reasonably ensure the identification and reporting of all known or suspected violations of law and suspicious transactions against or involving the Bank; (iii) established enhanced written policies and procedures designed to strengthen the Bank's internal controls and audit program, and (iv) submitted quarterly progress reports to the FRBSF detailing actions taken to secure compliance with the Agreement.
FDICIA prohibits state chartered banks and their subsidiaries from engaging, as principal, in activities not permissible by national banks and their subsidiaries, unless the bank’s primary federal regulator determines the activity poses no significant risk to the Bank Insurance Fund (“BIF”) and the state bank is and continues to be adequately capitalized. Similarly, state bank subsidiaries may not engage, as principal, in activities impermissible by subsidiaries of national banks. This prohibition extends to acquiring or retaining any investment, including those that would otherwise be permissible under California law.
The State Bank Parity Act, eliminates certain disparities between California state chartered banks and federally chartered national banks by authorizing the Commissioner to address such disparities through a streamlined rulemaking process. The Commissioner has taken action pursuant to the Parity Act to authorize, among other matters, previously impermissible share repurchases by state banks, subject to the prior approval of the Commissioner.
Under regulations of the Office of the Comptroller of the Currency (“OCC”) eligible institutions (those national banks that are well-capitalized, have a high overall rating and a satisfactory CRA rating, and are not subject to an enforcement order) may engage in activities related to banking through operating subsidiaries after going through a new expedited application process. In addition, the new regulations include a provision whereby a national bank may apply to the OCC to engage in an activity through a subsidiary in which the bank itself may not engage. In determining whether to permit the subsidiary to engage in the activity, the OCC will evaluate why the bank itself is not permitted to engage in the activity and whether a Congressional purpose will be frustrated if the OCC permits the subsidiary to engage in the activity. The State Bank Parity Act may permit state-licensed banks to engage in similar activities, subject to the discretion of the Commissioner.
TIE-IN ARRANGEMENTS AND TRANSACTIONS WITH AFFILIATED PERSONS
A bank is prohibited from certain tie-in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services. For example, with certain exceptions, a bank may not condition an extension of credit on a promise by its customer to obtain other services provided by it, its holding company or other subsidiaries (if any), or on a promise by its customer not to obtain other services from a competitor.
Directors, officers and principal shareholders of the Company, and the companies with which they are associated, may conduct banking transactions with the Company in the ordinary course of business. Any loans and commitments to loans included in such transactions must be made in accordance with applicable law, on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons of similar creditworthiness, and on terms not involving more than the normal risk of collectibility or presenting other unfavorable features.
CROSS-INSTITUTION ASSESSMENTS
Any insured depository institution owned by the Company can be assessed for losses incurred by the FDIC in connection with assistance provided to, or the failure of, any other depository institution owned by the Company.
INSURANCE PREMIUMS AND ASSESSMENTS
The FDIC has authority to impose a special assessment on members of the BIF to ensure that there will be sufficient assessment income for repayment of BIF obligations and for any other purpose which it deems necessary. The FDIC is authorized to set semi-annual assessment rates for BIF members at levels sufficient to maintain the BIF's reserve ratio to a designated level of 1.25% of insured deposits. The FDIC has developed a risk-based assessment system, under which the assessment rate for an insured depository institution varies according to the level of risk incurred in its activities. An institution's risk category is based upon whether the institution is “well capitalized,” “adequately capitalized,” or “undercapitalized.” Each insured depository institution is also assigned to "supervisory subgroup" A, B or C. Subgroup A institutions are financially sound institutions with no more than a few minor weaknesses; Subgroup B institutions are institutions that demonstrate weaknesses which, if not corrected, could result in significant deterioration; and Subgroup C institutions are institutions for which there is a substantial probability that the FDIC will suffer a loss in connection with the institution unless effective action is taken to correct the areas of weakness. The FDIC assigns each member institution an annual FDIC assessment rate which, as of the date of this report, varies between 0.0% per annum with a $2,000 minimum (for well capitalized Subgroup A institutions) and 0.27% per annum (for undercapitalized Subgroup C institutions). Insured institutions are not permitted to disclose their risk assessment classification.
AUDIT REQUIREMENTS
All insured depository institutions are required to have an annual, full-scope on-site examination. Depository institutions with assets greater than $500 million are required to have annual independent audits, prepare financial statements in accordance with generally accepted accounting principles, and develop policies that ensure adequate internal controls over financial reporting. Insured depository institutions are also required to have an independent audit committee comprised entirely of outside directors.
COMMUNITY REINVESTMENT ACT
The Community Reinvestment Act ("CRA") requires banks to identify the communities served by the bank's offices and to identify the types of credit the bank is prepared to extend within such communities. It also requires the bank's regulators to assess the bank's performance in meeting the credit needs of its community and to take that assessment into consideration in reviewing applications for mergers, acquisitions and other transactions. During January, 2005, a CRA examination was completed. The Bank was assigned a CRA rating of “outstanding” as of this examination.
BANK SECRECY ACT
The Bank Secrecy Act requires financial institutions to keep records and file reports regarding certain financial transactions that involve cash, and to implement counter-money laundering programs and compliance procedures.
SECURITIES AND EXCHANGE COMMISSION FILINGS
Under Section 13 of the Securities Exchange Act of 1934 (“Exchange Act”) and the SEC’s rules, the Company must electronically file periodic and current reports as well as proxy statements with the Securities and Exchange Commission (the “SEC”). The Company electronically files the following reports with the SEC: Form 10-K (Annual Report), Form 10-Q (Quarterly Report), and Form 8-K (Current Report). The Company may prepare additional filings and amendments to those as required. The SEC maintains an Internet site, http://www.sec.gov, at which all forms filed electronically may be accessed. Our SEC filings are also available free of charge on our website at http://www.ccow.com.
POTENTIAL ENFORCEMENT ACTIONS
Banks and their institution-affiliated parties may be subject to potential enforcement actions by the bank regulatory agencies for unsafe or unsound practices in conducting their businesses, or for violations of any law, rule, regulation or provision, any consent order with any agency, any condition imposed in writing by an agency, or any written agreement with the agency. Enforcement actions may include the imposition of a conservator or receiver, cease-and-desist orders and written agreements, the termination of deposit insurance, the imposition of civil money penalties, and removal and prohibition orders against institution-affiliated parties. See " -- County Bank".
INTERSTATE BANKING
Bank holding companies (including bank holding companies that also are financial holding companies) are required to obtain the prior approval of the Federal Reserve Board before acquiring more than five percent of any class of voting stock of any non-affiliated bank. Pursuant to the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Interstate Banking and Branching Act”), a bank holding company may acquire banks located in states other than its home state without regard to the permissibility of such acquisitions under state law, but subject to any state requirement that the bank has been organized and operating for a minimum period of time, not to exceed five years, and the requirement that the bank holding company, after the proposed acquisition, controls no more than 10 percent of the total amount of deposits of insured depository institutions in the United States and no more than 30 percent or such lesser or greater amount set by state law of such deposits in that state.
Subject to certain restrictions, the Interstate Banking and Branching Act also authorizes banks to merge across state lines to create interstate banks. The Interstate Banking and Branching Act also permits a bank to open new branches in a state in which it does not already have banking operations if such state enacts a law permitting de novo branching.
FINANCIAL SERVICES MODERNIZATION LEGISLATION
The Gramm-Leach-Bliley Act of 1999 (the “Modernization Act”) repealed two provisions of the Glass-Steagall Act: Section 20, which restricted the affiliation of Federal Reserve member banks with firms “engaged principally” in specified securities activities; and Section 32, which restricted officer, director, or employee interlocks between a member bank and any company or person “primarily engaged” in specified securities activities. In addition, the Modernization Act also expressly preempts any state law restricting the establishment of financial affiliations, primarily related to insurance. The law establishes a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms, and other financial service providers by revising and expanding the BHC Act framework to permit a holding company and its subsidiaries to engage in a full range of financial activities through a new entity known as a Financial Holding Company. “Financial activities” is broadly defined to include not only banking, insurance, and securities activities, but also merchant banking and additional activities that the Federal Reserve, in conjunction with the Secretary of the Treasury, determine to be financial in nature, incidental to such financial activities, or complementary activities that do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.
In order for the Company to take advantage of the authority provided by the Modernization Act to affiliate with other financial service providers, it must become a “Financial Holding Company.” To do so, the Company would file a declaration with the FRB, electing to engage in activities permissible for Financial Holding Companies and certifying that it is eligible to do so because its insured depository institution subsidiary (the Bank) is well-capitalized and well-managed. In addition, the Federal Reserve must determine that an insured depository institution subsidiary has at least a “satisfactory” rating under the Community Reinvestment Act. The Company currently meets the requirements for Financial Holding Company status. The Company will continue to monitor its strategic business plan to determine whether, based on market conditions and other factors, the Company wishes to utilize any of its expanded powers provided in the Modernization Act.
The Modernization Act also includes a new section of the Federal Deposit Insurance Act which governs subsidiaries of state banks that engage in activities as principal that would only be permissible for a national bank to conduct in a financial subsidiary. The Act expressly preserves the ability of a state bank to retain all existing subsidiaries. Because California currently permits commercial banks chartered by the state to engage in any activity permissible for national banks, the Bank will be permitted to form subsidiaries to engage in the activities authorized by the Modernization Act to the same extent as a national bank. In order to form a financial subsidiary, the Bank must be well-capitalized, and the Bank would be subject to the same capital deduction, risk management and affiliate transaction rules as are applicable to national banks. In the opinion of management, the Bank currently meets those requirements.
Under the Modernization Act, securities firms and insurance companies that elect to become Financial Holding Companies may acquire banks and other financial institutions. The Company does not believe that the Modernization Act will have a material adverse effect on its operations in the near-term. However, to the extent that it permits banks, securities firms, and insurance companies to affiliate, the financial services industry may experience further consolidation. The Modernization Act is intended to grant to community banks certain powers as a matter of right that larger institutions have accumulated on an ad hoc basis. Nevertheless, the Modernization Act may have the effect of increasing the amount of competition that the Company and the Bank face from larger institutions and other types of companies that offer financial products, many of which may have substantially more financial resources than the Company and the Bank.
INTERNATIONAL MONEY LAUNDERING ABATEMENT AND FINANCIAL ANTI-TERRORISM ACT OF 2001
The terrorist attacks in September, 2001, impacted the financial services industry and led to federal legislation that attempts to address certain issues involving financial institutions. On October 26, 2001, President Bush signed into law the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the "USA PATRIOT Act").
Part of the USA PATRIOT Act is the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 ("IMLAFATA"). IMLAFATA authorizes the Secretary of the Treasury, in consultation with the heads of other government agencies, to adopt special measures applicable to banks, bank holding companies, and other financial institutions. These measures may include enhanced recordkeeping and reporting requirements for certain financial transactions that are of primary money laundering concern, due diligence requirements concerning the beneficial ownership of certain types of accounts, and restrictions or prohibitions on certain types of accounts with foreign financial institutions.
Among its other provisions, IMLAFATA requires each financial institution to: (i) establish an anti-money laundering program; (ii) establish due diligence policies, procedures and controls with respect to its private banking accounts and correspondent banking accounts involving foreign individuals and certain foreign banks; and (iii) avoid establishing, maintaining, administering, or managing correspondent accounts in the United States for, or on behalf of, a foreign bank that does not have a physical presence in any country. In addition, IMLAFATA contains a provision encouraging cooperation among financial institutions, regulatory authorities and law enforcement authorities with respect to individuals, entities and organizations engaged in, or reasonably suspected of engaging in, terrorist acts or money laundering activities. IMLAFATA expands the circumstances under which funds in a bank account may be forfeited and requires covered financial institutions to respond under certain circumstances to requests for information from federal banking agencies within 120 hours. IMLAFATA also amends the Bank Holding Company Act and the Bank Merger Act to require the federal banking agencies to consider the effectiveness of a financial institution's anti-money laundering activities when reviewing an application under these acts.
Treasury regulations implementing the due diligence requirements of IMLAFATA include standards to verify customer identity, to encourage cooperation among financial institutions, federal banking agencies, and law enforcement authorities regarding possible money laundering or terrorist activities, to prohibit the anonymous use of "concentration accounts," and to require all covered financial institutions to have in place a Bank Secrecy Act compliance program.
SARBANES-OXLEY ACT OF 2002
The stated goals of the Sarbanes-Oxley Act of 2002 (“SOX”) are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly-traded companies, and to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws.
The SOX generally applies to all companies, both U.S. and non-U.S., that file or are required to file periodic reports with the SEC under the Exchange Act. The SOX includes very specific additional disclosure requirements and new corporate governance rules, requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules, and mandates further studies of certain issues by the SEC and the Comptroller General. The SOX represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and a board of directors and its committees.
The SOX addresses, among other matters: audit committees for all reporting companies; certification of financial statements by the chief executive officer and the chief financial officer; the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer’s securities by directors and senior officers in the twelve month period following initial publication of any financial statements that later require restatement; a prohibition on trading by officers and directors trading during certain black out periods under employee benefit plans; disclosure of off-balance sheet transactions; a prohibition on personal loans to directors and officers; expedited filing requirements for Form 4’s; disclosure of a code of ethics and filing of a Form 8-K for a change or waiver of such code; “real time” filing of issuers’ periodic reports; the formation of a public accounting oversight board; auditor independence; and various increased criminal penalties for violation of securities laws. The SEC has adopted a number of rules designed to effectuate the provisions of the SOX.
REGULATION W
Transactions between a bank and its “affiliates” are quantitatively and qualitatively restricted under the Federal Reserve Act. The Federal Deposit Insurance Act (“FDIA”) applies Section 23A and 23B to insured nonmember banks in the same manner and to the same extent as if they were members of the Federal Reserve System. The FRB has also issued Regulation W, which codifies prior regulations under Section 23A and 23B of the Federal Reserve Act and provides interpretive guidance with respect to affiliate transactions. Regulation W incorporates the exemption from the affiliate transaction rules but expands the exemption to cover the purchase of any type of loan or extension of credit from an affiliate. Affiliates of a bank include, among other entities, the bank’s holding company and companies that are under common control with the bank. The Company is considered to be an affiliate of the Bank. In general, subject to certain specified exemptions, a bank or its subsidiaries are limited in their ability to engage in “covered transactions” with affiliates: (i) to an amount equal to 10% of the bank’s capital and surplus in the case of covered transactions with any one affiliate; and (ii) to an amount equal to 20% of the bank’s capital and surplus in the case of covered transactions with all affiliates. In addition, a bank and its subsidiaries may engage in covered transactions and other specified transactions only on terms and under circumstances that are substantially the same, or at least as favorable to the bank or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies. “Covered transactions” include: (i) a loan or extension of credit to an affiliate; (ii) a purchase of, or an investment in, securities issued by an affiliate; (iii) a purchase of assets from an affiliate, with some exceptions; (iv) the acceptance of securities issued by an affiliate as collateral for a loan or extension of credit to any party; and (v) the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate. Additionally, under Regulation W, a bank and its subsidiaries may not purchase a low-quality asset from an affiliate; covered transactions and other specified transactions between a bank or its subsidiaries and an affiliate must be on terms and conditions that are consistent with safe and sound banking practices; and with some exceptions, each loan or extension of credit by a bank to an affiliate must be secured by collateral with a market value ranging from 100% to 130%, depending on the type of collateral, of the amount of the loan or extension of credit.
Regulation W generally excludes all non-bank subsidiaries of the banks from treatment as affiliates, except to the extent that the Federal Reserve Board decides to treat these subsidiaries as affiliates.
Concurrent with the adoption of Regulation W, the Federal Reserve Board has proposed a regulation that would further limit the amount of loans that could be purchased by a bank from an affiliate to not more than 100% of the bank’s capital and surplus.
CONCLUSIONS
It is impossible to predict with any degree of accuracy the competitive impact the laws and regulations described above will have on commercial banking in general and on the business of the Company in particular. It is anticipated that the banking industry will continue to be a highly regulated industry. Additionally, there appears to be a continued lessening of the historical distinction between the services offered by financial institutions and other businesses offering financial services. Finally, the trend toward nationwide interstate banking is expected to continue. As a result of these factors, it is anticipated banks will experience increased competition for deposits and loans and, possibly, further increases in their cost of doing business.
Selected Statistical Information
The following tables on pages 17 through 23 present certain statistical information concerning the business of the Company. This informa-tion should be read in conjunction with "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" incorporated in ITEM 7 of this report by reference to pages 39 through 55 of the Company's 2005 Annual Report to Shareholders and with the Company's Consolidated Financial Statements and the Notes thereto incorporated in Item 8 of this report by reference to pages 59 through 88 of the Company's 2005 Annual Report to Shareholders. The statistical information that follows is based on average daily amounts.
Interest Rates and Margins:
Managing interest rates and margins is essential to the Company in order to maintain profitability. The following table presents, for the periods indicated, the distribution of average assets, liabilities and shareholder’s equity, as well as the total dollar amount of interest income from average interest-earning assets and resultant yields and the dollar amounts of interest expense and average interest-bearing liabilities, expressed both in dollars and rates.
(1)
Tax-equivalent adjustments recorded at the statutory rate of 35% that are included in nontaxable investment securities income totaled $1,116,000, $726,000, and $442,000 in 2005, 2004, and 2003, respectively. Tax equivalent income adjustments included in the nontaxable investment securities income were derived from nontaxable municipal interest income. Tax equivalent income adjustments recorded at the statutory federal rate of 35% that are included in taxable investment securities income were created by a dividends received deduction of $124,000, $132,000, and $133,000 in 2005, 2004, and 2003, respectively.
(2)
Interest on non-accrual loans is recognized into income on a cash received basis.
(3)
Net interest margin is computed by dividing net interest income by total average interest-earning assets.
The Company’s net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities. It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and borrowed funds. The following table sets forth changes in interest income and interest expense for each major category of interest-earning asset and interest-bearing liability and the amount of change attributable to volume and rate changes for the years indicated. The changes due to both rate and volume have been allocated to rate and volume in proportion to the relationship of the absolute dollar amount of the change in each. Interest on non-accrual loans was recognized into income on a cash basis. Tax equivalent adjustments have been made to reflect the before tax interest income for tax advantaged investments.
Investment Portfolio Maturities
The following table sets forth the maturities of debt securities at December 31, 2005 and the weighted average yields of such securities calculated on a book value basis using the weighted average yield within each scheduled maturity grouping. Maturities of mortgage-backed securities and collateralized mortgage obligations are stipulated in their respective contracts, however, actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call prepayment penalties. Yields on municipal securities have not been calculated on a tax-equivalent basis.
The Company does not own securities of a single issuer whose aggregate book value is in excess of 10% of its total equity.
Asset / Liability Repricing
The interest rate gaps reported in the table below arise when assets are funded with liabilities having different repricing intervals. Since these gaps are actively managed and change daily as adjustments are made in interest rate views and market outlook, positions at the end of any period may not reflect the Company's interest rate sensitivity in subsequent periods. Active management dictates that longer-term economic views are balanced against prospects for short-term interest rate changes in all repricing intervals. For purposes of the analysis below, repricing of fixed-rate instruments is based upon the contractual maturity of the applicable instruments. Actual payment patterns may differ from contractual payment patterns.
Loan Portfolio
At December 31, 2005, the Company had approximately $495,313,000 in undisbursed loan commitments. This compares with $393,039,000 at December 31, 2004. Standby and performance letters of credit were $15,160,000 and $13,875,000, at December 31, 2005 and 2004. For further information about the composition of the Company's loan portfolio see the information in "ITEM 7 - -MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Credit Risk Management and Asset Quality,” incorporated by reference to page 47 of the Company's 2005 Annual Report to Shareholders.
The following table shows the composition of the loan portfolio of the Company by type of loan on the dates indicated:
The table that follows shows the maturity distribution of the portfolio of commercial and agricultural, real estate construction, real estate mortgage and installment loans on December 31, 2005 by fixed and floating rate attributes:
(1) All Cash Reserve loans that do not have a maturity date are included in “Over Five Years” category.
The Company seeks to mitigate the risks inherent in its loan portfolio by adhering to certain underwriting practices. They include analysis of prior credit histories, financial statements, tax returns and cash flow projections of its potential borrowers as well as obtaining independent appraisals on real and personal property taken as collateral and audits of accounts receivable or inventory pledged as security.
The Company also has an internal loan review process as well as periodic external reviews. The results of these reviews are assessed by the Company's audit committee. Collection of delinquent loans is generally the responsibility of the Company's credit administration staff. However, certain problem loans may be dealt with by the originating loan officer. The Directors Loan Committee reviews the status of delinquent and problem loans on a monthly basis. The Company's underwriting and review practices notwithstanding, in the normal course of business, the Company expects to incur loan losses in the future.
Nonaccrual, Past Due and Restructured Loans
The following table summarizes nonperforming loans of the Company as of the dates indicated:
Loans with significant potential problems or impaired loans are placed on nonaccrual status. Management defines impaired loans as those loans, regardless of past due status, in which management believes the collection of principal and interest is in doubt. The amount of gross interest income that would have been recorded on nonaccrual loans in the periods then ended if the loans had been current in accordance with the original terms and had been outstanding throughout the period or since origination, if held for part of the period, was $63,000, $4,000, $39,000, $131,000, and $170,000 in 2005, 2004, 2003, 2002,and 2001. The amount of interest income on nonaccrual loans that was included in net income was $88,000, $216,000, $231,000, $210,000, and $105,000 in 2005, 2004, 2003, 2002, and 2001.
Allocation of the Allowance for Loan Losses
The following table summarizes a breakdown of the allowance for loan losses by loan category and the percentage by loan category of total loans for the dates indicated:
Other Interest-Bearing Assets
The following table relates to other interest bearing assets not disclosed above for the dates indicated. This item consists of a salary continuation plan for the Company's executive management and a deferred compensation plan for participating board members. The Company has discontinued the deferred compensation plan for board members and entered into “Director Elective Income Deferral Agreements”. The plans are informally linked with universal life insurance policies containing cash surrender values as listed in the following table:
During 2005, 2004, and 2003 the Bank purchased $3,000,000, $3,175,000, and $6,000,000 in new bank owned life insurance policies. This additional life insurance is in the form of single premium life policies covering bank officers. These policies have a variable rate of return that is reset annually by each insurer. The Bank is the owner of these policies and also the named beneficiary. During 2005, and 2003, the Company received $607,000, $0 and $0 in proceeds related to death benefits on bank owned life insurance.
Deposits
The following table sets forth the average balance and the average rate paid for the major categories of deposits for the years indicated:
Maturities of Time Certificates of Deposits of $100,000 or More
Maturities of time certificates of deposits of $100,000 or more outstanding at December 31, 2005 are summarized as follows:
Return on Equity and Assets
The following table sets forth certain financial ratios for the periods indicated (averages are computed using actual daily figures):
Return on Average Equity and Assets
ITEM 1A.
ITEM 1A. RISK FACTORS
See the information in "ITEM 7 - -MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -Risk Factors” incorporated by reference to pages 53 through 55 of the Company's 2005 Annual Report to Shareholders
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None
ITEM 2.
ITEM 2. PROPERTIES
The Bank
Capital Corp of the West/County Bank is a community service bank with operations located mainly in the San Joaquin Valley of Central California. The corporate headquarters and main branch facility are located at 550 West Main Street, Merced, California in a three-story building with a two-story, attached parking garage and is approximately 29,000 square feet. In addition to this facility, there are three support centers in downtown Merced with an additional square footage of 33,000 square feet.
The Bank currently has 21 branch operations located in the central valley and 1 branch operation located in San Francisco. The central valley operations include branches located in: Merced (2), Atwater, Los Banos, Hilmar, Sacramento, Sonora, Turlock (2), Modesto (2), Dos Palos, Livingston, Mariposa, Madera, Clovis, Fresno (4), Stockton and San Francisco. The Bank owns eight of these branch facilities and the remaining fourteen facilities are leased. The Management of the Bank believes that the facilities will be adequate to accommodate operations for the foreseeable future.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
As of March 14, 2006, the Company, is not a party to, nor is any of its properties the subject of, any material pending legal proceedings, nor are any such proceedings known to be contemplated by government authorities.
The Company is, however, exposed to certain potential claims encountered in the normal course of business. In the opinion of Management, the resolution of these matters will not have a material adverse effect on the Company's consolidated financial position or results of operations in the foreseeable future.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company did not submit any matters to a vote of security holders in the quarter ended December 31, 2005.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
For information concerning the market for the Company's common stock and related shareholder matters, see page 52 of the Company's 2005 Annual Report to Shareholders incorporated herein by reference.
For information concerning the Company’s dividend policy, see the “Capital Resources” discussion on pages 51 through 52 of the Company’s 2005 Annual Report to Shareholders incorporated herein by reference.
Market for Company's Common Stock and Related Stock Matters
The Company’s stock is included for quotation on the Nasdaq National Market System with a stock quotation symbol of CCOW. The following table indicates the range of high and low bid prices for the period shown, based upon information provided by the Nasdaq National Market System. There were approximately 1,700 CCOW shareholders as of December 31, 2005.
* All stock prices are adjusted for the 9 for 5 split announced on March 29, 2005.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
For selected consolidated financial data concerning the Company, see page 38 of the Company's 2005 Annual Report to Shareholders incorporated herein by reference.
ITEM 7.
ITEM 7.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
For management's discussion and analysis of financial condition and results of operations, see pages 39 through 55 of the Company's 2005 Annual Report to Shareholders incorporated herein by reference.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK
For management's discussion and analysis of market risk and interest rate risk management, see pages 49 through 50 of the Company's 2005 Annual Report to Shareholders incorporated herein by reference.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Audited Consolidated Balance Sheets as of December 31, 2005 and 2004 and Audited Consolidated Statements of Income and Comprehensive Income, Shareholders' Equity and Cash Flows for the fiscal years ended December 31, 2005, 2004, and 2003 appear on pages 59 through 62 of the Company's 2005 Annual Report to Shareholders incorporated herein by reference. Notes to the Consolidated Financial Statements appear on pages 63 through 88 of the Company's 2005 Annual Report to Shareholders incorporated herein by reference. The Independent Auditors' Report appears on page 57 of the Company's 2005 Annual Report to Shareholders incorporated herein by reference.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE
There were no changes in and there were no disagreements with accountants on accounting and financial disclosure during 2005.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
Under the supervision and with the participation of the Company’s management, including its chief executive officer and chief financial officer, the Company’s management conducted an evaluation of the effectiveness of the design and operation of its disclosure controls and procedures as defined by Rules 13a-15(e) and 15d-15(e)) under the Securities Exchange Act of 1934.
Based on the evaluation, the chief executive officer and chief financial officer concluded that as of December 31, 2005, the end of the period covered by this report, the disclosure controls and procedures were adequate and effective, and that the material information required to be included in this report, including information from the Company’s consolidated subsidiaries, was made known to the chief executive officer and chief financial officer by others within the Company in a timely manner, particularly during the period when this annual report on Form 10-K was being prepared.
Management's Report on Internal Control over Financial Reporting.
Based on their evaluation as of December 31, 2005, our Chief Executive Officer and Chief Financial Officer, have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended) were sufficiently effective to ensure that the information required to be disclosed by us in this Annual Report on Form 10-K was recorded, processed, summarized and reported within the time periods specified within the SEC's rules and instructions for Form 10-K.
Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended). Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2005. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO") in Internal Control-Integrated Framework. Our management has concluded that, as of December 31, 2005, our internal control over financial reporting is effective based on these criteria. Our independent registered public accounting firm, KPMG LLP, has issued an audit report on our assessment of our internal control over financial reporting, which is included herein.
ITEM 9B.
ITEM 9B.
OTHER INFORMATION
None
PART III
ITEM 10.
ITEM 10.
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
As permitted by the Securities and Exchange Commission’s rules relating to Form 10-K, the information called for by this item is incorporated by reference from the section of the Company's 2005 Proxy Statement titled "Election of Directors," which is to be filed on or about March 14, 2006.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION
As permitted by the Securities and Exchange Commission, the information called for by this item is incorporated by reference from the section of the Company's Proxy Statement titled "Information Pertaining to Election of Directors," which is to be filed on or about March 14, 2006.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT AND RELATED STOCKHOLDER MATTERS
As permitted by the Securities and Exchange Commission’s rules relating to Form 10-K, the information called for by this item is incorporated by reference from the sections of the Company's 2005 Proxy Statement, titled “Beneficial Ownership of Management” and “Principal Shareholders” which is to be filed on or about March 14, 2006.
Securities authorized for issuance under equity compensation plans.
(a) The information in the following table is provided as of the end of the fiscal year ended December 2005 with respect to compensation plans (including individual compensation arrangements) under which equity securities are issuable:
Equity Compensation Plan Information
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
As permitted by the Securities and Exchange Commission’s rules relating to Form 10-K, the information called for by this item is incorporated by reference from the Company's Proxy Statement, which was filed on or about March 14, 2006.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTING FEES AND SERVICES
As permitted by the Securities and Exchange Commission, the information called for by this item is incorporated by reference from the section of the Company’s 2005 Proxy Statement titled “Auditor Fees,” which is to be filed on or about March 14, 2006.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS
ON FORM 8-K.
(a) Financial Statements and Schedules
An index of all financial statements and schedules filed as part of this Form 10-K appears below and the material which begins on the pages of the Company's Annual Report to Shareholders for the year ended December 31, 2005 listed, are incorporated herein by reference in response to Item 8 of this report.
(b) Exhibits (Numbered in accordance with Item 601 of Regulation S-K)
The Exhibit Index is located on the final page of this report on Form 10-K.
(c) Financial Statement Schedules
All other supporting schedules are omitted because they are not applicable, not required, or the information required to be set forth therein is included in the financial statements or notes thereto incorporated herein by reference.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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 the 14th day of March, 2006.
CAPITAL CORP OF THE WEST
Date: March 14, 2006
By: /s/ Thomas T. Hawker
THOMAS T. HAWKER
President and Chief Executive Officer
(Principal Executive Officer)
Date: March 14, 2006
By: /s/ R. Dale McKinney
R. DALE MCKINNEY
Executive Vice President and
Chief Financial Officer and Principal Accounting Officer
(Principal Financial and Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature
Capacity
Date
/s/ Dorothy L. Bizzini
Director
March 14, 2006
DOROTHY L. BIZZINI
/s/ Tom A. L. Van Groningen
Director
March 14, 2006
TOM A.L. VAN GRONINGEN
/s/ John Fawcett
Director
March 14, 2006
JOHN FAWCETT
/s/ G. Michael Graves
Director
March 14, 2006
G MICHAEL GRAVES
/s/ Thomas T. Hawker
Director/CEO and
March 14, 2006
THOMAS T. HAWKER
Principal Executive Officer
/s/ R. Dale McKinney
Chief Financial Officer
March 14, 2006
R. DALE MCKINNEY
Principal Financial and
Accounting Officer
/s/ Curtis Riggs
Director
March 14, 2006
CURTIS RIGGS
/s/ Jerry Tahajian
Director
March 14, 2006
JERRY TAHAJIAN
/s/ Curtis R. Grant
Director
March 14, 2006
CURTIS R. GRANT
/s/ Jerry E. Callister
Chairman of the
March 14, 2006
JERRY E. CALLISTER
Board of Directors
Exhibit Index
The following is a list of all exhibits required by Item 601 of Regulation S-K to be filed as part of this 10-K:
E-1
(1)
Nonperforming loans consist of loans on nonaccrual, loans past due 90 days or more and restructured loans.
Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis is designed to provide a better understanding of the significant changes and trends related to Capital Corp of the West (the “Company”). The following discussion should be read in conjunction with the consolidated financial statements of the Company and the notes thereto. The consolidated financial statements of the Company include its subsidiaries, County Bank (the "Bank"), and Capital West Group (“CWG”). It also includes the Bank's subsidiaries, Merced Area Investment Development, Inc. ("MAID"), County Asset Advisor, Inc. (“CAA”) and County Investment Trust (“REIT”). Regency Investment Advisors (“RIA”) was a wholly owned subsidiary of the Company from its purchase date in June, 2002 until it was sold in October, 2004.
Forward-Looking Statements
In addition to historical information, this discussion and analysis includes certain forward-looking statements that are subject to risks and uncertainties and include information about possible or assumed future results of operations. Many possible events or factors could affect the future financial results and performance of the Company. This could cause results or performance to differ materially from those expressed in our forward-looking statements. Words such as “expects,” “anticipates,” “believes,” “estimates,” “intends,” “plans,” “assumes,” “projects,” “predicts,” “forecasts,” variations of such words and other similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions which are difficult to assess. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in, or implied by, such forward-looking statements.
Readers of the Company’s Annual Report and Form 10-K should not rely solely on forward looking statements and should consider all uncertainties and risks discussed throughout this report, including the matter discussed under “Risk Factors” below. These statements are representative only on the date hereof, and the Company undertakes no obligation to update any forward-looking statements made. Some possible events or factors that could occur that may cause differences from expected results include the following: the Company’s loan growth is dependent on , among other things, economic conditions, as well as various discretionary factors, such as decisions to sell, or purchase certain loans or loan portfolios; or sell or buy participations of loans; the quality and adequacy of management of the borrower; developments in the industry the borrower is involved in, product and geographic concentrations and the mix of the loan portfolio. The rate of charge-offs and provision expense can be affected by local, regional and international economic and market conditions, concentrations of borrowers, industries, products and geographical conditions, the mix of the loan portfolio and management’s judgments regarding the collectibility of loans. Liquidity requirements may change as a result of fluctuations in assets and liabilities and off-balance sheet exposures, which will impact the capital and debt financing needs of the Company and the mix of funding sources. Decisions to purchase, hold, or sell securities are also dependent on liquidity requirements and market volatility, as well as on, and any off balance sheet positions. Factors that may impact interest rate risk include local, regional and international economic conditions, levels, mix, maturities, yields or rates of assets and liabilities and the wholesale and retail funding sources of the Company. The Company is also exposed to the potential of losses arising from adverse changes in market rates and prices which can adversely impact the value of financial products, including securities, loans, and deposits. In addition, the banking industry in general is subject to various monetary and fiscal policies and regulations, which include those determined by the Federal Reserve Board, the Federal Deposit Insurance Corporation and state regulators, whose policies and regulations affect the Company’s results.
Other factors that may cause actual results to differ from the forward-looking statements include the following: competition with other local and regional banks, savings and loan associations, credit unions and other non-bank financial institutions, such as investment banking firms, investment advisory firms, brokerage firms, mutual funds and insurance companies, as well as other entities which offer financial services; interest rate, market and monetary fluctuations; inflation; market volatility; general economic conditions; introduction and acceptance of new banking-related products, services and enhancements; fee pricing strategies, mergers and acquisitions and their integration into the Company; civil disturbances or terrorist threats or acts, or apprehension about the possible future occurrences or acts of this type, outbreak or escalation of hostilities in which the United States is involved, any declaration of war by the U. S. Congress or any other national or international calamity, crisis or emergency; changes in laws and regulations; recently issued accounting pronouncements; government policies, regulations, and their enforcement (including Bank Secrecy Act-related matters, taxing statutes and regulations); restrictions on dividends that our subsidiaries are allowed to pay to us; the ability to satisfy requirements related to the Sarbanes-Oxley Act and other regulations on internal control; and management’s ability to manage these and other risks factors.
Critical Accounting Policies and Estimates
The Company’s discussion and analysis of its financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and disclosures related thereto, including those regarding contingent assets and liabilities. On an on-going basis, the Company monitors and revises its estimates where appropriate, including those related to the adequacy of the allowance for loan losses, investments, and intangible assets. The Company bases its estimates on historical experience, applicable risk factors and on various other assessments that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates depending on the future circumstances actually encountered.
The Allowance for Loan Losses represents management’s estimate of the amount of probable losses inherent in the loan portfolio as of the balance sheet date. Determining the amount of the Allowance for Loan Losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends, uncertainties and conditions, all of which may be susceptible to significant change. The policies related to the adequacy of the allowance for loan losses can be found in Note 1 to the financial statements, the section titled “Allowance for Loan Losses” as well as in Note 3, titled “Loans” in this report.
A decline in the fair value of any securities that is considered other than temporarily impaired is recorded in our consolidated statements of income in the period in which the impairment occurs. The cost basis of the underlying security is written down to fair value as a new basis. Management considers the Company’s other than temporary impairment accounting policies to be critical, as the timing and amount of income, if any, from these instruments typically depend upon factors beyond the Company’s control. These factors include the general condition of the public equity markets, levels of mergers and acquisitions activity, fluctuations in the market prices of the underlying common stock of these companies, and legal and contractual restrictions on the Company’s ability to sell the underlying securities. The policies related to the valuation of the investment securities can be found in Note 1, the section titled “Investment Securities” in this report as well as Note 2 “Investment Securities”.
Goodwill, which arises from the Company’s purchase price exceeding the fair value of the net assets of an acquired business or other assets. Goodwill represents the value attributable to intangible elements acquired. The value of this goodwill is supported ultimately by profit from the acquired businesses. A decline in earnings could lead to impairment, which would be recorded as a write-down in the Company’s consolidated statements of income. Events that may indicate goodwill impairment include significant or adverse changes in results of operations of the acquired business or asset, economic or political climate; an adverse action or assessment by a regulator; unanticipated competition; and a more likely-than-not expectation that a reporting unit will be sold or disposed of at a loss. The policies related to the adequacy of the goodwill and other intangible assets can be found in Note 1, the section titled “Goodwill” and “Other Intangibles”, and “Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed Of” in this report.
Management must use estimates in accounting for derivative securities. The accounting for changes in fair value depends on whether the derivative instrument is designated and qualifies as part of a hedging relationship and, if so, the nature of the hedging activity. Changes in the fair value of derivatives that do not qualify for hedge treatment, as well as the ineffective portion of a particular hedge, must be recognized in earnings. For derivative instruments that are designated and qualify as a fair value hedge, the gain or loss on the derivative instrument and the offsetting gain or loss on the hedged item attributable to the hedged risk are recognized in earnings in the current period, unless the derivative instrument meets the qualification for the short-cut treatment, as defiled by SFAS No. 133. For derivative instruments that are designated and qualify as a cash flow hedge, changes in the fair value of the effective portion of the derivative instrument are recognized in other comprehensive income (OCI). These amounts are reclassified from OCI and recognized in earnings when either the forecasted transaction occurs or it becomes probable that the forecasted transaction will not occur.
The Company files a consolidated federal income tax return, and consolidated, combined, or separate state income tax returns as appropriate. The Company’s federal and state income tax provisions are based upon taxes payable for the current year as well as current year changes in deferred taxes related to temporary differences between the tax basis and financial statement balances of assets and liabilities. Deferred tax assets and liabilities are included in the consolidated financial statements at currently enacted income tax rates applicable to the period in which the deferred tax assets and liabilities are expected to be realized. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.
Overview
The earnings increase from $12,323,000 in 2004 to $20,954,000 in 2005 was primarily the result of increased net interest income and the absence of an other than temporary impairment charge that was taken in 2004. The earnings decrease in 2004 when compared to 2003 levels, was primarily the result of the following transactions in 2004; an other-than-temporary impairment charge of $3,709,000; the write-off of tax benefits related to the Company’s REIT consent dividend tax benefit of $1,229,000 which resulted to a higher effective tax rate; and increases in noninterest expenses of $2,005,000 which were partially offset by an increase in net interest income of $7,314,000. The growth in assets in 2005 and 2004 was primarily funded through increases in the deposit portfolio as well as increased borrowings. Loan growth was obtained primarily from increased loan production within our existing branch network. The increase in deposits was obtained primarily from increased deposit gathering within our existing branch network. In the opinion of management the Company is well capitalized in accordance with regulatory definitions.
The table below highlights some of the important Consolidated Balance Sheets amounts and their change from 2004 to 2005:
The table below highlights some of the important Consolidated Statements of Income and Comprehensive Income information and their change from 2003 to 2005:
Results of Operations
The Company’s earnings during 2005 were driven primarily by an increase in net interest income. The Company's primary source of revenue is net interest income, which is the difference between interest income and fees derived from earning assets and interest paid on interest-bearing liabilities. The level of interest income is affected by changes in the volume of, and the rates earned on, interest-earning assets. During 2005, the increase in interest income was primarily due to an increase in average earning assets with increased yields on those assets compared to 2004. The primary cause for the increase in rates on interest-earning assets was higher prevailing market rates that were available for reinvestments in 2005 when compared to 2004. During 2004, increases in interest income over 2003 levels were caused primarily by volume increases in average interest earning assets.
Interest expense is a function of the volume of, and rates paid on, interest-bearing liabilities. Interest-bearing liabilities consist primarily of certain deposits and borrowed funds. The increase in volume was primarily attributable to increased market penetration within the Bank’s our existing branch network. If the current interest rate environment remains unchanged during 2006, it is anticipated that the average interest paid on certificates of deposit should stay about the same as maturing accounts “reprice” at their maturities to an anticipated current equivalent interest rate level. If prevailing market interest rates increase or decrease in 2006, then it is anticipated that the average interest paid on certificates of deposit should follow this change in market rates, either up or down, as maturing accounts reprice at their maturities to a market interest rate level.
The Company's net interest margin percentage is the ratio of net interest income to average interest-earning assets. The increase in net interest margin during was primarily the result of increased volumes of interest earning assets coupled with rising short term interest rates earned during much of 2005. If the current interest rate environment continues throughout 2006, it is anticipated the Company’s overall net interest margin should be in the 4.45% to 4.70% range. A modest increase in rates should cause the Company’s net interest margin to slightly increase. A modest decrease in rates should cause the Company’s net interest margin to slightly decrease. In 2005, loans comprised 68% of average interest-earning assets as compared with 67% in both 2004 and 2003. Securities comprised 31% of average interest-earning in 2005 compared with 32% and 31% in 2004 and 2003. Loans earn at a higher interest rate than securities therefore, a higher loan concentration will increase net interest margin.
The Company's net interest income is affected by changes in the volume and mix of interest-earning assets and interest-bearing liabilities. It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds. The changes due to both rate and volume have been allocated to rate and volume in proportion to the relationship of the absolute dollar amount of the change in each.
The Company uses a taxable equivalent method to evaluate performance in its investment portfolio. The taxable equivalent method converts tax benefits into an equivalent pretax interest or dividend income on tax advantaged investment securities. This adjustment is made in order to make yield comparisons using a total economic benefit approach. Taxable equivalent interest income is equal to recorded interest income plus the interest income pretax equivalent of the tax benefit afforded certain investment securities, such as bank qualified state and municipal debt securities and corporate dividends received from certain equity securities. The tax rate used in calculating the taxable equivalent interest income is 35% in 2005, 2004, and 2003.
The increase in taxable equivalent interest income of $19,975,000 in 2005 is comprised of a $13,885,000 volume increase primarily attributable to an increase in interest-earning assets between 2004 and 2005 that was combined with a $6,090,000 increase attributable to rate improvement during this same period. The increase in total interest expense of $7,623,000 in 2005 related to a $2,441,000 volume increase attributable to an increase in average interest-bearing liabilities during 2005 when compared to 2004 that was partially offset with a $5,182,000 increase attributable to rate increases during this same period.
The increase in taxable equivalent interest income of $8,441,000 in 2004 is comprised of a $9,150,000 volume increase attributable to an increase in interest-earning assets between 2003 and 2004 that was partially offset by a $709,000 rate decrease during this same period. The increase in total interest expense of $844,000 in 2004 related to a $1,519,000 volume increase attributable to an increase in average interest-bearing liabilities during 2004 when compared to 2003 that was partially offset by a $675,000 rate decrease during this same period. Interest rate declines were greater for interest earning assets than interest bearing liabilities during 2004.
Provision for Loan Losses
The Company maintains an allowance for loan losses at a level considered by management to be sufficient to absorb the probable losses inherent in its loan portfolio. The provision for loan losses is charged against income and increases the allowance for loan losses. The provision for loan losses for the year ended December 31, 2005 was $2,051,000 compared to $2,731,000 in 2004 and $2,170,000 in 2003. The decreased level of provision for loan losses in 2005 when compared to 2004 was primarily the result of decreased classified credits and decreased nonperforming loan which were partially offset by the reserves that were assigned to higher loan volumes at expected loss experience rates. The increased level of provision for loan losses in 2004 when compared to 2003 was primarily the result of increased loan balances and loan volume. The methodology used to determine the level of provision for loan losses includes an analysis of relevant risk factors within the entire loan portfolio, including nonperforming loans. The methodology is based, in part, on management’s use of an internally developed loan grading and classification system. The Bank’s management grades its loans through internal reviews and periodically subjects loans to external reviews. When performed, these external reviews are presented to, and assessed by, the Bank’s management and the director’s loan committee. In addition, the Audit Committee provides oversight to the external loan review process. Credit reviews are performed three times per year and the quality grading process occurs on a monthly basis. For more information related to the provision for loan loss see the “Allowance for Loan Losses” section.
Noninterest Income
The following table summarizes noninterest income for the years ended December 31,
The increase in 2005 was primarily the result of increased other noninterest income and the absence of an other than temporary impairment on securities in 2005 compared to 2004 where an other than temporary impairment occurred in the fourth quarter. The expense decrease in 2004 was caused primarily by an increase in other than temporary impairment of investment securities that was recorded in the fourth quarter of 2004. The 2004 decrease in noninterest income when compared to 2003 results was also negatively affected by the fact there were no real estate sales in 2004. The decrease in deposit service charges in 2005 was primarily caused by greater balances being held by the Bank’s customers in their commercial demand deposit and NOW accounts that resulted in less fees per account being assessed. The increase in deposit service charges in 2004 and was primarily the result of an increase in demand deposit and NOW accounts in each of these years. Loan packaging fees increased in 2005 primarily due to a strong mortgage market and more affordable terms in that market. Retail investment income declined in 2005 primarily due to the October 15, 2004 divesture of Regency Investment Advisors (“RIA”). Other income includes letters of credit commitment fees, operating recoveries, miscellaneous income and ATM fee income.
Noninterest Expense
The following table summarizes noninterest expense and change for the years ended December 31,
Salary increases were primarily due to staff additions to support growth and normal salary progression. Premises and occupancy increases in 2005 and 2004 were caused primarily by the addition of new branch facilities, an operations center, and improvements in existing branch facilities. The increase in equipment expenses in 2005 was primarily due to the addition of new equipment costs within the branch network and general growth of the Company. The Company’s professional fees include legal, consulting, audit and accounting fees. The Company’s professional fees increased primarily by the retention of an internal auditing consultant whose fees where greater then the prior consultant and increased external auditor fees. The increase in 2004 over 2003 was primarily the result of the implementation and scope of the Sarbanes-Oxley act of 2002. Intangible amortization declined in 2005 primarily because of the full amortization of core deposit premiums on branches purchased from Bank of America in 1997.
The Company’s supplies expense has increased for the last three years in response to branch office growth, changes in regulations and product disclosures, and with paper transaction volumes. Supply expense increases were partially offset by decreases due to an ongoing transition from paper-based to electronic deposit transactions. Generally, as more banking transactions are delivered electronically, paper costs are reduced. Marketing expenses have increased over the past few years as the Company has actively promoted various deposit and loan products using television, newspaper, and other media sources to assist in attracting new, and retaining, existing customers. Also in-branch marketing expenditures have increased steadily during 2004 and 2005. The decrease in intangible amortization was attributable to the full amortization in 2004 of the core deposit premium paid in 1977 for the purchase of three branch offices from Bank of America. Charitable donations have increased in 2005 due to increased giving to the communities we served. Growth in other noninterest expense in was due to increased costs related to the growth of the Company, which include increased costs related to postage, travel, and telephone expenses. The decrease between 2004 and 2003 was related to a decrease in the expenses related to reserves for off balance sheet loan commitments recorded in 2004 when compared to 2003 levels.
Provision for Income Taxes
The Company's provision for income taxes was $9,962,000 in compared to a provision for income taxes of $7,150,000 and $4,857,000 in 2004 and 2003. The effective income tax rates (computed as income taxes as a percentage of income before income taxes) were 32%, 37%, and 26% for 2005, 2004, and 2003. During 2003 and 2005 the tax rate was lower than the statutory rate due in part, to tax credits earned from an investment in low-income housing partnerships that qualify for housing tax credits under Internal Revenue Code Section 42. Also in 2003, the effective tax rate was positively affected by the partial recognition of a REIT consent dividend benefit. No such benefit was recorded in 2004 or 2005. In 2004, the tax rate was in excess of the statutory rate due primarily to the payment of $2,411,000 in state income taxes in conjunction with the State of California’s Voluntary Compliance Initiative in April of 2004. Total housing tax credits for 2005, 2004, and 2003 were approximately $980,000, $1,028,000, and $975,000. In addition, during 2005, 2004, and 2003, the Company realized tax benefits of approximately $1,116,000, $726,000, and $442,000 from nontaxable interest income received from bank qualified municipal securities.
During 2003, California enacted tax legislation that added new penalties for taxpayers that engaged in strategies and transactions that the Franchise Tax Board defined as abusive tax shelters. The new tax shelter regulations gave taxpayers until April 30, 2004 to take advantage of an amnesty period that would allow taxpayers to amend prior year tax filings without being subject to the new tax shelter penalties. Similar to other California based banks, the Company utilized a Real Estate Investment Trust (“REIT”) which had achieved tax savings. Subsequent to our investment, this activity was classified by the California Franchise Tax Board as an abusive tax shelter. Company management believes the strategy used was lawful and defensible, and intends to defend the tax positions taken. This position resulted in a cumulative total of $1,229,000 in recorded tax benefits from the REIT from January 1, 2001 through December 31, 2002. Because of the position taken by the Franchise Tax Board regarding the REIT related state income tax benefits, management decided that all recorded book tax benefits should be completely expensed in 2004.
Securities
The following table sets forth the carrying amount (fair value) of available for sale securities at December 31,
The following table sets forth the carrying amount (amortized cost) and fair value of held to maturity securities at December 31,
Available for sale securities increased $48,966,000 or 18% to $318,155,000 at December 31, 2005 compared with a balance of $269,189,000 at December 31, 2004. Held to maturity securities increased $14,038,000 or 8% to $181,025,000 at December 31, 2005 compared to $166,987,000 outstanding at December 31, 2004. The increase achieved within the available for sale and held to maturity segment of the securities portfolio were made possible by increased deposit inflows and increased Company borrowings that were used to fund increased purchases of investment securities. The single largest component of the Company’s investment portfolio during the last three years has been mortgage-backed securities, which generally provide a higher yielding investment return, but contain a longer maturity than the other types of securities contained within the investment portfolios. At December 31, 2005 and 2004 the Company did not hold any structured notes. See Note 1 and 2 to the Company’s Consolidated Financial Statements for further information concerning the securities portfolio.
Loans
Total loans increased due to, among other things, increased penetration within existing geographic markets. The Company concentrates its lending activities in five principal areas: commercial, agricultural, real estate construction, real estate mortgage, and consumer loans. In the first quarter of 2006 the Company purchased an asset based lending portfolio from Heritage Bank of Commerce for approximately $30,015,000 at the note amount. Interest rates charged for loans made by the Company vary with the degree of risk, the size and term of the loan, and borrowers' depository relationships with the Company and prevailing market rates.
As a result of the Company's loan portfolio mix, the future quality of these assets could be affected by any adverse trends in its geographic market or in the broader economy. These trends are beyond the control of the Company.
The Bank's business activity is with customers located primarily in the counties of Fresno, Madera, Mariposa, Merced, Sacramento, San Francisco, San Joaquin, Stanislaus, and Tuolumne in the state of California. Consumer lending and small working capital total loan portfolio consists of consumer lending, loans to small businesses, credit cards and the purchase of financing contracts principally from automobile dealers. Individual loans and lines of credit are made in a variety of ways. In many cases collateral such as real estate, automobiles and equipment are used to support the extension of credit. Repayment, however, is largely dependent upon the borrower’s personal cash flow.
Commercial lending activities are spread across a wide spectrum of customers including loans to businesses, construction and permanent real estate financing, short and long term agricultural loans for production and real estate purposes and SBA financing. Where appropriate, collateral is taken to secure and reduce the Bank’s credit risk. Each loan is submitted to an individual risk grading process but the borrowers’ ability to repay is dependent, in part, upon factors affecting the local and national economies.
Credit Risk Management and Asset Quality
The Company closely monitors the markets in which it conducts its lending operations and adjusts its strategy to control exposure to loans with higher credit risk. Asset reviews are performed using grading standards and criteria similar to those employed by bank regulatory agencies. Assets receiving lesser grades become "classified assets" which include all nonperforming assets and potential problem loans and receive an elevated level of attention to improve the likelihood of collection. The policy of the Company is to review each loan in the portfolio to identify problem credits. There are three classifications for problem loans: "substandard," "doubtful" and "loss." Substandard loans have one or more defined weaknesses and are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. Doubtful loans have the weaknesses of substandard loans with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. A loan classified as loss is considered uncollectible and its continuance as an asset is not warranted. The level of nonperforming loans and real estate acquired through foreclosure are two indicators of asset quality. Nonperforming loans are those in which the borrower fails to perform under the original terms of the obligation and are categorized as loans past due 90 days or more but still accruing, loans on nonaccrual status and restructured loans. Loans are generally placed on nonaccrual status and accrued but unpaid interest is reversed against current year income when interest or principal payments become 90 days past due unless the outstanding principal and interest is adequately secured and, in the opinion of management, are deemed to be in the process of collection. Loans that are not 90 days past due may also be placed on nonaccrual status if management reasonably believes the borrower will not be able to comply with the contractual loan repayment terms and the collection of principal or interest is in question.
Management defines impaired loans as those loans, regardless of past due status, in which principal and interest are not expected to be collected under the original contractual loan repayment terms. An impaired loan is charged off at the time management believes the collection of principal and interest process has been exhausted. Partial charge-offs are recorded when portions of impaired loans are deemed uncollectable. At December 31, 2005 and 2004, impaired loans were measured based upon the present value of future cash flows discounted at the loan's effective rate, the loan's observable market price, or the fair value of collateral if the loan is collateral dependent.
The Company had impaired loans at December 31, 2005 of $1,692,000 as compared with $4,394,000 at December 31, 2004. The Company recorded $254,000 in specific allowance for loan losses against impaired loans at December 31, 2005 as compared to $704,000 at December 31, 2004. Other forms of collateral, such as inventory, chattel, and equipment secure the remaining nonperforming loans as of each date. The primary reason for the decline in impaired loans between 2004 and 2005 was the strong commercial and residential real estate market that pushed real estate appraised values up to levels not previously experienced in our market area.
At December 31, 2005 and 2004 the Bank had $60,000 of real estate acquired through foreclosure, which consisted of one residential foreclosure property.
Allowance for Loan Losses
In determining the adequacy of the allowance for loan losses, management takes into consideration the growth trend in the portfolio, examinations by financial institution supervisory authorities, internal and external credit reviews, prior loan loss experience of the Company, concentrations of credit risk, delinquency trends, general economic conditions, the interest rate environment, and collateral values. The allowance for loan losses is based on estimates and ultimate losses may vary from current estimates. It is always possible that future economic or other factors may adversely affect the Company's borrowers, and thereby cause loan losses to exceed the current allowance for loan losses.
The balance in the allowance for loan losses was affected by the amounts provided from operations, amounts charged-off and recoveries of loans previously charged off. The Company had provisions to the allowance in 2005 of $2,051,000 as compared to $2,731,000 and $2,170,000 in 2004 and 2003. See “Results of Operations - Provision for Loan Losses.”
The following table summarizes the loan loss experience of the Company for the years ended December 31,
Net Charge-Offs
The decline in charge-offs was driven primarily by a decline in charge-offs of $1,317,000 in the business, construction, and agricultural segments of the loan portfolio. This decline was partially offset by an increase in charge-offs of $572,000 in the lease segment of the Bank’s loan portfolio. A strong real estate market, increased collateral values, and strong profit margin in agriculture have contributed to the overall decline in net charge-offs. Commercial real estate values have increased in 2005 in our market area, which has helped keep net charge-off rates lower in 2005 than those experienced in 2004.
Liquidity
To maintain adequate liquidity requires that sufficient resources be available at all times to meet cash flow requirements of the Company. The need for liquidity in a banking institution arises principally to provide for deposit withdrawals, the credit needs of customers and to take advantage of investment opportunities as they arise. The Company may achieve desired liquidity from both assets and liabilities. The Company considers cash and deposits held in other banks, federal funds sold, other increases in short term investments, maturing loans and investments, receipts of principal and interest on loans, available for sale investments and potential loan sales as sources of asset liquidity. Deposit growth and access to credit lines established with correspondent banks and market sources of funds are considered by the Company as sources of liquidity. The Company is the sole shareholder of the Bank, and derives its primary source of liquidity from its ability to receive dividends from the Bank. Dividends from the Bank are subject to certain regulatory limitations.
The Company reviews its liquidity position regularly based upon its current position and expected trends of loans and deposits. Management believes that the Company maintains adequate amounts of liquid assets to meet its liquidity needs. These assets include cash, demand and time deposits in other banks, available for sale securities and federal funds sold. The Company's liquid assets totaled $410,086,000 and $330,358,000 at December 31, 2005 and 2004 and were 23% of total assets on December 31, 2005 and 2004. Cash and noninterest-bearing deposits in other banks increased $20,877,000 or 52% to $61,331,000 at December 31, 2005, compared to $40,454,000 at December 31, 2004. The increase in the cash position when compared to 2004 was the result of increased cash letters in process of collection at the end of December 2005 when compared to the same period in 2004. Liquidity is also affected by collateral requirements of the Bank’s public agency deposits and certain borrowings. Total pledged securities were $452,337,000 and $321,688,000 at December 31, 2005 and 2004.
Although the Company's primary sources of liquidity include liquid assets and a stable deposit base, the Company maintains lines of credit with certain correspondent banks, the Federal Reserve Bank, and the Federal Home Loan Bank aggregating $260,684,000 of which $93,384,000 was outstanding as of December 31, 2005. This compares with lines of credit of $217,832,000 of which $155,326,000 was outstanding as of December 31, 2004.
The following table sets forth known contractual obligations of the Company at December 31, 2005:
Borrowings, junior subordinated debentures, operating lease obligations and purchase obligations are discussed in the consolidated financial statements at Notes 5, 6, and 9, respectively. The purchase obligation consists of one contract to build a retail branch office in Fresno, California and one contract to build a branch in Clovis, California.
Market and Interest Rate Risk Management
In the normal course of business, the Company is exposed to market risk which includes both price and liquidity risk. Price risk is created from fluctuations in interest rates and the mismatch in repricing characteristics of assets, liabilities, and off-balance sheet instruments at a specified point in time. Mismatches in interest rate repricing among assets and liabilities arise primarily through the interaction of the various types of loans versus the types of deposits that are maintained as well as from management's discretionary investment and funds gathering activities. Liquidity risk arises from the possibility that the Company may not be able to satisfy current and future financial commitments or that the Company may not be able to liquidate financial instruments at market prices. Risk management policies and procedures have been established by the Company and are utilized to manage the Company's exposure to market risk. Quarterly testing of the Company’s assets and liabilities under both increasing and decreasing interest rate environments are performed to insure the Company does not assume a magnitude of risk that is outside approved policy limits.
The Company’s success is largely dependent upon its ability to manage interest rate risk. Interest rate risk can be defined as the exposure of the Company’s net interest income to adverse movements in interest rates. Although the Company manages other risks, such as credit and liquidity risk in the normal course of its business, management considers interest rate risk to be its most significant market risk and could potentially have the largest material effect on the Company’s financial condition and results of operations. Correspondingly, the overall strategy of the Company is to manage interest rate risk, primarily through balance sheet structure, to be interest rate neutral. The Company does use derivative instruments to control interest rate risk.
During the third quarter of 2005, the Company purchased an interest rate floor from Wachovia Bank. The interest rate floor provides the Company with partial protection against an interest rate downturn on loans that are indexed off the Prime rate through September 1, 2010. For more information on the interest rate floor see the Note 1 in the derivative instruments and hedging activities section.
In December 2005, the Bank entered into a repurchase agreement with an embedded LIBOR floor for $100,000,000 with J.P. Morgan. This agreement has a maturity date of December 15, 2010. The repurchase agreement will help to insulate the Company from the effects of a downward rate environment. For more information about the agreement, see Note 5 on “Other Borrowings” in the Company’s 2005 annual report.
The Company’s interest rate risk management is the responsibility of the Asset/Liability Management Committee (ALCO), which reports to the Board of Directors. ALCO establishes policies that monitor and coordinate the Company’s sources, uses and pricing of funds. ALCO is also involved in formulating the economic projections for the Company’s budget and strategic plan. ALCO sets specific rate sensitivity limits for the Company. ALCO monitors and adjusts the Company’s exposure to changes in interest rates to achieve predetermined risk targets that it believes are consistent with current and expected market conditions. Balance sheet management personnel monitor the asset and liability changes on an ongoing basis and provide report information and recommendations to the ALCO committee in regards to those changes.
Earnings Sensitivity
The Company’s net income is dependent on its net interest income. Net interest income is susceptible to interest rate risk to the degree that interest-bearing liabilities mature or reprice on a different basis than interest-earning assets. When interest-bearing liabilities mature or reprice more quickly than interest-earning assets in a given period, a significant increase in market rates of interest could adversely affect net interest income. Similarly, when interest-earning assets mature or reprice more quickly than interest-bearing liabilities, falling interest rates could result in a decrease in net interest income.
The primary analytical tool used by the Company to gauge interest rate sensitivity is a net interest income simulation model that is also used by many other financial institutions. The model, which is updated quarterly, incorporates all of the Company’s assets and liabilities and off-balance sheet funding commitments, together with assumptions that reflect the current interest rate environment. The Company does utilize off-balance sheet derivative financial instruments such as interest rate swaps, or other financial hedging instruments in managing interest rate risk. The model projects changes in cash flow of the various interest-earning assets and interest-bearing liabilities in both rising and falling interest rate environments. Based on the current portfolio mix, this model is used to estimate the effects of changes in market rates on the Company’s net interest income under interest rate conditions that simulate a gradual and sustained shift in the yield curve of up 2 percent and down 2 percent over a twelve month period at December 31, 2005 and up 2 percent and down 1 percent over a twelve month period at December 31, 2004, as well as the effect of immediate and sustained flattening or steepening of the yield curve. This model’s estimate of interest rate sensitivity takes into account the differing time intervals and differing rate change increments of each type of interest sensitive asset and liability.
The estimated impact of immediate changes in interest rates at the specified levels at December 31, 2005 and 2004 is presented in the following tables:
December 31, 2005
Change in interest rates
(In basis points)
Change in net interest
Income(1)
Percentage change in net interest
income
+200
$43,000
0.06%
$(1,745,000)
(2.44)%
December 31, 2004
Change in interest rates
(In basis points)(2)
Change in net interest
Income(1)
Percentage change in net interest
income
+200
$ 536,000
0.95 %
$ (1,002,000)
(1.78) %
(1)
The amount in this column represents the change in net interest income for 12 months in a stable interest rate environment versus the net interest income in the various rate scenarios.
(2)
The change in interest rates downward was limited to 100 basis points due to short term interest rates at levels below 2% at 12/31/04.
It should be emphasized that the foregoing estimate are dependent on material assumptions such as those discussed above. For instance, asymmetrical interest rate behavior can have a material impact on the estimated results.
The Company’s primary objective in managing interest rate risk is to minimize the adverse impact of changes in interest rates on the Company’s net interest income and capital, while structuring the Company’s asset-liability structure to obtain the maximum yield-cost spread on that structure. The Company relies primarily on its asset-liability structure to control interest rate risk. In the opinion of management, the Company is modestly asset sensitive.
Off-Balance Sheet Arrangements
The Bank has also extended firm lending commitments in the form of unused credit lines to loan customers. These commitments may or may not ever be drawn upon, depending on the credit needs of the Bank’s loan customers. For more information regarding these loan commitments, See Footnote 9, titled “Commitments and Financial Instruments with Off-Balance Sheet Credit Risk” in the Company’s 2005 annual report.
Capital Resources
The Company is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate mandatory and possibly additional discretionary actions by the regulators that, if undertaken, could have a material effect on the Company's financial statements. Management believes, as of December 31, 2005, that the Company and the Bank meet all capital requirements to which they are subject. The Company's leverage capital ratio at December 31, 2005 was 8.57% as compared with 8.46% as of December 31, 2004. The Company's total risk-based capital ratio at December 31, 2005 was 11.13% as compared to 11.55% as of December 31, 2004.
First, a bank must meet a minimum Tier I (as defined in the regulations) capital ratio ranging from 3% to 5% based upon the bank's CAMEL (“capital adequacy, asset quality, management, earnings and liquidity”) rating.
Second, a bank must meet minimum total risk based capital to risk weighted assets ratio of 8%. Risk based capital and asset guidelines vary from Tier I capital guidelines by redefining the components of capital, categorizing assets into different risk classes, and including certain off-balance sheet items in the calculation of the capital ratio. The effect of the risk based capital guidelines is that banks with high exposure will be required to raise additional capital while institutions with low risk exposure could, with the concurrence of regulatory authorities, be permitted to operate with lower capital ratios. In addition, a bank must meet minimum Tier I capital to average assets ratio of 4%.
Capital ratios are reviewed on a regular basis to ensure that capital exceeds the prescribed regulatory minimums and is adequate to meet the Company's future needs. All ratios are in excess of the current regulatory definitions of "well capitalized". Management believes that, under the current regulations, the Company will continue to meet its minimum capital requirements in the foreseeable future. Management intends to maintain regulatory capital ratios at well capitalized levels in 2006 and beyond.
The Company has a formal dividend policy, and dividends are issued solely at the discretion of the Company’s Board of Directors, subject to compliance with regulatory requirements. In order to pay any cash dividend, the Company must receive payments of dividends or management fees from the Bank. There are certain legal and regulatory limitations on the payment of cash dividends by banks. Notwithstanding regulatory restrictions, in order for the Company and the Bank to maintain a 10% risk weighted capital ratio, the Company had the ability to pay cash dividends at December 31, 2005 of $15,653,000 and the Bank had the ability to pay cash dividends to the Company of $3,360,000.
Impact of Inflation
The primary impact of inflation on the Company is its effect on interest rates. The Company's primary source of income is net interest income which is affected by changes in interest rates. The Company attempts to limit inflation's impact on its net interest margin through management of rate-sensitive assets and liabilities and the analysis of interest rate sensitivity. The effect of inflation on premises and equipment, as well as noninterest expenses, has not been significant for the periods covered in this report.
Market for Company’s Common Stock and Related Stock Matters
The Company’s stock is included for quotation on the NASDAQ Global Market System with a stock quotation symbol of CCOW.
The following table indicates the range of high and low sales prices for the period shown, based upon information provided by the NASDAQ Global Market System.
* All stock prices are adjusted for the 9 for 5 split announced on March 29, 2005.
Generally, the Company has retained most of its earnings to support the growth of the Company. The Company did not pay regular cash dividends prior to 2004. The Company began paying dividends in the first quarter of 2004. Any future dividends will depend on the Company’s performance, the judgment of the Board as to the appropriateness of declaring a dividend, and compliance with various legal and regulatory provisions which restrict the amount of dividends which the Company may declare. (See “Capital Resources” above).
RISK FACTORS
Readers and prospective investors in our securities should carefully consider the following risk factors as well as the other information contained or incorporated by reference in this report.
The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair our business operations. This report is qualified in its entirety by these risk factors.
If any of the following risks actually occur, the Company’s financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of the Company’s securities could decline significantly, and you could lose all or part of your investment.
Market and Interest Rate Risk
Changes in interest rates could reduce income and cash flow
The discussion in this report under “Market and Interest Rate Risk Management” and “Earnings Sensitivity” is incorporated by reference in this paragraph. The Company’s income and cash flow depend to a great extent on the difference between the interest earned on loans and investment securities, and the interest paid on deposits and other borrowings. We cannot control or prevent changes in the level of interest rates. They fluctuate in response to general economic conditions and the policies of various governmental and regulatory agencies, in particular, the Federal Reserve Board. Changes in monetary policy, including changes in interest rates, will influence the origination of loans, the purchase of investments, the generation of deposits and the rates received on loans and investment securities and paid on deposits and other liabilities.
Risks Related to the nature and geographical location of Capital Corp of the West’s business
Capital Corp of the West invests in loans that contain inherent credit risks that may cause us to incur losses
The Company closely monitors the markets in which it conducts its lending operations and adjusts its strategy to control exposure to loans with higher credit risk. Asset reviews are performed using grading standards and criteria similar to those employed by bank regulatory agencies. We can provide no assurance that the credit quality of our loans will not deteriorate in the future and that such deterioration will not adversely affect Capital Corp of the West.
Capital Corp of the West's operations are concentrated geographically in California, and poor economic conditions may cause us to incur losses
Substantially all of Capital Corp of the West's business is located in California. Capital Corp of the West's financial condition and operating results will be subject to changes in economic conditions in California. In the early to mid-1990s, California experienced a significant and prolonged downturn in its economy, which adversely affected financial institutions, including Capital Corp of the West. Economic conditions in California are subject to various uncertainties at this time, including the decline in the technology sector, the California state government's budgetary difficulties and continuing fiscal difficulties. The Company will be subject to changes in economic conditions. We can provide no assurance that conditions in the California economy will not deteriorate in the future and that such deterioration will not adversely affect Capital Corp of the West.
The markets in which Capital Corp of the West operates are subject to the risk of earthquakes and other natural disasters
Most of the properties of Capital Corp of the West are located in California. Also, most of the real and personal properties which currently secure the Company's loans are located in California. California is a state which is prone to earthquakes, brush fires, flooding and other natural disasters. In addition to possibly sustaining damage to its own properties, if there is a major earthquake, flood or other natural disaster, Capital Corp of the West faces the risk that many of its borrowers may experience uninsured property losses, or sustained job interruption and/or loss which may materially impair their ability to meet the terms of their loan obligations. A major earthquake, flood or other natural disaster in California could have a material adverse effect on Capital Corp of the West's business, financial condition, results of operations and cash flows.
Substantial competition in the California banking market could adversely affect us
Banking is a highly competitive business. We compete actively for loan, deposit, and other financial services business in California. Our competitors include a large number of state and national banks, thrift institutions and credit unions, as well as many financial and nonfinancial firms that offer services similar to those offered by us. Other competitors include large financial institutions that have substantial capital, technology and marketing resources. Such large financial institutions may have greater access to capital at a lower cost than us, which may adversely affect our ability to compete effectively.
Regulatory Risks
Restrictions on dividends and other distributions could limit amounts payable to us
As a holding Company, a substantial portion of our cash flow typically comes from dividends our bank and nonbank subsidiaries pay to us. Various statutory provisions restrict the amount of dividends our subsidiaries can pay to us without regulatory approval. In addition, if any of our subsidiaries liquidate, that subsidiary's creditors will be entitled to receive distributions from the assets of that subsidiary to satisfy their claims against it before we, as a holder of an equity interest in the subsidiary, will be entitled to receive any of the assets of the subsidiary.
Adverse effects of, or changes in, banking or other laws and regulations or governmental fiscal or monetary policies could adversely affect us
We are subject to significant federal and state regulation and supervision, which is primarily for the benefit and protection of our customers and not for the benefit of investors. In the past, our business has been materially affected by these regulations. This trend is likely to continue in the future. Laws, regulations or policies, including accounting standards and interpretations currently affecting us and our subsidiaries, may change at any time. Regulatory authorities may also change their interpretation of these statutes and regulations. Therefore, our business may be adversely affected by any future changes in laws, regulations, policies or interpretations or regulatory approaches to compliance and enforcement, including legislative and regulatory reactions to the terrorist attack on September 11, 2001 and future acts of terrorism, and major U.S. corporate bankruptcies and reports of accounting irregularities at U.S. public companies.
Additionally, our business is affected significantly by the fiscal and monetary policies of the federal government and its agencies. We are particularly affected by the policies of the Federal Reserve Board, which regulates the supply of money and credit in the U.S. Under long-standing policy of the Federal Reserve Board, a bank holding Company is expected to act as a source of financial strength for its subsidiary banks. As a result of that policy, we may be required to commit financial and other resources to our subsidiary bank in circumstances where we might not otherwise do so. Among the instruments of monetary policy available to the Federal Reserve Board are (a) conducting open market operations in U.S. government securities, (b) changing the discount rates of borrowings by depository institutions, and (c) imposing or changing reserve requirements against certain borrowings by banks and their affiliates. These methods are used in varying degrees and combinations to directly affect the availability of bank loans and deposits, as well as the interest rates charged on loans and paid on deposits. The policies of the Federal Reserve Board may have a material effect on our business, results of operations and financial condition.
Systems, Accounting and Internal Control Risks
The accuracy of the Company’s judgments and estimates about financial and accounting matters will impact operating results and financial condition
The discussion under “Critical Accounting Policies and Estimates” in this report and the information referred to in that discussion is incorporated by reference in this paragraph. The Company’s makes certain estimates and judgments in preparing its financial statements. The quality and accuracy of those estimates and judgments will have an impact on the Company’s operating results and financial condition.
The Company’s information systems may experience an interruption or breach in security
The Company relies heavily on communications and information systems to conduct its business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in the Company’s customer relationship management and systems. There can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately corrected by the Company. The occurrence of any such failures, interruptions or security breaches could damage the Company’s reputation, result in a loss of customer business, subject the Company to additional regulatory scrutiny, or expose the Company to litigation and possible financial liability, any of which could have a material adverse effect on the Company’s financial condition and results of operations.
The Company’s controls and procedures may fail or be circumvented
Management regularly reviews and updates the Company’s internal control over financial reporting, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls and procedures, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the Company’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Company’s business, results of operations and financial condition.
CAPITAL CORP OF THE WEST AND SUBSIDIARIES
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management of Capital Corp of the West and subsidiaries (the “Company”) is responsible for establishing and maintaining effective internal control over financial reporting. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles.
Under the supervision and with the participation of management, including the principal executive officer and principal financial officer, the Company conducted an evaluation of the effectiveness of internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management of the Company has concluded the Company maintained effective internal control over financial reporting, as such term is defined in Securities Exchange Act of 1934 Rules 13a-15(f), as of December 31, 2005.
Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting can also be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the Company’s financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk.
Management is also responsible for the preparation and fair presentation of the consolidated financial statements and other financial information contained in this report. The accompanying consolidated financial statements were prepared in conformity with U.S. generally accepted accounting principles and include, as necessary, best estimates and judgments by management.
KPMG LLP, an independent registered public accounting firm, has audited the Company’s consolidated financial statements as of and for the year ended December 31, 2005, and the Company’s assessment as to the effectiveness of internal control over financial reporting as of December 31, 2005, as stated in their reports, which are included herein.
/s/ Thomas T. Hawker
Director/CEO and
March 14, 2006
THOMAS T. HAWKER
Principal Executive Officer
/s/ R. Dale McKinney
Chief Financial Officer
March 14, 2006
R. DALE MCKINNEY
Principal Financial and
Accounting Officer
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of
Capital Corp of the West:
We have audited management's assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that Capital Corp of the West and subsidiaries (the Company) maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management's assessment that Capital Corp of the West and subsidiaries maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Capital Corp of the West and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Capital Corp of the West and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income and comprehensive income, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2005, and our report dated March 13, 2006 expressed an unqualified opinion on those consolidated financial statements.
/s/ KPMG LLP
Sacramento, California
March 13,
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of
Capital Corp of the West:
We have audited the accompanying consolidated balance sheets of Capital Corp of the West and subsidiaries (the Company) as of December 31, 2005 and 2004, and the related consolidated statements of income and comprehensive income, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2005. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Capital Corp of the West and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Capital Corp of the West’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 13, 2006 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
/s/ KPMG LLP
Sacramento, California
March 13,
Capital Corp of the West
Consolidated Balance Sheets
See accompanying notes to consolidated financial statements
Capital Corp of the West
Consolidated Statements of Income and Comprehensive Income
See accompanying notes to consolidated financial statements
Capital Corp of the West
Consolidated Statements of Shareholders’ Equity
See accompanying notes to consolidated financial statements
Capital Corp of the West
Consolidated Statements of Cash Flows
See accompanying notes to consolidated financial statements
NOTE 1. Summary of Significant Accounting Policies
Capital Corp of the West (the "Company") is a registered bank holding company, whose bank subsidiary provides a full range of banking services to individual and business customers primarily in the Central San Joaquin Valley, through its subsidiaries. The following is a description of the significant policies.
Principles of Consolidation: The consolidated financial statements of Capital Corp of the West include its subsidiaries: County Bank (the "Bank"), Capital West Group (“CWG”), Regency Investment Advisors (“RIA”), and the subsidiaries of County Bank which include County Asset Advisor, Inc. (“CAA”), Merced Area Investment Development, Inc. (“MAID”), and County Investment Trust (“REIT”). CWG, a subsidiary formed in 1996, became inactive in 1997. Regency Investment Advisors was acquired in June 2002 and divested in October 2004. All significant intercompany balances and transactions are eliminated.
The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period. Actual results could differ from those estimates applied in the preparation of the consolidated financial statements. A material estimate that is particularly susceptible to change in the near term relates to the determination of the allowance for loan losses.
Cash and Cash Equivalents: The Company maintains deposit balances with various banks which are necessary for check collection and account activity charges. Cash in excess of immediate requirements is invested in federal funds sold or other short-term investments. Generally, federal funds are sold for periods from one to thirty days. Cash, noninterest-bearing deposits in other banks and federal funds sold are considered to be cash and cash equivalents for the purposes of the consolidated statements of cash flows. Banks are required to maintain minimum average reserve balances with the Federal Reserve Bank. The amount of those reserve balances was approximately $25,000 at December 31, 2005 and 2004.
Investment Securities: Investment securities consist of federal agencies, state and county municipal securities, corporate bonds, mortgage-backed securities, collateralized mortgage obligations, agency preferred stock, trust preferred stock and equity securities. Investment securities are classified into one of three categories. These categories include trading, available for sale, and held to maturity. The category of each security is determined based on the Company’s investment objectives, operational needs and intent. The Company has not purchased securities with the intent of actively trading them.
Securities available for sale may be sold prior to maturity and are available for future liquidity requirements. These securities are carried at fair value. Unrealized gains and losses on securities available for sale are excluded from earnings and reported net of tax as a separate component of shareholders' equity until realized.
Securities held to maturity are classified as such where the Company has the ability and positive intent to hold them to maturity. These securities are carried at cost, adjusted for amortization of premiums and accretion of discounts.
Premiums and discounts are amortized or accreted over the life of the related investment security as an adjustment to yield using the effective interest method. Dividend and interest income are recognized when earned. Realized gains and losses for securities classified as available for sale or held to maturity are included in earnings and are derived using the specific identification method for determining the cost of securities sold. Unrealized losses due to fluctuations in fair value of securities held to maturity or available for sale are recognized through earnings when it is determined that there is other than temporary impairment and a new basis is then established for the security.
Loans: Loans are carried at the principal amount outstanding, net of unearned income, including deferred loan origination fees and other costs. Nonrefundable loan origination and commitment fees and the estimated direct labor costs associated with originating or acquiring the loans are deferred and amortized as an adjustment to interest income over the life of the related loan using a method that approximates the level yield method.
Interest income on loans is accrued based on contract interest rates and principal amounts outstanding. Loans which are more than 90 days delinquent, with respect to interest or principal, are placed on non-accrual status, unless the outstanding principal and interest is adequately secured and, in the opinion of management, remains collectable. Uncollected accrued interest on nonaccrual loans is reversed against interest income, and interest is subsequently recognized only as received until the loan is returned to accrual status. Interest accruals are resumed when such loans are brought fully current with respect to interest and principal and when, in the judgment of management, the loans are estimated to be fully collectable as to both principal and interest.
A loan is considered impaired, if it is probable that the Company will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Any allowance for loan losses on impaired loans is measured based upon the present value of future cash flows discounted at the loan's effective rate, the loan's observable market price, or the fair value of collateral if the loan is collateral dependent. Interest on impaired loans is recognized on a cash basis. In general, these statements above are not applicable to large groups of small balance homogenous loans that are collectively evaluated for impairment, such as residential mortgage and consumer installment loans. Income recognition on impaired loans conforms to the method the Company uses for income recognition on nonaccrual loans. Interest income on nonaccrual loans is recorded on a cash basis. Payments may be treated as interest income or return of principal depending upon management’s opinion of the ultimate risk of loss on the individual loan. Cash payments are treated as interest income when management believes the remaining principal balance is fully collectable.
Allowance for Loan Losses: The allowance for loan losses is maintained at the level considered to be adequate to absorb probable inherent loan losses based on management's assessment of various factors affecting the loan portfolio, which include: growth trends in the portfolio, historical experience, concentrations of credit risk, delinquency trends, general economic conditions, underlying collateral and internal and external credit reviews. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance for loan losses based on their judgment of information available to them at the time of their examination. Additions to the allowance for loan losses, in the form of provision for loan losses, are reflected in current operating results, while charge-offs to the allowance for loan losses are made when a loss is determined to have occurred. Recoveries on loans previously charged off increases the allowance for loan losses and are not reflected in the Consolidated Statements of Income and Comprehensive Income.Management uses the best information available on which to base estimates, however, ultimate losses may vary from current estimates.
Reserve for Unfunded Loan Commitments: The Company reserves for the possibility of an unfunded loan commitment being funded and subsequently being charged off. Each quarter, the Bank’s unfunded credit obligations are reviewed and assigned a risk factor. The reserve for unfunded loan commitments is either increased or decreased to insure that it represents the volume of unfunded loan commitments multiplied by the assigned risk factor.
Gain or Loss on Sale of Loans: Transfers of real estate mortgage loans held for sale in which the Company surrenders control over those loans are accounted for as a sale to the extent that consideration other than beneficial interests in the transferred loans is received in exchange. Gains or losses are recognized at the time of sale and are reported in noninterest income. All loan sales during 2005, 2004 and 2003 were sales of the guaranteed portion of loans that received partial guarantees from the Small Business Administration (“SBA”). The SBA typically guarantees a major portion of small business loans that meet the SBA’s underwriting and collateral requirements. In 2005, 2004 and 2003 the Company recognized a gain on the sale of loans of $235,000, $251,000 and $296,000.
Premises and Equipment: Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are computed on the straight line basis over the estimated useful life of each type of asset. Estimated useful lives range up to 39 years for buildings, up to the lease term for leasehold improvements, and 3 to 15 years for furniture and equipment.
Other Real Estate: Other real estate is comprised of property acquired through foreclosure proceedings or acceptance of deeds-in-lieu of foreclosure. Losses recognized at the time of acquiring property in full or partial satisfaction of debt are charged against the allowance for loan losses. Other real estate is recorded at the lower of the related loan balance or fair value, less estimated disposition costs. Fair value of other real estate is generally based on an independent appraisal of the property. Any subsequent costs or losses are recognized as noninterest expense when incurred.
Goodwill and Other Intangible Assets: Goodwill represents the excess of costs over the fair value of net assets of businesses acquired. Goodwill was generated with the purchase of the Town and County Finance and Thrift (the “Thrift”) in June 1996. The Thrift’s assets, including intangible assets, were subsequently merged into County Bank in November 1999, and the Thrift’s charter eliminated. Goodwill associated with the purchase of the Thrift is no longer being amortized beginning on January 1, 2002 and had a balance of $1,405,000 as of December 31, 2005 and 2004. The goodwill associated with the purchase of Regency Investment Advisors Inc. in June 2002 was $520,000. RIA was subsequently sold in the third quarter of 2004. There is no goodwill on the Balance Sheet related to RIA at December 31, 2005 and 2004. Core deposit intangibles, representing the excess of purchase price paid over the fair value of net savings deposits acquired, were generated by the purchase of the Thrift in June 1996 and the purchase of three branches from the Bank of America in December, 1997. Core deposit intangibles resulting from these acquisitions are being amortized over 10 and 7 years, respectively. Core deposit intangibles had a balance of $23,000 and $69,000 as of December 31, 2005 and 2004. Amortization of core deposit premiums was $46,000, $655,000, and $676,000 for the years ended December 31, 2005, 2004 and 2003. Core deposit premiums are scheduled to amortize by $23,000 in the year 2006 and are scheduled to be fully amortized by December 2006. Goodwill and intangible assets are reviewed on an annual basis for impairment. If impairment is indicated, recoverability of the asset is assessed based upon expected undiscounted net cash flows.
An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. This determination is made at the reporting unit level and consists of two steps. First, the Company determines the fair value of a reporting unit and compares it to its carrying amount. Second, if the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation, in accordance with FASB Statement No. 141, Business Combinations. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. There has been no impairment losses recognized on the Town and Country Finance and Thrift recorded goodwill as of December 31, 2005.
Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of: Long-lived assets, such as property, plant, and equipment and certain purchased intangibles subject to amortization are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future net cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, such an asset is considered to be impaired, and an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposed group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet.
Director Elective Income Deferral Agreements: The Company has purchased single premium universal life insurance policies in conjunction with implementation of salary continuation plans for certain members of management, a deferred compensation plan for certain members of the Board of Directors, and for general funding of various benefit programs of the company. This plan was changed in 2004 and is currently being used by five directors. The expenses related to the deferral agreements are accrued in other expenses. The Company is the owner and beneficiary of these policies. The Bank has also formed a Rabbi trust and has irrevocably assigned some of these universal life insurance policies to the Rabbi trust in support of these salary continuation and deferred compensation benefits. The cash surrender value of the insurance policies totaled $31,796,000 and $28,362,000 as of December 31, 2005 and 2004. Income from these policies is recorded in noninterest income and the load, mortality and surrender charges have been recorded in other expenses. An accrued liability of $3,885,000 and $3,610,000 as of December 31, 2005 and 2004 was recorded to reflect the present value of the expected retirement benefits for the salary continuation plans and the deferred compensation benefits and was included in other liabilities. Salary continuation expense of $339,000 and $484,000 and deferred compensation expense of $89,000 and $97,000 was recorded for the years ending December 31, 2005 and 2004.
Advertising Costs: The Company expenses all advertising costs as incurred.
Income Taxes: The Company files a consolidated federal income tax return and a combined state franchise tax return. The provision for income taxes includes federal income and state franchise taxes. Income tax expense is allocated to each entity of the Company based upon the analysis of the tax consequences of each company on a stand alone basis.
The Company accounts for income taxes under the asset and liability method. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company establishes a tax valuation allowance when a recorded tax benefit is not expected to be fully realized. The expense to create the tax valuation is recorded as an additional income tax expense in the period the tax valuation allowance is created.
Income Tax Credits: The Company has investments in limited partnerships which own low income affordable housing projects that generate tax benefits in the form of federal and state housing tax credits. As an investor in these partnerships, the Company receives tax benefits in the form of tax deductions from partnership operating losses and income tax credits. These income tax credits are earned over a 10-year period as a result of the investment meeting certain criteria and are subject to recapture over a 15-year period. The expected benefit resulting from the affordable housing income tax credits (“HTC”) is recognized in the period in which the tax benefit is recognized in the Company's consolidated tax returns. These investments are accounted for using the cost method and are evaluated at each reporting period for impairment. The Bank had gross investments in these partnerships of $11,727,000 and $10,901,000 as of December 31, 2005 and 2004. The difference between the Bank’s gross investment in these HTC partnerships and the net book value of these partnerships is a valuation reserve that has been established to reflect the negative cash flows of these HTC projects and its effect on the value of the underlying assets of each partnership.
Securities Purchased and Sold Agreements: Securities under resale agreements and securities sold under repurchase agreements are generally accounted for as collateralized financing transactions and are recorded at the amount at which the securities were acquired or sold plus accrued interest. It is the Company’s policy to take possession of securities purchased under resale agreements, which are primarily U.S. Government agency securities. The market value of securities purchased and sold is monitored and collateral is obtained from or returned to the counterparty when appropriate.
Derivative Instruments and Hedging Activities: The Company accounts for derivatives and hedging activities in accordance with FASB Statement No. 133, Accounting for Derivative Instruments and Certain Hedging Activities, as amended, which requires that all derivative instruments be recorded on the balance sheet at their respective fair values.
On the date a derivative contract is entered into, the Company designates the derivative as either a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge), a hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge), a foreign-currency fair-value or cash-flow hedge (foreign currency hedge), or a hedge of a net investment in a foreign operation. For all hedging relationships the Company formally documents the hedging relationship and its risk-management objective and strategy for undertaking the hedge, the hedging instrument, the hedged item, the nature of the risk being hedged, how the hedging instrument’s effectiveness in offsetting the hedged risk will be assessed prospectively and retrospectively, and a description of the method of measuring ineffectiveness. This process includes linking all derivatives that are designated as fair-value, cash-flow, or foreign-currency hedges to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions. The Company also formally assesses, both at the hedge’s inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. Changes in the fair value of a derivative that is highly effective and that is designated and qualifies as a fair-value hedge, along with the loss or gain on the hedged asset or liability or unrecognized firm commitment of the hedged item that is attributable to the hedged risk, are recorded in earnings. Changes in the fair value of a derivative that is highly effective and that is designated and qualifies as a cash-flow hedge are recorded in other comprehensive income to the extent that the derivative is effective as a hedge, until earnings are affected by the variability in cash flows of the designated hedged item. Changes in the fair value of derivatives that are highly effective as hedges and that are designated and qualify as foreign-currency hedges are recorded in either earnings or other comprehensive income, depending on whether the hedge transaction is a fair-value hedge or a cash-flow hedge. However, if a derivative is used as a hedge of a net investment in a foreign operation, its changes in fair value, to the extent effective as a hedge, are recorded in the cumulative translation adjustments account within other comprehensive income. The ineffective portion of the change in fair value of a derivative instrument that qualifies as a cash-flow hedge is reported in earnings. Changes in the fair value of derivative trading instruments are reported in current period earnings.
The Company discontinues hedge accounting prospectively when it is determined that the derivative is no longer effective in offsetting changes in the fair value or cash flows of the hedged item, the derivative expires or is sold, terminated, or exercised, the derivative is designated as a hedging instrument, because it is unlikely that a forecasted transaction will occur, a hedged firm commitment no longer meets the definition of a firm commitment, or management determines that designation of the derivative as a hedging instrument is no longer appropriate.
In all situations in which hedge accounting is discontinued and the derivative is retained, the Company continues to carry the derivative at its fair value on the balance sheet and recognizes any subsequent changes in its fair value in earnings. When hedge accounting is discontinued because it is determined that the derivative no longer qualifies as an effective fair-value hedge, the Company no longer adjusts the hedged asset or liability for changes in fair value. The adjustment of the carrying amount of the hedged asset or liability is accounted for in the same manner as other components of the carrying amount of that asset or liability. When hedge accounting is discontinued because the hedged item no longer meets the definition of a firm commitment, the Company removes any asset or liability that was recorded pursuant to recognition of the firm commitment from the balance sheet, and recognizes any gain or loss in earnings. When it is probable that a forecasted transaction will not occur, the Company discontinues hedge accounting if not already done and recognizes immediately in earnings gains and losses that were accumulated in other comprehensive income.
Earnings Per Share: Basic earnings per share (EPS) includes no dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution of securities that could share in the earnings of an entity.
On January 25, 2005, April 26, 2005, July 26, 2005, October 25, 2005 and January 24, 2006, the Board of Directors authorized a $0.05 cash dividend payable on February 25, 2005, May 26, 2005, August 26, 2005, November 25, 2005, and February 28, 2006 respectively.
The following table provides a reconciliation of the numerator and denominator of the basic and diluted earnings per share computation for the years ended December 31:
In 2005, 2004, and 2003 there were options covering 17,051, 0, and 7,675 shares that were not considered in the earnings per share computations because the option exercise price was in excess of the stock closing price on December 31, 2005, 2004 and 2003 making these shares antidilutive.
Stock Option Plan: During 2005, 2004 and 2003, for annual reporting periods beginning after June 15, 2005, equity based compensation will be accounted for by the Company, using the fair value method. During 2005, 2004 and 2003, the Company accounted for stock-based awards to employees and directors using the intrinsic value method of accounting in accordance with Accounting Principles Board Opinion No. 25. Under the intrinsic value method, compensation cost is generally the excess, if any, of the quoted market price of the stock at the grant or other measurement date over the exercise price. Statement of Financial Accounting Standards No 148, “Accounting for Stock Based Compensation-Transition and Disclosure” an amendment of FASB Statement No. 123 and revised Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” establish financial accounting and reporting standards for stock-based compensation plans, including employee stock purchase plans, stock options and restricted stock. Statement No. 148 and 123R encourages all entities to adopt a fair value method of accounting for stock-based compensation plans, whereby compensation cost is measured at the grant date upon the fair value of the award and is realized as an expense over the service or vesting period. However, Statement No. 148 and 123 also allow an entity to continue to measure compensation cost for these plans using the intrinsic value method of accounting prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” as long as proforma fair market method disclosures of net income, basic earnings per share, diluted earnings per share and stock-based compensation costs, net of related tax effects, are prominently disclosed. See Note 12 for additional disclosure information relative to options granted and outstanding.
The Company applies APB Opinion No. 25 in accounting for its stock options and, accordingly, no compensation cost has been recognized for its stock options, except as explained in the action by the November board of directors action noted below, in the accompanying consolidated financial statements. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS No. 123, Accounting for Stock-Based Compensation, the Company’s net income would have been reduced to the proforma amounts indicated as follows:
On November 29, 2005, the Company’s board of directors approved the 100% vesting of all existing unvested stock options outstanding. All the options affected were in-the-money, and were held by certain members of management and the board of directors. The board took this action so that the Company would not have to recognize equity compensation expense in the Consolidated Statements of Income and Comprehensive Income on the unvested portion of the stock options outstanding as of November 29, 2005. The unvested equity compensation expense related to this action was $2,409,000. During 2005, the Company recorded equity compensation expense related to this board action of $150,000 to reflect management’s estimate of additional equity compensation expense incurred that relates to the forfeiture of stock options that occurs when management or members of the board of directors leave the Company. Equity compensation expense will be recognized in the Consolidated Statements of Income and Comprehensive Income beginning in 2006 for any stock options issued after November 29, 2005.
Total compensation expense related to the issuance of options that would have been reported was $2,951,000, $972,000, and $601,000 during 2005, 2004 and 2003, respectively.
The per share weighted average fair value of stock options granted during 2005, 2004, and 2003 was $10.11, $7.76, and $6.12 on the date of grant using the Black Scholes option pricing model with the following weighted average assumptions: 2005, 2004, and 2003 expected dividend yield of 0.5%, 0.4% and 0%; 2005, 2004, and 2003 expected volatility of 29%, 26%, and 29%; and a risk free interest rate of 4.07%, 4.00%, and 4.75% for 2005, 2004, and 2003, and an expected life of 6.32, 7, and 7 years in 2005, 2004, and 2003, respectively.
Comprehensive Income: Comprehensive income consists of net income and unrealized gains (losses) on securities and certain derivative instruments and is presented in the consolidated statements of income and comprehensive income.
Reclassifications: Certain amounts in the 2004 and 2003 consolidated financial statements have been reclassified to conform with the 2005 presentation. The reclassification that pertains to this statement is the reserve for unfunded loan commitments. For more information regarding the reserve for unfunded loan commitments, see the discussion earlier in Note 1.
NOTE 2. Investment Securities
The amortized cost and estimated market value of investment securities at December 31 are summarized below:
At December 31, 2005 and 2004, investment securities with carrying values of approximately $452,337,000 and $321,688,000, respectively, were pledged as collateral for deposits of public funds, government deposits, the Bank's use of the Federal Reserve Bank's discount window and Federal Home Loan Bank line of credit. The Bank is a member of the Federal Reserve Bank and the Federal Home Loan Bank. The Bank carried balances, stated at cost, of $7,888,000 and $7,304,000 of Federal Home Loan Bank stock and $1,187,000 of Federal Reserve Bank stock as of December 31, 2005 and 2004. Gross realized losses on sale of available for sale securities of $0, $6,000, and $0, were recognized in 2005, 2004, and 2003. Gross realized gains on sale of available for sale securities of $0, $50,000, and $0 were recognized in 2005, 2004, and 2003. Gross losses on sale of available for sale securities were $0, $3,715,000, and $0 in 2005, 2004, and 2003. The gross losses on sale of available for sale securities in 2004 is composed of an unrealized other-than-temporary impairment loss of $3,709,000 and a realized loss of $6,000 on the sale of available for sale securities.
In June, 2003, state and municipal debt securities with a carrying value of $24,558,000 and a market value of $26,204,000 were transferred from the available for sale portfolio to the held to maturity portfolio at market value. The Company made the decision based on management’s intent to hold these securities to maturity. The unrealized holding gain at the date of transfer is reported as accumulated other comprehensive income, a separate component of shareholders’ equity, and amortized over the remaining life of the securities as an adjustment of yield in a manner consistent with the amortization of a premium or accretion of a discount.
The carrying and estimated fair values of debt securities at December 31, 2005 by contractual maturity, are shown on the following table. Actual maturities may differ from contractual maturities because issuers generally have the right to call or prepay obligations with or without call or prepayment penalties.
Gross unrealized losses on investment securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2005, were as follows:
Gross unrealized losses on investment securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2004, were as follows:
The Company has determined that unrealized losses on debt securities were driven primarily by increases in interest rates over the last year. The Company has the ability and intent to retain it’s investments until maturity or until anticipated recovery in market value occurs. No other-than-temporary impairment was recorded in 2005.
The Company invests in mutual funds that hold adjustable rate mortgage loan investments which fluctuate in value with prevailing market interest rates. The unrealized losses on equity securities were primarily caused by generally rising market rates during 2005. The market price of adjustable rate loans declines during periods of rising interest rates. There was one investment in an adjustable rate mortgage mutual fund that had a fair value of $12,549,000 and an unrealized loss of $393,000 as of December 31, 2005. In addition, the Company holds an investment in a CRA mutual fund that had a fair market value of $2,933,000 and an unrealized loss of $67,000 as of December 31, 2005. Both mutual funds have been in an unrealized loss position for 12 consecutive months as of December 31, 2005. Due to the fact the Company has the ability and intent to hold this investment until a market price recovery, this investment is not considered other-than-temporarily impaired.
Loans are net of deferred loan fees of $3,183,000 and $2,446,000, as of December 31, and 2004. Consumer loans are net of deferred loan costs of $874,000 and $401,000 as of December 31, 2005 and 2004.
Nonaccrual loans totaled $1,692,000 and $4,394,000 at December 31, 2005 and 2004. Foregone interest on nonaccrual loans was approximately $63,000, $4,000, and $39,000 for the years ended December 31, 2005, 2004 and 2003.
Impaired loans are loans which, based on current information and events, management believes it is probable that the Bank will be unable to collect all amounts due according to the contractual terms of the loan agreement. At December 31, 2005 and 2004, the recorded investment in impaired loans was $1,692,000 and $4,394,000 which had a related allowance for loan losses of $254,000 and $704,000 in 2005 and 2004. As of December 31, 2005 and 2004, there were no impaired loans without a related allowance for loan loss assigned to them. The average outstanding balance of impaired loans for the years ended December 31, 2005, 2004 and 2003 was $2,236,000, $4,206,000, and $2,328,000 on which $88,000, $216,000, and $231,000 was recognized as interest income on a cash basis.
At December 31, 2005 and 2004, the collateral value method was used to measure impairment for all loans classified as impaired. The following table shows the recorded investment in impaired loans by loan category at December 31:
The following is a summary of changes in the allowance for loan losses during the years ended December 31:
The following is a summary of changes in the reserve for unfunded loan commitments during the years ended December 31:
In the ordinary course of business, the Company, through its subsidiaries, has made loans to certain directors and officers and their related businesses. In management's opinion, these loans are granted on substantially the same terms, including interest rates and collateral, as those prevailing on comparable transactions with unrelated parties, and do not involve more than the normal risk of collectibility.
Activity in loans to, or guaranteed by, directors and executive officers and their related businesses at December 31, are summarized as follows:
NOTE 4. Premises and Equipment
Premises and equipment consisted of the following at December 31:
Depreciation expense totaled $2,411,000, $1,717,000, and $1,661,000 in 2005, 2004, and 2003. Interest is capitalized during the branch office construction period totaled $6,000 and $0 in 2005 and 2004. Capitalized lease payments during the branch office construction period totaled $45,000 and $0 in 2005 and 2004.
NOTE 5. Other Borrowings
The following is a summary of selected information for other borrowings. These borrowings generally mature in less than one year:
(1) The Treasury tax loan is a variable rate product that reprices weekly based on the Federal Funds rate. The account is payable on a daily basis.
The Company maintains a secured line of credit with the Federal Home Loan Bank of San Francisco (FHLB). Based on the FHLB stock requirements at December 31, 2005, this line provided for maximum borrowings of $160,583,000 of which $93,384,000 was outstanding. At December 31, 2005 this borrowing line was collateralized by securities with a market value of $169,034,000. At December 31, 2004, the line of credit was collateralized by securities with a market value of $163,956,000 of which $155,326,000 was outstanding. At December 31, 2004 this borrowing line is collateralized by securities with a market value of $172,585,000. The Company had additional secured, unused lines of credit of $29,301,000 and unsecured unused lines of credit of $70,800,000 at December 31, 2005. This compares with secured, unused lines of credit of $9,876,000 and unsecured unused lines of credit of $44,000,000 as of December 31, 2004. As part of this agreement, the Bank has borrowed $100,000,000 that is fully secured by $100,000,000 in investment securities that serve as collateral for the debt obligation.
In December 2005, the Bank entered into a repurchase agreement for $100,000,000. This agreement has a maturity date of December 15, 2010. The Bank pays the month LlBOR rate plus 0.295%, reset quarterly, on this repurchase agreement for five years, with an embedded floor that drives down funding cost further if the 3 month LlBOR falls below 4%, with the minimum funding cost at 0%. The formula for the quarterly reset is as follows: [3 Month LIBOR + 0.295%]- the larger of 0% or 4.00% - 3 Month LIBOR. The repurchase agreement has an embedded derivative that does not qualify as a separate derivative as defined by SFAS No. 133 and SFAS No. 149. The Financial Accounting Standards Board ("FASB") is considering adding repurchase agreement accounting to its agenda of new projects. If this were to occur, the FASB may provide additional guidance related to the accounting for repurchase agreements in the future.
The following is a summary of selected information for long-term borrowings. These borrowings generally mature in greater than one year.
Interest expense related to FHLB borrowings totaled $4,447,000, $4,368,000, and $4,069,000 in 2005, 2004, and 2003. Interest expense related to the mortgage note totaled $230,000, $236,000, and $240,000 in 2005, 2004, and 2003. This long term note is secured by Company land and buildings. Interest expense on federal funds purchased was $438,000, $21,000, and $11,000 in 2005, 2004, and 2003. Compensating balance arrangements are not significant to the operations of the Company.
Principal payments required to service the Company's borrowings during the next five years and thereafter are:
NOTE 6. Junior Subordinated Debentures
At December 31, 2005 the Company had 2 wholly-owned trusts (“Trusts”) that were formed to issue trust preferred securities and related common securities of the Trusts. As a result of adoption of FASB Interpretation Number 46R, the Company deconsolidated the Trusts as of and for the years ended December 31, 2005 and 2004. There was $16,496,000 of junior subordinated debentures issued and outstanding as of December 31, 2005 and 2004. The junior subordinated debentures were reflected as long-term debt in the consolidated balance sheets at December 31, 2005 and 2004.
County Statutory Trust I and County Statutory Trust II are Connecticut statutory trusts, which were formed for the purpose of issuing County Statutory Trust I Capital Securities and County Statutory Trust II Capital Securities (“Trust Preferred Securities”). The Trust Preferred Securities are described below. Interest on the Trust Preferred Securities is payable semi-annually on the 10.20% issue and quarterly on the Statutory Trust II issue and is deferrable, at the option of the Company for up to five years for both issues. Following the issuance of the Trust Preferred Securities, the Trust used the proceeds from the Trust Preferred Securities offering to purchase a like amount of Junior Subordinated Debt Securities (the Debt Securities) of the Company. The debt securities bear the same terms and interest rates as the related Trust Preferred Securities. The debt securities are the sole assets of the Trust. The Company has fully and unconditionally guaranteed all of the obligations of the Trust.
County Statutory Trust I issued $6,000,000 in Trust Preferred Securities on February 22, 2001. These securities pay interest at the rate of 10.20% and have a stated maturity date of February 22, 2031. They also have an optional redemption date of February 22, 2021. County Statutory Trust II issued $10,000,000 in Trust Preferred Securities on December 17, 2003. These securities pay interest at a variable rate of interest that was 7.32% at December 31, 2005, and have a stated maturity date of December 17, 2033. They have an optional redemption date of December 17, 2008. The interest rate on this issue is indexed to the average quarterly prime rate plus 0.07%, for the first five years, then after the optional redemption date of December 17, 2008, the rate will be indexed to the then-current 3 month LIBOR rate plus 2.85%.
The debentures issued, less the common securities of the Trusts, qualify as Tier capital under the interim guidance issued by the Board of Governors of the Federal Reserve System (Federal Reserve Board).
The Trust Preferred Securities are mandatorily redeemable, in whole or in part, upon repayment of their underlying Debt Securities at their respective stated maturities or their earlier redemption. The Debt Securities are redeemable prior to maturity at the option of the Company on or after their respective optional redemption dates.
NOTE 7. Income Taxes
The provision for income taxes for the years ended December 31 is comprised of the following:
In April 2004, the Company amended 2001 and 2002 state income tax returns and paid $2,411,000 in state income taxes as part of the State of California’s Voluntary Compliance Initiative. The payment was related to the tax treatment of consent dividends received by the Bank from the Bank’s REIT subsidiaries. The Company has maintained the right to file income tax refunds related to these payments, but has recorded the payments as a state income tax expense.
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31 consists of the following:
In assessing the Company’s ability to realize the tax benefits of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods which the deferred tax assets are deductible, management believes it is more likely than not the Company will realize the benefits of these deductible differences, net of the existing valuation allowances at December 31, 2005 and 2004.
During 2004, the Company increased the tax valuation allowance by $404,000 to a total valuation allowance of $424,000 at December 31, 2004. The increase was related to management’s assessment of the ultimate collectibility of tax benefits related to the book deduction for other than temporary impairment of equity securities. In order to realize the tax benefits related to any capital losses when recognized for tax purposes, the Company would need to generate offsetting capital gains within six years beginning with the year of any recognized loss. After an evaluation by management of the potential sources of future capital gains from the recorded assets at December 31, 2004, it was management’s conclusion that the deferred tax asset related to the other than temporary impairment of equity securities may not be entirely realized. Therefore, a tax valuation allowance was established to the extent that management believed it was more likely than not that the asset would not be realized. The realizability of this deferred tax asset was also reviewed at December 31, 2005, at which time management concluded no additional allowance was required.
A reconciliation of income tax at the federal statutory rate to the provision for income taxes follows:
As of December 31, 2005, the anticipated 2005 tax refund related to federal and state income taxes was $870,000.
NOTE 8. Regulatory Matters
The Company is subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate mandatory and possibly, additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the Company's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weighting and other factors.
Management believes, as of December 31, 2005 that the Company and the Bank met all capital adequacy requirements to which they are subject, including the ratio test for a well capitalized bank under the regulatory framework for prompt corrective action. The most recent notification from the FRB categorized the Company and the Bank as well capitalized under the FDICIA regulatory framework for prompt corrective action. Subsequent to this notification, there are no conditions or events that management believes have changed the risk based capital category of the Company and the Bank.
On December 15, 2005 the Federal Reserve Bank of San Francisco (“FRBSF”) terminated the written agreement (the “Agreement”) which was entered into with the Company on October 26, 2004. Under the Agreement, the Bank, among other actions taken, (i) developed a written program designed to improve the Bank's system of internal controls to ensure compliance with applicable provisions of the Bank Secrecy Act; (ii) developed an enhanced written customer due diligence program designed to reasonably ensure the identification and reporting of all known or suspected violations of law and suspicious transactions against or involving the Bank; (iii) established enhanced written policies and procedures designed to strengthen the Bank's internal controls and audit programs, and (iv) submitted quarterly progress reports to the FRBSF detailing actions taken to secure compliance with the Agreement.
The Company has a formal dividend policy, and dividends are issued solely at the discretion of the Company’s Board of Directors subject to compliance with regulatory requirements. In order to pay any cash dividends, the Company must receive payments of dividends or management fees from the Bank. There are certain regulatory limitations on the payment of cash dividends by banks.
Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain minimum amounts and ratios (set forth in the following table).
The Company's and Bank's actual capital amounts and capital ratios as of December 31, 2005 are as follows:
(1) The leverage ratio consists of Tier 1 capital divided by quarterly average assets. The minimum leverage ratio is 3 percent for banking organizations that do not anticipate significant growth and that have well diversified risk, excellent asset quality and in general, are considered top-rated banks.
The Company's and Bank's actual capital amounts and ratios as of December 31, 2004 are as follows:
(1) The leverage ratio consists of Tier 1 capital divided by quarterly average assets. The minimum leverage ratio is 3 percent for banking organizations that do not anticipate significant growth and that have well diversified risk, excellent asset quality and in general, are considered top-rated banks.
NOTE 9. Commitments and Financial Instruments With Off-Balance Sheet Credit Risk
At December 31, 2005, the Company has operating lease rental commitments for remaining terms of one to twenty years. The Company has options to renew four of its leases for periods of 10 through years. The minimum future commitments under non-cancelable lease agreements having terms in excess of one year at December 31, 2005 are as follows:
Rent expense was approximately $1,649,000, $1,226,000, and $986,000, for the years ended December 31, 2005, 2004, and 2003.
In the ordinary course of business, the Company enters into various types of transactions which involve financial instruments with off-balance sheet risk. These instruments include commitments to extend credit and standby letters of credit and are not reflected in the accompanying balance sheets. These transactions may involve, to varying degrees, credit and interest risk in excess of the amount, if any, recognized in the balance sheets.
The Company's off-balance sheet credit risk exposure is the contractual amount of commitments to extend credit and standby letters of credit. The Company applies the same credit standards to these contracts as it uses in its lending process. Additionally, commitments to extend credit and standby letters of credit bear similar credit risk characteristics as outstanding loans.
Commitments to extend credit are agreements to lend to customers. These commitments have specified interest rates and generally have fixed expiration dates, but may be terminated by the Company if certain conditions of the contract are violated. Although currently subject to draw down, many of these commitments are expected to expire or terminate without funding. Therefore, the total commitment amounts do not necessarily represent future cash requirements. Collateral held relating to these commitments varies, but may include securities, equipment, inventory and real estate.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of the customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held for standby letters of credit is based on an individual evaluation of each customer's credit worthiness, but may include cash, equipment, inventory and securities.
The Company, because of the nature of its business, is subject to various threatened or filed legal cases. The Company, based on the advice of legal counsel, does not expect that the resolution of such cases will have a material, adverse effect on its financial position or results of operations.
NOTE 10. Time Deposits
At December 31, 2005 the aggregate maturities for customer time deposits are as follows:
NOTE. 11. Employee and Director Benefit Plans
The Company has a noncontributory employee stock ownership plan ("ESOP") and an employee savings plan covering substantially all employees. During 2005, 2004, and 2003, the Company contributed approximately $649,000, $580,000, and $541,000 to the ESOP and $260,000, $226,000, and $193,000 to the employee savings plan.
Under provisions of the ESOP, the Company can make discretionary contributions to be allocated based on eligible individual annual compensation, as approved by the Board of Directors. Contributions to the ESOP are recognized as compensation expense. For the years ended December 31, 2005, 2004, and 2003, the ESOP owned 383,315, 213,607, and 206,980 shares of the Company’s stock. ESOP shares are included in the weighted average number of shares outstanding for earnings per share computations.
The employee savings plan allowed participating employees to contribute up to $14,000 each in 2005. Eligible employees above the age of 50 have the ability to contribute an additional $4,000 in catch up contributions in 2005. The Company matched 25% of the employees’ elective contribution, as defined, not to exceed 10% of eligible annual compensation. The expense relating to the 25% match was $314,000, $225,000 and $193,000 in 2005, 2004 and 2003.
The Company maintains a non-qualified salary continuation plan for certain senior executive officers of the Company and the Bank. Under the plan, the Company has agreed to pay these executives retirement benefits for a ten to fifteen year period after their retirement so long as they meet certain length of service vesting requirements. The plan is informally linked to several single premium universal life insurance policies that provide life insurance on certain senior executive officers with the Company named as the owner and beneficiary of these policies. The Bank has a Rabbi trust and specific life insurance contracts have been irrevocably assigned to the trust in support of the salary continuation plans. Salary continuation expense totaled $339,000, $484,000, and $669,000, in 2005, 2004, and 2003. Total liabilities carried by the Company for salary continuation totaled $3,287,000, $3,067,000, and $2,499,000 in 2005, 2004, and 2003 respectively.
The Company also maintains a non-qualified Director Elective Income Deferral Agreement plan for members of the board of directors of the Company and the Bank. Under the present deferred compensation plan, members of the board of directors have the ability to defer compensation they receive as directors until a future date elected by the director. The director then also elects either to be paid in a lump sum or annuity starting at the date elected by the director. The plan is informally linked to several single premium universal life insurance policies that provide life insurance on certain directors with the Company named as the owner and beneficiary of these policies. The Bank has a Rabbi trust and life insurance contracts have been irrevocably assigned to the trust in support of the deferred compensation plans. Deferred compensation expense totaled $88,000, $97,000, and $64,000 in 2005, 2004, and 2003. Total liabilities carried by the Company for Director Elective Income Deferral totaled $598,000, $543,000, and $446,000 in 2005, 2004, and 2003 respectively.
NOTE 12. Stock Option Plan
In 1992, shareholders approved the adoption of an incentive stock option plan for bank management and a non-statutory stock option plan for directors. In 2002, shareholders approved the adoption of a new incentive stock option plan for bank management and a new non-statutory stock option plan for directors. The maximum number of shares issuable under the plans was 126,000 and was amended by the shareholders in 1995 and 2001 to 450,000 and 675,000 options available for grant. Options are available for grant under the plans at prices that approximate fair market value of the stock at the date of grant. Options granted under both plans become exercisable 25% at the time of grant and 25% each year thereafter and expire 10 years from the date of grant. At the November meeting, the Board of Directors approved the accelerated vesting of all outstanding stock options. The Board of Directors performed this action to mitigate the effect of the adoption of Financial Accounting Statement 123R, which goes into effect January 1, 2006, which will require the Company to record compensation expense as stock options vest in 2006 and beyond. During 2005, the Company recorded equity compensation expense related to this board action of $150,000 to reflect management’s estimate of additional equity compensation expense incurred that relates to the forfeiture of stock options that occurs when management or members of the board of directors leave the Company.
A summary of the status of the Company’s stock options as of and for the years ended December 31, 2005, 2004, and 2003 and changes during the years ended on those dates, follows:
The number of shares and exercise price per share has been adjusted for stock dividends and stock splits. See Footnote 1 for additional information related to total compensation and effects on net income.
NOTE 13. Fair Value of Financial Instruments
The Company in estimating its fair value disclosures for financial instruments used the following methods and assumptions:
Financial Assets:
Cash and cash equivalents: For these assets, the carrying amount is a reasonable estimate for fair value.
Investments: Fair values for available for sale and held to maturity investment securities are based on quoted market prices where available. If quoted market prices were not available, fair values were based upon quoted market prices of comparable instruments.
Net loans: The fair value of loans is estimated by utilizing discounted future cash flow calculations using the interest rates currently being offered for similar loans to borrowers with similar credit risks and for the remaining or estimated maturities considering prepayments. The carrying value of loans is net of the allowance for loan losses and unearned loan fees.
Bank Owned Life Insurance: The carrying amount of this asset is a reasonable estimate of fair value.
Interest Receivable: The carrying amount of this asset is a reasonable estimate of fair value.
Financial Liabilities:
Deposits: The fair values disclosed for deposits generally paid upon demand (i.e. noninterest-bearing and interest-bearing demand) savings and money market accounts are considered equal to their respective carrying amounts as reported on the consolidated balance sheets. The fair value of fixed rate certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities.
Borrowings: For these instruments, the fair value is estimated using rates currently available for similar loans with similar credit risk and for the remaining maturities.
Commitments to extend credit and standby letters of credit: The fair value of commitments to extend credit and standby letters of credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present credit worthiness of the counter parties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rate. The fair value of letters of credit is based on fees currently charged for similar arrangements or on the estimated cost to terminate them or otherwise settle the obligation with the counter parties at the recording date.
Fair values for financial instruments are management’s estimates of the values at which the instruments could be exchanged in a transaction between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. In addition, other significant assets are not considered financial assets including, any deferred tax assets and premises and equipment. Further, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on the fair value estimates and have not been considered in any of these estimates.
NOTE 14. Parent Company Only Financial Information
This information should be read in conjunction with the other notes to the consolidated financial statements. The following are the condensed balance sheets of the Company as of December 31, 2005 and 2004 and the condensed statements of income and cash flows for the years ended December 31, 2005, 2004, and 2003:
NOTE 15. Quarterly Results of Operations (Unaudited)
(1) Basic and diluted earnings per share calculations are based upon the weighted average number of shares outstanding during each period. Full year weighted average shares differ from quarterly weighted average shares and, therefore, annual earnings per share may not equal the sum of the quarters.
During the fourth quarter of 2004, the Company recorded two separate adjustments to earnings. The first was an other-than-temporary impairment charge $3,709,000 related to unrealized losses on three agency preferred stocks. The second was a charge to income tax expense of $1,229,000 related to the write-off of tax benefits derived from the utilization of consent dividends declared by the Bank’s REIT. See Note 2 and Note 8 for additional disclosure information related to these two charges.
NOTE 16. Derivatives
During the third quarter of 2005, the Company purchased an interest rate floor contract from Wachovia Bank to be effective from October 1, 2005 until September 1, 2010, at a price of $1,270,000 which will be amortized over the life of the contract. The notional amount of the floor is $100,000,000 with a strike rate of 6.5% vs. the Prime rate as published in the H15 bulletin from the Federal Reserve Bank for the first of each month. The interest rate floor provides the Company with partial protection against an interest rate downturn on loans that are indexed off the Prime rate through September 1, 2010. The floor is designated as a cash flow hedge. The Company assesses the effectiveness of the interest rate floor contract based on changes in the option’s intrinsic value. The change in the time value of the contract is excluded from the assessment of the hedge effectiveness and such planned ineffectiveness is recorded as a reduction in interest income. For the year ended December 31, 2005, the Company recognized a net reduction in interest income of $4,000.
The Company uses derivatives to manage exposure to interest rate risk. Derivative transactions are measured in terms of the notional amount, but this amount is not recorded on the balance sheet and is not, when viewed in isolation, a meaningful measure of the risk profile of the instruments. The notional amount is not exchanged, but is used only as the basis on which interest and other payments are determined.
For derivatives, the Company’s exposure to credit risk is measured by the current fair value of all derivatives in a gain position plus a prudent estimate of potential change in value over the life of the contract and generally takes into account legally enforceable risk mitigating agreements for each obligor such as netting and collateral.
The fair value and notional amounts for trading derivatives at December 31, 2005 are presented below.
Risk management derivative financial instruments represent financial instruments the Company has designated and accounted for as accounting hedges. Information related to these derivative financial instruments used for the Company’s interest rate risk management purposes at December 31, 2005, follows.
NOTE 17. Subsequent Events
In the first quarter of 2006 the Company purchased an asset based lending portfolio from Heritage Bank of Commerce for approximately $30,015,000. The loans were purchased from Heritage Bank at the note amount. There was no discount or premium paid related to these loans. As part of the transaction several employees from Heritage Bank of Commerce have joined County Bank. These employees are responsible for the management and expansion of the segment.