ITEM 1. BUSINESS
GENERAL
Center Financial Corporation
Center Financial Corporation (“Center Financial”) is a California corporation registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (the “BHC Act”), and is headquartered in Los Angeles, California. Center Financial was incorporated in April 2000 and acquired all of the outstanding shares of Center Bank (the “Bank”) in October 2002. Center Financial’s principal subsidiary is Center Bank. Center Financial exists primarily for the purpose of holding the stock of the Bank and of such other subsidiaries as it may acquire or establish. Currently, Center Financial’s only other direct subsidiary is Center Capital Trust I, a Delaware statutory business trust that was formed in December 2003 solely to facilitate the issuance of capital trust pass-through securities. (See Note 11 to the Financial Statements in Item 8 herein.) As used herein, the term “Center Financial” is used to designate Center Financial Corporation only, the term the “Bank” is used to designate Center Bank, and the term the “Company” refers collectively to Center Financial Corporation, the Bank and Center Capital Trust I, unless the context otherwise requires.
Center Financial’s principal source of income has historically been dividends from the Bank, though payment of such dividends currently requires prior regulatory approval due to (i) an informal agreement entered into with the FDIC and the Department of Financial Institutions (the “DFI”), and (ii) the Bank’s losses in 2009, as a result of which the Bank must obtain prior DFI approval of dividends under the California Financial Code”) (see “Current Developments-Informal Regulatory Agreements” and “Item 5 - MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES-Dividends”). Center Financial also intends to explore supplemental sources of income in the future. Expenditures, including (but not limited to) the payment of dividends to shareholders, if and
when declared by the board of directors, and the cost of servicing debt, will generally be paid from such payments made to Center Financial by the Bank. The Company’s liabilities include $18.6 million in debt obligations due to Center Capital Trust I, related to capital trust pass-through securities issued by that entity.
At December 31, 2009, the Company had consolidated assets of $2.2 billion, deposits of $1.7 billion and shareholders’ equity of $256.1 million.
The Company’s and the Bank’s headquarters are located at 3435 Wilshire Boulevard, Suite 700, Los Angeles, California 90010 and its telephone number is (213) 251-2222. Our Website address is www.centerbank.com. Information contained on the web site is not part of this report.
Center Bank
The Bank is a California state-chartered and Federal Deposit Insurance Corporation (“FDIC”) insured financial institution, which was incorporated in 1985 and commenced operations in March 1986. The Bank changed its name from California Center Bank to Center Bank in December 2002. The Bank provides comprehensive financial services for small to medium sized business owners, primarily in Southern California. The Bank specializes in commercial loans, most of which are secured by real property, to small business customers. In addition, the Bank is a Preferred Lender of Small Business Administration (“SBA”) loans and provides trade finance loans. The Bank’s primary market is the greater Los Angeles metropolitan area, including Los Angeles, Orange, San Bernardino, and San Diego counties, primarily focused in areas with high concentrations of Korean-Americans. The Bank currently has 19 full-service branch offices, 16 of which are located in Los Angeles, Orange, San Bernardino, and San Diego counties. The Bank opened all California branches as de novo branches, and one branch in Chicago, Illinois by acquisition in 2004. The Bank opened one new branch in the Seattle area of Washington in November 2007, and one new branch in Diamond Bar, California in March 2008. The Bank also operates one Loan Production Office (“LPO”) in Seattle. Effective February 17, 2009, the Company closed five LPO’s in Denver, Washington D.C., Atlanta, Dallas and Northern California.
The Bank’s primary focus is on small and medium sized Korean-American businesses, professionals and other individuals in its market area, with particular emphasis on the growth of deposits, the origination of commercial and real estate secured loans and consumer banking services. The Bank offers bilingual services to its customers in English and Korean and has a network of ATM’s located in eighteen of its branch offices.
The Bank engages in a full complement of lending activities, including the origination of commercial real estate loans, commercial loans, working capital lines, SBA loans, trade financing, automobile loans and other personal loans, and construction loans. The Bank has offered SBA loans since 1989, providing financing for various purposes for small businesses under guarantee of the SBA, a federal agency created to provide financial assistance for small businesses. The Bank is a Preferred SBA Lender with full loan approval authority on behalf of the SBA.
The Bank also participates in the SBA’s Export Working Capital Program. SBA loans are generally secured by deeds of trust on industrial buildings or retail establishments.
The Bank regularly sells a portion of the guaranteed and unguaranteed portion of the SBA loans it originates. The Bank retains the obligation to service the loans and receives a servicing fee. As of December 31, 2009, the Bank was servicing $113.0 million of sold SBA loans.
As of December 31, 2009, the principal areas of focus related to the Bank’s lending activities, and the percentage of total loan portfolio composition for each of these areas, were as follows: commercial loans secured by first deeds of trust on real estate 65.5% and commercial loans 19.2%. The Bank funds its lending activities primarily with demand deposits, savings and time deposits (obtained through its branch network) and Federal
Home Loan Bank (“FHLB”) borrowings. The Bank’s deposit products include demand deposit accounts, money market accounts, and savings accounts, time certificates of deposit and fixed maturity installment savings. The Bank’s deposits are insured under the Federal Deposit Insurance Act, up to the maximum applicable limits thereof. Like most state- chartered banks of the Bank’s size in California, it is not currently a member of the Federal Reserve System. As of December 31, 2009, the Bank had approximately 51,000 deposit accounts with balances totaling approximately $1.75 billion. As of December 31, 2009, the Bank had $352.4 million or 20.2% in non-interest bearing demand deposits; $528.3 million or 30.2% in money market and NOW accounts; $86.6 million or 5.0% in savings accounts; $256.0 million or 14.6% in time deposits less than $100,000; and $524.4 million or 30.0% in time deposits of more than $100,000. As of December 31, 2009, the Bank had $115.0 million of State municipal time deposits and $260.2 million of brokered deposits.
The Bank also offers international banking services such as letters of credit, acceptances and wire transfers, as well as merchant deposit services, cash management services, travelers’ checks, debit cards and safe deposit boxes.
The Bank provides Internet banking services to allow its customers to access their loan and deposit accounts through the Internet. Customers can obtain transaction history and account information, transfer funds between the Bank’s accounts and process bill payments.
The Bank does not hold any patents or licenses (other than licenses required to be obtained from appropriate banking regulatory agencies), franchises or concessions. The Bank’s business is generally not seasonal. Federal, state and local environmental regulations have not had any material effect upon our capital expenses, earnings or competitive position.
The majority of the Bank’s customers are Korean-American small businesses and individuals. Approximately 66.9% of the Bank’s loan portfolio as of December 31, 2009 was concentrated in commercial real estate and construction loans. Most of our customers are concentrated in the greater Los Angeles area but efforts have been made in the last several years to diversify the geographic risk with branches in Chicago and Seattle.
The Bank has not engaged in any material research activities relating to the development of new services or the improvement of existing banking services during the last three fiscal years. However, the Bank, with its officers and employees, is engaged continually in marketing activities, including the evaluation and development of new services, which enable it to retain and improve our competitive position in our service area.
Recent Developments
Fourth Quarter Capital Raises
On November 30, 2009, the Company completed a private placement of its common stock to a limited number of accredited investors, including insiders (the “November Private Placement”). The Company issued a total of 3,360,000 shares of its common stock, without par value, for aggregate cash consideration of $12.8 million. The purchase price per share was $4.69 for directors and officers of the Company and $3.71 for other investors. The difference in the purchase price was necessary to comply with NASDAQ Listing Rule 5635(c). The Company intends to seek shareholder approval of the November Private Placement in March 2010 so that all investors in the November Private Placement may be treated equally. If such approval is obtained, 85,045 additional shares would be issued without additional consideration to effectuate this result.
On December 29, 2009, the Company entered into Securities Purchase Agreements with a limited number of institutional and other accredited investors, including insiders, to sell a total of 73,500 shares of Mandatorily Convertible Non-Cumulative Non-Voting Perpetual Preferred Stock, Series B, without par value (the “Series B Preferred Stock”) at a price of $1,000 per share, for an aggregate gross purchase price of $73,500,000, which closed on December 31, 2009, and the Company issued an aggregate of 73,500 shares of Series B Preferred Stock upon its receipt of consideration in cash.
The Series B Preferred Stock will automatically convert into a number of shares of Center Financial’s common stock after the Company has received shareholder approval of such conversion at a Special Meeting of Shareholders to be held on March 24, 2010. The conversion ratio for each share of Series B Preferred Stock will be equal to the quotient obtained by dividing the Series B Share Price by the conversion price. The initial conversion price of $3.75 per share is subject to certain possible adjustments in the future under certain circumstances, including failure to obtain shareholder approval for the conversion by May 17, 2010, which will decrease the conversion price by 10%. The Series B Preferred Stock will carry a non-cumulative cash dividend at a per annum rate equal to 12%, payable on June 30 and December 31 of each year, which dividend will not be paid as long as shareholder approval is obtained on or before May 17, 2010. The Series B Preferred Stock is redeemable at the option of the Company after five years on specified terms, and carries a liquidation preference of $1,000 per share, subject to certain adjustments. The Series B Preferred Stock may not be redeemed at the option of the holder. In the event the Company chooses to redeem the Series B Preferred Stock, the holders would be entitled instead to convert their shares into common stock under specified guidelines.
Informal Regulatory Agreements
Effective December 18, 2009, the Bank entered into a memorandum of understanding (“MOU”) with the FDIC and the Department of Financial Institutions (the “DFI”). The MOU is an informal administrative agreement pursuant to which the Bank has agreed to take various actions and comply with certain requirements to facilitate improvement in its financial condition. In accordance with the MOU, the Bank agreed among other things to (a) develop and implement strategic plans to restore profitability; (b) develop a capital plan containing specified elements including achieving by December 31, 2009 and thereafter maintaining a Leverage Capital Ratio of not less than 9% and a Total Risk-Based Capital Ratio of not less than 13%; (c) refrain from paying cash dividends without prior regulatory approval; (d) reduce the amounts of its assets adversely classified or criticized in its most recent FDIC examination or internally graded Special Mention within certain specified time parameters; (e) increase the allowance for loan and lease losses (“ALLL”) by $18.7 million (which was completed in the second quarter of 2009) and thereafter maintain an appropriate ALLL balance; (f) develop and implement certain specified policies and procedures relating to the ALLL, troubled debt restructurings, and non-accrual and impaired loans; (g) develop and implement a plan for reducing concentrations of commercial real estate loans; (h) make certain revisions to the Bank’s liquidity policy concerning “high-rate” deposits and reduce the Net Non-Core Funding Dependency Ratio to less than 40% by December 31, 2010; (i) conduct a complete review of management and staffing and submit written findings to the FDIC and the DFI concerning the same; (j) notify the FDIC and the DFI prior to appointing any new director or senior executive officer; (k) refrain from establishing any new offices without prior regulatory approval; and (l) submit written quarterly progress reports to the FDIC and the DFI detailing the form and manner of any actions taken to secure compliance with the MOU and the results thereof.
On December 9, 2009, the Company entered into an MOU with the Federal Reserve Bank of San Francisco (the “FRB”) pursuant to which the Company agreed, among other things, to (i) take steps to ensure that the Bank complies with the Bank’s MOU; (ii) implement a capital plan addressing specified items and submit the plan to the FRB for approval; (iii) submit annual cash flow projections to the FRB; (iv) refrain from paying cash dividends, receiving cash dividends from the Bank, increasing or guaranteeing debt, redeeming or repurchasing its stock, or issuing any additional trust preferred securities, without prior FRB approval; and (v) submit written quarterly progress reports to the FRB detailing compliance with the MOU.
The MOUs will remain in effect until modified or terminated by the FRB, the FDIC and the DFI. We do not expect the actions called for by the MOUs to change our business strategy in any material respect, although they may have the effect of limiting or delaying the Bank’s or the Company’s ability or plans to expand. The board of directors and management of the Bank and the Company have taken various actions to comply with the MOUs, and will diligently endeavor to take all actions necessary for compliance. Management believes that the Bank and the Company are currently in substantial compliance with the terms of the MOUs, although formal determinations of compliance with the MOUs can only be made by the regulatory authorities. In that regard, the Bank’s Leverage Capital Ratio and Total Risk-Based Capital ratios as of December 31, 2009 were 12.0% and 17.2%, considerably in excess of the required ratios for the Bank.
Recent Accounting Pronouncements
For information regarding the recently issued accounting standards, see Note 2, entitled “Summary of Significant Accounting Policies,” to the Company’s consolidated financial statements presented elsewhere herein.
Competition
The current banking business and intended future strategic market areas are highly competitive with respect to virtually all products and services and have become increasingly so in recent years. While the Company’s primary market area is generally dominated by a relatively small number of major banks with many offices operating over a wide geographic area, the Company’s direct competitors in the niche markets are three Korean-American banks of which two are comparable in size and one is twice the Company’s asset size, which also focus their business strategy on Korean-American consumers and businesses. There are also a number of smaller Korean-American community banks that compete in the same market as the Company.
There is significant competition within this specific market. In the greater Los Angeles, Chicago and Seattle metropolitan areas, the Company’s main competitors are locally owned and operated Korean-American banks and subsidiaries of Korean banks. These competitors have branches located in many of the same neighborhoods as the Company, provide similar types of products and services, and use the same Korean language publications and media for their marketing purposes.
A less significant source of competition in the Los Angeles metropolitan area is a small number of branches of major banks which maintain a limited bilingual staff for Korean-speaking customers. While such banks have not traditionally focused their marketing efforts on the Company’s customer base primarily in Southern California, the competitive influence of these major bank branches could increase in the event they choose to focus on this market. Large commercial bank competitors have, among other advantages, the ability to finance wide-ranging and effective advertising campaigns and to allocate their investment resources to areas of highest yield and demand. Many of the major banks operating in our market area offer certain services, which the Company does not offer directly (some of which the Company can offer through the use of correspondent institutions). By virtue of their greater total capitalization, such banks also have substantially higher lending limits than the Company.
In addition to other banks, competitors include savings institutions, credit unions, and numerous non-banking institutions, such as finance companies, leasing companies, insurance companies, brokerage firms, and investment banking firms. In recent years, increased competition has also developed from specialized finance and non-finance companies that offer money market and mutual funds, wholesale finance, credit card, and other consumer finance services, including on-line banking services and personal finance software. Strong competition for deposit and loan products affects the rates of those products as well as the terms on which they are offered to customers. To the extent that the Company is affected by more general competitive trends in the industry, those trends are towards increased consolidation and competition. Unregulated competitors have entered banking markets with strategies directly targeted at the Company’s customers. Many largely unregulated competitors are able to compete across geographic boundaries and provide customers increasing access to meaningful alternatives to banking services in nearly all-significant products. Consolidation of the banking industry has placed additional pressure on surviving community banks within the industry to streamline their operations, reduce expenses and increase revenues to remain competitive. Competition has also intensified due to federal and state interstate banking laws, which permit banking organizations to expand geographically, and the California market has been particularly attractive to out-of-state institutions.
Technological innovations have also resulted in increased competition in the financial services industry. Such innovations have, for example, made it possible for non-depository institutions to offer customers automated transfer payment services that previously have been considered traditional banking products. In
addition, many customers now expect a choice of several delivery systems and channels, including telephone, mail, home computer, ATM’s, self-service branches and/or in-store branches. Other sources of competition for such hi-tech products include savings associations, credit unions, brokerage firms, money market and other mutual funds, asset management groups, finance and insurance companies, and mortgage banking firms.
In order to compete with the other financial services providers, the Company provides quality, personalized, friendly service and fast decision making to better serve our customers’ needs. For customers whose loan demands exceed the Company’s lending limit, the Company has attempted to establish relationships with correspondent banks for the development of such loans on a participation basis. The Company also maintains an international trade finance department to meet the growing needs of the business communities within our niche market. In order to compete on the technological front, the Company offers Internet banking services to allow its customers to access their loan and deposit accounts through the Internet. Customers can obtain transaction history and account information, transfer funds between bank accounts and process bill payments.
Employees
As of December 31, 2009, the Company had 273 full-time equivalent employees and 265 full-time employees as compared to 316 and 311 as of December 31, 2008.
Supervision and Regulation
Both federal and state laws extensively regulate bank holding companies. These regulations are intended primarily for the protection of depositors and the deposit insurance fund and not for the benefit of shareholders. The following is a summary of particular statutes, regulations and certain regulatory guidance affecting Center Financial and the Bank. This summary is qualified in its entirety by such statutes, regulations and guidance.
Regulation of Center Financial Corporation Generally
Center Financial’s stock is traded on the NASDAQ Global Select Market under the symbol “CLFC”, and as such the Company is subject to NASDAQ rules and regulations including those related to corporate governance. Center Financial is also subject to the periodic reporting requirements of Section 13 of the Securities Exchange Act of 1934 (the “Exchange Act”), which requires us to file annual, quarterly, current and other reports with the Securities and Exchange Commission (the “SEC”). The Company is also subject to additional regulations including, but not limited to, the proxy and tender offer rules promulgated by the SEC under Sections 13 and 14 of the Exchange Act; the reporting requirements of directors, executive officers and principal shareholders regarding transactions in Center Financial’s common stock and short-swing profits rules promulgated by the SEC under Section 16 of the Exchange Act; and certain additional reporting requirements to Center Financial’s principal shareholders promulgated by the SEC under Section 13 of the Exchange Act. The Company is classified as an “accelerated filer” for purposes of its Exchange Act filing requirements. In addition to accelerated time frames for filing SEC periodic reports, this also means that the Company is subject to the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 with regard to documenting, testing, and attesting to internal controls over financial reporting.
Center Financial is a bank holding company within the meaning of the Bank Holding Company Act of 1956 and is registered as such with the Federal Reserve Board. A bank holding company is required to file with the Federal Reserve Board annual reports and other information regarding its business operations and those of its subsidiaries. It is also subject to examination by the Federal Reserve Board and is required to obtain Federal Reserve Board approval before acquiring, directly or indirectly, ownership or control of any voting shares of any bank if, after such acquisition, it would directly or indirectly own or control more than 5% of the voting stock of that bank, unless it already owns a majority of the voting stock of that bank.
The Federal Reserve Board has determined by regulation certain activities in which a bank holding company may or may not conduct business. A bank holding company must engage, with certain exceptions, in the business
of banking or managing or controlling banks or furnishing services to or performing services for its subsidiary banks. The permissible activities and affiliations of certain bank holding companies have been expanded.
Center Financial and the Bank are deemed to be affiliates of each other within the meaning set forth in the Federal Reserve Act and are subject to Sections 23A and 23B of the Federal Reserve Act. This means, for example, that there are limitations on loans by the Bank to affiliates, and that all affiliate transactions must satisfy certain limitations and otherwise be on terms and conditions at least as favorable to the Bank as would be available for non-affiliates.
The Federal Reserve Board has a policy that bank holding companies must serve as a source of financial and managerial strength to their subsidiary banks. It is the Federal Reserve Bank’s position that bank holding companies should stand ready to use their available resources to provide adequate capital to their subsidiary banks during periods of financial stress or adversity. Bank holding companies should also maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting their subsidiary banks.
The Federal Reserve Board also has the authority to regulate bank holding companies’ debt, including the authority to impose interest rate ceilings and reserve requirements on such debt. Under certain circumstances, the Federal Reserve Board may require a bank holding company to file written notice and obtain its approval prior to purchasing or redeeming our equity securities, unless certain conditions are met.
Regulation of Center Bank Generally
As a California state-chartered bank whose accounts are insured by the FDIC up to the maximum limits thereof, the Bank is subject to regulation, supervision and regular examination by the California Department of Financial Institutions (“DFI”) and the FDIC. In addition, while the Bank is not a member of the Federal Reserve System, the Bank is subject to certain regulations of the Federal Reserve Board. The regulations of these agencies govern most aspects of our business, including the making of periodic reports, and activities relating to dividends, investments, loans, borrowings, capital requirements, certain check-clearing activities, branching, mergers and acquisitions, reserves against deposits and numerous other areas. Supervision, legal action and examination by the FDIC are generally intended to protect depositors and are not intended for the protection of shareholders.
The earnings and growth of the Bank are largely dependent on its ability to maintain a favorable differential or “spread” between the yield on its interest-earning assets and the rate paid on its deposits and other interest-bearing liabilities. As a result, the Bank’s performance is influenced by general economic conditions, both domestic and foreign, the monetary and fiscal policies of the federal government and the policies of the regulatory agencies, particularly the Federal Reserve Board. The Federal Reserve Board implements national monetary policies by its open-market operations in United States Government securities, by adjusting the required level of reserves for financial institutions subject to its reserve requirements and by varying the discount rate applicable to borrowings by banks which are members of the Federal Reserve System. The actions of the Federal Reserve Board in these areas influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and deposits. The nature and impact of any future changes in monetary policies cannot be predicted.
Capital Adequacy Requirements
Center Financial and the Bank are subject to the regulations of the Federal Reserve Board and the FDIC, respectively, governing capital adequacy. Each of the federal regulators has established risk-based and leverage capital guidelines for the banks or bank holding companies it regulates, which set total capital requirements and define capital in terms of “core capital elements,” or Tier 1 capital; and “supplemental capital elements,” or Tier 2 capital. Tier 1 capital is generally defined as the sum of the core capital elements less goodwill and certain other deductions, notably the unrealized net gains or losses (after tax adjustments) on investment securities
available for sale carried at fair market value. The following items are defined as core capital elements: (i) common shareholders’ equity; (ii) qualifying non-cumulative perpetual preferred stock and related surplus (and, in the case of holding companies, senior perpetual preferred stock issued to the U.S. Treasury Department pursuant to the Troubled Asset Relief Program); and (iii) minority interests in the equity accounts of consolidated subsidiaries. Supplementary capital elements include: (i) allowance for loan and lease losses (but not more than 1.25% of an institution’s risk-weighted assets); (ii) perpetual preferred stock and related surplus not qualifying as core capital; (iii) hybrid capital instruments, perpetual debt and mandatory convertible debt instruments; and (iv) term subordinated debt and intermediate-term preferred stock and related surplus. The maximum amount of supplemental capital elements, that qualifies as Tier 2 capital is limited to 100% of Tier 1 capital, net of goodwill.
The minimum required ratio of qualifying total capital to total risk-weighted assets (“Total Risk-Based Capital Ratio”) is 8.0%, at least one-half of which must be in the form of Tier 1 capital, and the minimum required ratio of Tier 1 capital to total risk-weighted assets (“Tier 1 Risk-Based Capital Ratio”) is 4.0%. Risk-based capital ratios are calculated to provide a measure of capital that reflects the degree of risk associated with a banking organization’s operations for both transactions reported on the statements of financial condition as assets, and transactions, such as letters of credit and recourse arrangements, which are recorded as off-balance sheet items. Under the risk-based capital guidelines, the nominal dollar amounts of assets and credit-equivalent amounts of off-balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain U. S. Treasury securities, to 100% for assets with relatively high credit risk, such as business loans. In addition, pursuant to the Bank’s MOU with the FDIC and the DFI, the Bank is required to maintain a Total Risk-Based Capital Ratio of 13% (see “Recent Developments-Informal Regulatory Agreements” above). As of December 31, 2009 and 2008, Total Risk-Based Capital Ratios and Tier 1 Risk-Based Capital Ratios of the Bank considerably exceeded the required ratios.
The risk-based capital requirements also take into account concentrations of credit involving collateral or loan type and the risks of “non-traditional” activities (those that have not customarily been part of the banking business). The regulations require institutions with high or inordinate levels of risk to operate with higher minimum capital standards, and authorize the regulators to review an institution’s management of such risks in assessing an institution’s capital adequacy.
Additionally, the regulatory Statements of Policy on risk-based capital include exposure to interest rate risk as a factor that the regulators will consider in evaluating an institution’s capital adequacy, although interest rate risk does not impact the calculation of risk-based capital ratios. Interest rate risk is the exposure of a bank’s current and future earnings and equity capital arising from adverse movements in interest rates. While interest rate risk is inherent in a bank’s role as financial intermediary, it introduces volatility to bank earnings and to the economic value of the bank or bank holding company.
The FDIC and the Federal Reserve Board also require the maintenance of a leverage capital ratio designed to supplement the risk-based capital guidelines. Banks and bank holding companies that have received the highest rating of the five categories used by regulators to rate such institutions and are not anticipating or experiencing any significant growth must maintain a ratio of Tier 1 capital, net of all intangibles, to adjusted total assets (“Leverage Capital Ratio”) of at least 3%. All other institutions are required to maintain a leverage ratio of at least 100 to 200 basis points above the 3% minimum, for a minimum of 4% to 5%. Pursuant to federal regulations, banking institutions must maintain capital levels commensurate with the level of risk to which they are exposed, including the volume and severity of problem loans, and federal regulators may set, however, higher capital requirements when an institution’s particular circumstances warrant. In addition, pursuant to the Bank’s MOU with the FDIC and the DFI, the Bank is required to maintain a Leverage Capital Ratio of 9% (see “Recent Developments-Informal Regulatory Agreements” above). Both the Company and the Bank were well capitalized as of December 31, 2009, and the Bank’s leverage capital ratio considerably exceeded the required ratio.
On March 1, 2005, the Federal Reserve Board adopted a final rule that allows the continued inclusion of trust-preferred securities in the Tier I capital of bank holding companies. However, under the final rule, after a five-year transition period, the aggregate amount of trust preferred securities and certain other capital elements that could qualify as Tier I capital would be limited to 25 percent of Tier I capital elements, net of goodwill. As of December 31, 2009, trust preferred securities made up 6.7% of the Company’s Tier I capital.
The following table sets forth Center Financial’s and the Bank’s capital ratios at December 31, 2009 and 2008:
Risk Based Ratios
Prompt Corrective Action Provisions
Federal law requires each federal banking agency to take prompt corrective action to resolve the problems of insured financial institutions, including but not limited to those that fall below one or more prescribed minimum capital ratios. The federal banking agencies have defined by regulation the following five capital categories:
• Well capitalized:
Total Risk-Based Capital Ratio of 10%; Tier 1 Risk-Based Capital Ratio of 6%; and Leverage Ratio of 5%;
• Adequately capitalized:
Total Risk-Based Capital Ratio of 8%; Tier 1 Risk-Based Capital Ratio of 4%; and Leverage Ratio of 4% or 3% if the institution receives the highest rating from its primary regulator;
• Undercapitalized:
Total Risk-Based Capital Ratio of less than 8%; Tier 1 Risk-Based Capital Ratio of less than 4%; or Leverage Ratio of less than 4% or 3% if the institution receives the highest rating from its primary regulator;
• Significantly undercapitalized:
Total Risk-Based Capital Ratio of less than 6%; Tier 1 Risk-Based Capital Ratio of less than 3%; or Leverage Ratio of less than 3%; and
• Critically undercapitalized:
Tangible equity to total assets of less than 2%.
As of December 31, 2009 and 2008, both the Company and the Bank were deemed to be well capitalized for regulatory capital purpose. A bank may be treated as though it were in the next lower capital category if after notice and the opportunity for a hearing, the appropriate federal agency finds an unsafe or unsound condition or practice so warrants, but no bank may be treated as “critically undercapitalized” unless its actual capital ratio warrants such treatment.
At each successively lower capital category, an insured bank is subject to increased restrictions on its operations. For example, a bank is generally prohibited from paying management fees to any controlling persons or from making capital distributions if to do so would make the bank “undercapitalized.” Asset growth and branching restrictions apply to undercapitalized banks, which are required to submit written capital restoration plans meeting specified requirements (including a guarantee by the parent holding company, if any). “Significantly undercapitalized” banks are subject to broad regulatory authority, including among other things, capital directives, forced mergers, restrictions on the rates of interest they may pay on deposits, restrictions on asset growth and activities and prohibitions on paying bonuses or increasing compensation to senior executive
officers without FDIC approval. Even more severe restrictions apply to critically undercapitalized banks. Most importantly, except under limited circumstances, not later than 90 days after an insured bank becomes critically undercapitalized, the appropriate federal banking agency is required to appoint a conservator or receiver for the bank.
In addition to measures taken under the prompt corrective action provisions, insured banks may be subject to potential actions by the federal regulators for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the issuance of cease and desist orders, termination of insurance of deposits (in the case of a bank), the imposition of civil money penalties, the issuance of directives to increase capital, formal and informal agreements, or removal and prohibition orders against “institution-affiliated” parties.
Safety and Soundness Standards
The federal banking agencies have also adopted guidelines establishing safety and soundness standards for all insured depository institutions. Those guidelines relate to internal controls, information systems, internal audit systems, loan underwriting and documentation, compensation and interest rate exposure. In general, the standards are designed to assist the federal banking agencies in identifying and addressing problems at insured depository institutions before capital becomes impaired. If an institution fails to meet these standards, the appropriate federal banking agency may require the institution to submit a compliance plan and institute enforcement proceedings if an acceptable compliance plan is not submitted.
The Emergency Economic Stabilization Act of 2008 and the Troubled Asset Relief Program
In response to unprecedented market turmoil and the financial crises affecting the overall banking system and financial markets in the United States, the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted in October 2008. On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (the “Stimulus Bill”) was enacted, which among other things augmented certain provisions of the EESA. Under the EESA, the U.S. Treasury Department has authority, among other things, to purchase up to $700 billion in mortgage loans, mortgage-related securities and certain other financial instruments, including debt and equity securities issued by financial institutions in the Troubled Asset Relief Program (the “TARP”). The purpose of the TARP is to restore confidence and stability to the U.S. banking system and to encourage financial institutions to increase their lending to customers and to each other.
Pursuant to the EESA, the U.S. Treasury Department was initially authorized to use $350 billion for the TARP. Of this amount, the U.S. Treasury Department allocated $250 billion to the TARP Capital Purchase Program (see description below). On January 15, 2009, the second $350 billion of TARP monies was released to the U.S. Treasury Department.
The TARP Capital Purchase Program (“CPP”) was developed to purchase $250 billion in senior preferred stock from qualifying financial institutions, and was designed to strengthen the capital and liquidity positions of viable institutions and to encourage banks and thrifts to increase lending to creditworthy borrowers. The amount of the U.S. Treasury Department’s preferred stock a particular qualifying financial could be approved to issue would be not less than 1% of risk-weighted assets and not more than the lesser of $25 billion or 3% of risk-weighted assets.
The general terms of the TARP CPP include:
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dividends on the U.S. Treasury Department’s preferred stock at a rate of five percent for the first five years and nine percent thereafter;
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common stock dividends cannot be increased for three years while the U.S. Treasury Department is an investor unless preferred stock is redeemed or consent from the Treasury is received;
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the U.S. Treasury Department’s preferred stock cannot be redeemed for three years unless the participating institution receives the approval of its applicable banking regulator and the U.S. Treasury Department, after demonstrating to those agencies that the participating institution is financially sound without the TARP proceeds;
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the U.S. Treasury Department must consent to any buyback of other stock (common or other preferred);
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the U.S. Treasury Department’s preferred stock will have the right to elect two directors if dividends have not been paid for six periods;
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the U.S. Treasury Department receives warrants equal to 15 percent of the U.S. Treasury Department’s total investment in the participating institution; and
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the participating institution’s executives must agree to certain compensation restrictions, and restrictions on the amount of executive compensation that is tax deductible.
The Company elected to participate in the TARP CPP and in December 2008 issued $55.0 million worth of preferred stock to the U.S. Treasury Department pursuant to this program. See “Capital Resources.”
The EESA also established a Temporary Liquidity Guarantee Program (“TLGP”) that gives the FDIC the ability to provide a guarantee for newly-issued senior unsecured debt and non-interest bearing transaction deposit accounts at eligible insured institutions. The Company has no current plans to participate in the senior unsecured debt of the TLGP. The Company is currently participating in the guarantee program for non-interest bearing transaction deposit accounts. For non-interest bearing transaction deposit accounts, a 10 basis point annual rate surcharge will be applied to deposit amounts in excess of $250,000.
Deposit Insurance
The Bank’s deposits are insured under the Federal Deposit Insurance Act, up to the maximum applicable limits by the Deposit Insurance Fund (“DIF”) of the FDIC and are subject to deposit insurance assessments to maintain the DIF. Effective January 1, 2007 the FDIC adopted a new risk-based insurance assessment system designed to tie what banks pay for deposit insurance more closely to the risks they pose. The FDIC also adopted a new base schedule of rates that the FDIC could adjust up or down, depending on the needs of the DIF, and set initial premiums for 2007 that ranged from 5 cents per $100 of domestic deposits in the lowest risk category to 43 cents per $100 of domestic deposits for banks in the highest risk category. The new assessment system resulted in annual assessments on the Bank’s deposits of 5 cents per $100 of domestic deposits. An FDIC credit available to the Bank for prior contributions offset a portion of the assessments for 2007 and was fully utilized in its 2007 second quarter assessment. The Bank’s deposit insurance premiums for 2009 and 2008 were $3.4 million and $1.3 million, respectively.
On October 16, 2008, in response to the problems facing the financial markets and the economy, the Federal Deposit Insurance Corporation published a restoration plan (Restoration Plan) designed to replenish the Deposit Insurance Fund (DIF) such that the reserve ratio would return to 1.15 percent within five years. On December 16, 2008, the FDIC adopted a final rule increasing risk-based assessment rates uniformly by seven basis points, on an annual basis, for the first quarter 2009.
On February 27, 2009, the FDIC concluded that the problems facing the financial services sector and the economy at large constituted extraordinary circumstances and amended the Restoration Plan and extended the time within which the reserve ratio would return to 1.15 percent from five to seven years (Amended Restoration Plan). In May 2009, Congress amended the statutory provision governing establishment and implementation of a Restoration Plan to allow the FDIC eight years to bring the reserve ratio back to 1.15 percent, absent extraordinary circumstances.
On May 22, 2009, the FDIC adopted a final rule imposing a five basis point special assessment on each insured depository institution’s assets minus Tier 1 capital as of June 30, 2009. The Bank paid $1.0 million for its special assessment which was collected in September 30, 2009.
In a final rule issued on September 29, 2009, the FDIC amended the Amended Restoration Plan as follows:
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The period of the Amended Restoration Plan was extended from seven to eight years.
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The FDIC announced that it will not impose any further special assessments under the final rule it adopted in May 2009.
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The FDIC announced plans to maintain assessment rates at their current levels through the end of 2010. The FDIC also immediately adopted a uniform three basis point increase in assessment rates effective January 1, 2011 to ensure that the DIF returns to 1.15 percent within the Amended Restoration Plan period of eight years.
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The FDIC announced that, at least semi-annually following the adoption of the Amended Restoration Plan, it will update its loss and income projections for the DIF. The FDIC also announced that it may, if necessary, adopt a new rule prior to the end of the eight-year period to increase assessment rates in order to return the reserve ratio to 1.15 percent.
On November 12, 2009, the FDIC adopted a final rule to require insured institutions to prepay their quarterly risk-based deposit insurance assessments for the fourth quarter of 2009, and for all of 2010, 2011 and 2012, on December 30, 2009. Our prepaid assessment was $11.4 million.
In addition, banks must pay an amount which fluctuates but is currently 0.285 cents per $100 of insured deposits per quarter, towards the retirement of the Financing Corporation bonds issued in the 1980’s to assist in the recovery of the savings and loan industry. These assessments will continue until the Financing Corporation bonds mature in 2019.
The enactment of the EESA (discussed above) temporarily raised the basic limit on federal deposit insurance coverage from $100,000 to $250,000 per depositor. The limit is permanent for certain retirement accounts including IRAs. For all other deposit accounts the standard deposit insurance limit will return to $100,000 after December 31, 2013. In addition, pursuant to the guarantee program for non-interest bearing transaction deposit accounts under the TLGP in which the Bank has elected to participate, a 10 basis point annual rate surcharge will be applied to deposit amounts in excess of $250,000.
Community Reinvestment Act
The Bank is subject to certain requirements and reporting obligations involving Community Reinvestment Act (“CRA”) activities. The CRA generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of its local communities, including low and moderate-income neighborhoods. The CRA further requires the agencies to take a financial institution’s record of meeting its community credit needs into account when evaluating applications for, among other things, domestic branches, consummating mergers or acquisitions, or holding company formations. In measuring a bank’s compliance with its CRA obligations, the regulators utilize a performance-based evaluation system which bases CRA ratings on the bank’s actual lending service and investment performance, rather than on the extent to which the institution conducts needs assessments, documents community outreach activities or complies with other procedural requirements. In connection with its assessment of CRA performance, the FDIC assigns a rating of “outstanding,” “satisfactory,” “needs to improve” or “substantial noncompliance.” The Bank was last examined for CRA compliance in 2009 and received a “satisfactory” CRA Assessment Rating.
Privacy and Data Security
The Gramm-Leach-Bliley Act (“GLBA”) imposed new requirements on financial institutions with respect to consumer privacy. The statute generally prohibits disclosure of consumer information to non-affiliated third parties unless the consumer has been given the opportunity to object and has not objected to such disclosure. Financial institutions are further required to disclose their privacy policies to consumers annually. Financial institutions, however, will be required to comply with state law if it is more protective of consumer privacy than the GLBA. The statute also directed federal regulators, including the Federal Reserve and the FDIC, to prescribe standards for the security of consumer information. The Company and the Bank are subject to such standards, as well as standards for notifying consumers in the event of a security breach.
Other Consumer Protection Laws and Regulations
Activities of all insured banks are subject to a variety of statutes and regulations designed to protect consumers, such as including the Fair Credit Reporting Act, Equal Credit Opportunity Act, and Truth-in-Lending Act. Interest and other charges collected or contracted for by the Bank are also subject to state usury laws and certain other federal laws concerning interest rates. The Bank’s loan operations are also subject to federal laws and regulations applicable to credit transactions. Together, these laws and regulations include provisions that:
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govern disclosures of credit terms to consumer borrowers;
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require financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;
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prohibit discrimination on the basis of race, creed, or other prohibited factors in extending credit;
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govern the use and provision of information to credit reporting agencies; and
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govern the manner in which consumer debts may be collected by collection agencies.
The Bank’s deposit operations are also subject to laws and regulations that:
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impose a duty to maintain the confidentiality of consumer financial records and prescribe procedures for complying with administrative subpoenas of financial records; and
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govern automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services
On November 17, 2009, the Board of Governors of the Federal Reserve System promulgated a rule entitled “Electronic Fund Transfers”, with an effective date of January 19, 2010 and a mandatory compliance date of July 1, 2010. The rule, which applies to all FDIC-regulated institutions, prohibits financial institutions from assessing an overdraft fee for paying automated teller machine (ATM) and one-time point-of-sale debit card transactions, unless the customer affirmatively opts in to the overdraft service for those types of transactions. The opt-in provision establishes requirements for clear disclosure of fees and terms of overdraft services for ATM and one-time debit card transactions. The rule does not apply to other types of transactions, such as check, automated clearinghouse (ACH) and recurring debit card transactions. Since a small portion of the Company’s service charges on deposits are in the form of overdraft fees on point-of-sale transactions, this would not have a significant adverse impact on our non-interest income. However, the impact ultimately depends on the level of customer opt-in and cannot be predicted with any degree of certainty.
Interstate Banking and Branching
Since 1995, adequately capitalized and managed bank holding companies have been permitted to acquire banks located in any state, subject to two exceptions: first, any state may still prohibit bank holding companies from acquiring a bank which is less than five years old; and second, no interstate acquisition can be
consummated by a bank holding company if the acquirer would control more than 10% of the deposits held by insured depository institutions nationwide or 30% or more of the deposits held by insured depository institutions in any state in which the target bank has branches.
A bank may establish and operate de novo branches in any state in which the bank does not maintain a branch if that state has enacted legislation to expressly permit all out-of-state banks to establish branches in that state.
In 1995, California enacted legislation to implement important provisions of the Interstate Banking Act discussed above and to repeal California’s previous interstate banking laws, which were largely preempted by the Interstate Banking Act.
The changes effected by the Interstate Banking Act and California laws have increased competition in the environment in which the Bank operates to the extent that out-of-state financial institutions directly or indirectly enter the Bank’s market areas. It appears that the Interstate Banking Act has contributed to the accelerated consolidation of the banking industry. While many large out-of-state banks have already entered the California market as a result of this legislation, it is not possible to predict the precise impact of this legislation on the Bank and Center Financial and the competitive environment in which they operate.
USA Patriot Act of 2001
The USA Patriot Act of 2001 (the “Patriot Act”) was enacted in response to the terrorist attacks in New York, Pennsylvania and Washington, D.C. on September 11, 2001, and is intended to strengthen U.S. law enforcement’s and the intelligence communities’ ability to work cohesively to combat terrorism on a variety of fronts. The impact of the Patriot Act on financial institutions of all kinds has been significant and wide ranging. The Patriot Act substantially enhanced existing anti-money laundering and financial transparency laws, and required appropriate regulatory authorities to adopt rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. Under the Patriot Act, financial institutions are subject to prohibitions regarding specified financial transactions and account relationships, as well as enhanced due diligence and “know your customer” standards in their dealings with foreign financial institutions and foreign customers. For example, the enhanced due diligence policies, procedures, and controls generally require financial institutions to take reasonable steps:
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to conduct enhanced scrutiny of account relationships to guard against money laundering and report any suspicious transactions;
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to ascertain the identity of the nominal and beneficial owners of, and the source of funds deposited into, each account as needed to guard against money laundering and report any suspicious transactions;
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to ascertain for any foreign bank, the shares of which are not publicly traded, the identity of the owners of the foreign bank, and the nature and extent of the ownership interest of each such owner; and
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to ascertain whether any foreign bank provides correspondent accounts to other foreign banks and, if so, the identity of those foreign banks and related due diligence information.
The Patriot Act also requires all financial institutions to establish anti-money laundering programs, which must include, at minimum:
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the development of internal policies, procedures, and controls;
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the designation of a compliance officer;
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an ongoing employee training program; and
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an independent audit function to test the programs.
To fulfill the requirements, the Bank expanded its BSA Compliance Department and intensified due diligence procedures concerning the opening of new accounts. The Bank also implemented new systems and procedures to identify suspicious activity reports and report to the Financial Crimes Enforcement Network (“FINCEN”).
The Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”) was enacted to increase corporate responsibility, provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and protect investors by improving the accuracy and reliability of disclosures pursuant to the securities laws. Sarbanes-Oxley includes important new requirements for public companies in the areas of financial disclosure, corporate governance, and the independence, composition and responsibilities of audit committees. Among other things, Sarbanes-Oxley mandates chief executive and chief financial officer certifications of periodic financial reports, additional financial disclosures concerning off-balance sheet items, and speedier transaction reporting requirements for executive officers, directors and 10% shareholders. In addition, penalties for non-compliance with the Exchange Act were heightened. SEC rules promulgated pursuant to Sarbanes-Oxley impose obligations and restrictions on auditors and audit committees intended to enhance their independence from management, and include extensive additional disclosure, corporate governance and other related rules. Sarbanes-Oxley 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 between a board of directors and its committees.
The Company has incurred, and expects to continue to incur, certain costs in connection with its compliance with Sarbanes-Oxley, particularly with Section 404 thereof, which requires management to undertake an assessment of the adequacy and effectiveness of the Company’s internal controls over financial reporting and requires the Company’s auditors to audit the operating effectiveness of these controls.
Commercial Real Estate Lending and Concentrations
On December 2, 2006, the federal bank regulatory agencies released Guidance on Concentrations in Commercial Real Estate (“CRE”) Lending, Sound Risk Management Practices (“the Guidance”). The Guidance, which was issued in response to the agencies’ concern that rising CRE concentrations might expose institutions to unanticipated earnings and capital volatility in the event of adverse changes in the commercial real estate market, reinforces existing regulations and guidelines for real estate lending and loan portfolio management.
Highlights of the Guidance include the following:
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The agencies have observed that CRE concentrations have been rising over the past several years with small to mid-size institutions showing the most significant increase in CRE concentrations over the last decade. However, some institutions’ risk management practices are not evolving with their increasing CRE concentrations, and therefore, the Guidance reminds institutions that strong risk management practices and appropriate levels of capital are important elements of a sound CRE lending program.
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The Guidance applies to national banks and state chartered banks and is also broadly applicable to bank holding companies. For purposes of the Guidance, CRE loans include loans for land development and construction, other land loans and loans secured by multifamily and non-farm residential properties. The definition also extends to loans to real estate investment trusts and unsecured loans to developers if their performance is closely linked to the performance of the general CRE market.
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The agencies recognize that banks serve a vital role in their communities by supplying credit for business and real estate development. Therefore, the Guidance is not intended to limit banks’ CRE lending. Instead, the Guidance encourages institutions to identify and monitor credit concentrations, establish internal concentration limits, and report all concentrations to management and the board of directors on a periodic basis.
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The agencies recognized that different types of CRE lending present different levels of risk, and therefore, institutions are encouraged to segment their CRE portfolios to acknowledge these distinctions. However, the CRE portfolio should not be divided into multiple sections simply to avoid the appearance of risk concentration.
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Institutions should address the following key elements in establishing a risk management framework for identifying, monitoring, and controlling CRE risk: (1) board of directors and management oversight; (2) portfolio management; (3) management information systems; (4) market analysis; (5) credit underwriting standards; (6) portfolio stress testing and sensitivity analysis; and (7) credit review function.
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As part of the ongoing supervisory monitoring processes, the agencies will use certain criteria to identify institutions that are potentially exposed to significant CRE concentration risk. An institution that has experienced rapid growth in CRE lending, has notable exposure to a specific type of CRE, or is approaching or exceeds specified supervisory criteria may be identified for further supervisory analysis.
The Bank believes that the Guidance is applicable to it, as it has a relatively high level concentration in CRE loans. The Bank and its board of directors have discussed the Guidance and believe that the Bank’s underwriting policy, management information systems, independent credit administration process and monthly monitoring of real estate loan concentrations will be sufficient to address the Guidance.
Allowance for Loan and Lease Losses
On December 13, 2006, the federal bank regulatory agencies released Interagency Policy Statement on the Allowance for Loan and Lease Losses (“ALLL”), which revises and replaces the banking agencies’ 1993 policy statement on the ALLL. The revised statement was issued to ensure consistency with generally accepted accounting principles (“GAAP”) and more recent supervisory guidance. The revised statement extends the applicability of the policy to credit unions. Additionally, the agencies issued 16 FAQs to assist institutions in complying with both GAAP and ALLL supervisory guidance.
Highlights of the revised statement include the following:
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The revised statement emphasizes that the ALLL represents one of the most significant estimates in an institution’s financial statements and regulatory reports and that an assessment of the appropriateness of the ALLL is critical to an institution’s safety and soundness.
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Each institution has a responsibility to develop, maintain, and document a comprehensive, systematic, and consistently applied process for determining the amounts of the ALLL. An institution must maintain an ALLL that is sufficient to cover estimated credit losses on individual impaired loans as well as estimated credit losses inherent in the remainder of the portfolio.
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The revised statement updates the previous guidance on the following issues regarding ALLL: (1) responsibilities of the board of directors, management, and bank examiners; (2) factors to be considered in the estimation of ALLL; and (3) objectives and elements of an effective loan review system.
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The agencies recognize that institutions may not have sufficient time to bring their ALLL processes and documentation into full compliance with the revised guidance for 2006 year end reporting purposes. However, these changes and enhancements should be completed near term.
The Bank and its board of directors have discussed the revised statement and believe that the Bank’s ALLL methodology is comprehensive, systematic, and consistently applied across the Bank. The Bank believes its management information systems, independent credit administration process, policies and procedures are sufficient to address the guidance.
Fiscal and Monetary Policy
Banking is a business that depends on interest rate differentials. In general, the difference between the interest paid by a bank on its deposits and its other borrowings, and the interest received by a bank on its loans and securities holdings, constitutes the major portion of a bank’s earnings. Thus, the Company’s earnings and growth will be subject to the influence of economic conditions generally, both domestic and foreign, and also to the monetary and fiscal policies of the United States and its agencies, particularly the Federal Reserve. The Federal Reserve regulates the supply of money through various means, including open market dealings in United States government securities, the discount rate at which banks may borrow from the Federal Reserve, and the reserve requirements on deposits.
These policies have a direct effect on the amount of the Company’s loans and deposits and on the interest rates charged on loans and paid on deposits, with the result that federal policies may have a material effect on the Company’s earnings. Policies that are directed toward changing the supply of money and credit and raising or lowering interest rates may have an effect on the Company’s earnings. It is not possible to predict the conditions in the national and international economies and money markets, the actions and changes in policy by monetary and fiscal authorities, or their effect on the Company’s operations.
Other Pending and Proposed Legislation
Other legislative and regulatory initiatives, which could affect Center Financial, the Bank and the banking industry, in general are pending, and additional initiatives may be proposed or introduced, before the United States Congress, the California legislature and other governmental bodies in the future. Such proposals, if enacted, may further alter the structure, regulation and competitive relationship among financial institutions, and may subject Center Financial and the Bank to increased regulation, disclosure and reporting requirements. In addition, the various banking regulatory agencies often adopt new rules and regulations to implement and enforce existing legislation. It cannot be predicted whether, or in what form, any such legislation or regulations may be enacted or the extent to which the business of Center Financial or the Bank would be affected thereby.
ITEM 1A.
ITEM 1A. RISK FACTORS
You should carefully consider the following risk factors and all other information contained in this Annual Report before making investment decisions concerning the Company’s common stock. The risks and uncertainties described below are not the only ones the Company faces. Additional risks and uncertainties not presently known to the Company or that the Company currently believes are immaterial but may also impair the Company’s business. If any of the events described in the following risk factors occur, the Company’s business, results of operations and financial condition could be materially adversely affected. In addition, the trading price of the Company’s common stock could decline due to any of the events described in these risks.
Risks Relating to Our Bank and the Banking Business
The Company and the Bank have each entered into MOUs with their respective regulatory agencies and may be subject to future additional regulatory restrictions and enforcement actions if they fail to comply with the MOUs or if their financial condition should further deteriorate.
As discussed above under “Recent Developments-Informal Regulatory Agreements,” the Company and the Bank have recently entered into MOUs with their respective regulatory agencies to facilitate improvement in their financial condition. In addition, the Company incurred substantial losses for the fourth quarter of 2009 and for the 2009 fiscal year, and reflected a substantial increase in the level of nonperforming assets between year-end 2009 and 2008. Under federal and state laws and regulations pertaining to the safety and soundness of insured depository institutions, the regulatory agencies have the authority to compel or restrict certain actions if the Bank’s capital should fall below adequate capital standards as a result of operating losses, or if its regulators otherwise determine that it has insufficient capital or is otherwise operating in an unsafe and unsound manner.
The corrective actions may include, but are not limited to, requiring the Company or the Bank to enter into formal enforcement orders, including written agreements or consent or cease and desist orders, or more drastic measures should circumstances warrant.
In light of the current challenging operating environment, along with our elevated level of non-performing and adversely classified assets and our recent operating results, we are subject to increased regulatory scrutiny as a result of the potential risk of loss in our loan portfolio in the form of the MOUs described above. If we fail to comply with the terms of the MOUs or if our business or financial condition worsens, future corrective actions could require us to limit our lending activities and reduce our levels of certain categories of loans and classified or non-performing assets within specified timeframes, which might prevent us from maximizing the price which might otherwise be received for the underlying properties. In addition, future corrective action, could require us to, among other things, increase our allowance for loan losses, further increase our capital ratios, or enter into a strategic transaction, whether by merger or otherwise, with a third party.
In addition, the FDIC has the power to deem the Bank only adequately capitalized even though its capital ratios meet the well capitalized standard. In such event, the Bank would be prohibited from using brokered deposits, which have been a source of funds for us in recent years, and rates on deposits would be limited to market rates determined by the FDIC, potentially adversely affecting our liquidity. The terms of any such corrective action could have a material adverse effect on our business, our financial condition and the value of our common stock.
Our business has been and may continue to be adversely affected by volatile conditions in the financial markets and deteriorating economic conditions generally.
The United States economy has been in a recession since December 2007. Negative developments since the latter half of 2007 in the financial services industry resulted in uncertainty in the financial markets in general and a related economic downturn. Business activity across a wide range of industries and regions is greatly reduced and many local governments and businesses are in serious difficulty due to the lack of consumer spending and the lack of liquidity in the credit markets. Unemployment has increased significantly.
Since mid-2007, and particularly during the second half of 2008 but continuing throughout 2009, the financial services industry and the securities markets generally were materially and adversely affected by significant declines in the values of nearly all asset classes and by a serious lack of liquidity. This was initially triggered by declines in home prices and the values of subprime mortgages, but spread to all mortgage and real estate asset classes, to leveraged bank loans and to nearly all other asset classes, including equities. The global markets have been characterized by substantially increased volatility and short-selling and an overall loss of investor confidence, initially in financial institutions but more recently in companies in a number of other industries and in the broader markets.
Market conditions have also contributed to the failure of a number of prominent financial institutions. Financial institution failures or near-failures have resulted in further systemic losses as a consequence of defaults on securities issued by them and defaults under contracts entered into with them as counterparties. Furthermore, declining asset values, defaults on mortgages and consumer loans, and the lack of market and investor confidence, as well as other factors, have all combined to increase credit default swap spreads, to cause rating agencies to lower credit ratings, and to otherwise increase the cost and decrease the availability of liquidity, despite very significant declines in rates on advances from the Federal Reserve Board and other government actions. Some banks and other lenders have suffered significant losses and have been reluctant to lend, even on a secured basis, due to the increased risk of default and the impact of declining asset values on the value of collateral. The foregoing has significantly weakened the strength and liquidity of many financial institutions worldwide. In 2008 and 2009, the U.S. government, the Federal Reserve Board and other regulators took numerous steps to increase liquidity and to restore investor confidence, including investing approximately $250 billion in the equity of banking organizations, but asset values continued to decline and access to liquidity remains limited for weakened institutions.
As a result of these financial and economic crises, we have experienced substantial increases in nonperforming loans, including construction, development and land loans, and unsecured commercial and consumer loans. Total nonperforming loans increased to $60.7 million at December 31, 2009 from $20.5 million at December 31, 2008 and $6.3 million at December 31, 2007, representing 4.12%, 1.19% and 0.35% of total loans owned at December 31, 2009, December 31, 2008 and December 31, 2007, respectively. Total nonperforming assets, net of SBA guarantees, increased to $62.2 million at December 31, 2009 from $18.3 million at December 31, 2008 and $3.9 million at December 31, 2007, representing 4.21%, 1.19% and 0.37% of total gross loans and other real estate owned at December 31, 2009, December 31, 2008 and December 31, 2007, respectively. The Company had nonperforming commercial real estate loans of $39.9 million, $13.1 million and $0 as of December 31, 2009, December 31, 2008 and 2007, and no subprime mortgage loans as of any of those dates.
Moreover, competition among depository institutions for deposits and quality loans has increased. In addition, the values of real estate collateral supporting many commercial loans and home mortgages have declined and may continue to decline. Financial institution stock prices have been negatively affected, and the ability of banks and bank holding companies to raise capital or borrow in the debt markets has become more difficult compared to recent years. As a result, there is the potential for new federal or state laws and regulations regarding lending and funding practices and liquidity standards, and bank regulatory agencies have been very aggressive in responding to concerns and trends identified in examinations, including the issuance of many regulatory enforcement actions or orders. Further, the impact of new legislation or regulatory initiatives in response to those developments may restrict our business operations, including our ability to originate or sell loans, and could adversely impact our financial performance or stock price.
In addition, continued negative market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increased delinquencies and default rates, which could further increase our charge-offs and provision for loan losses. A worsening of these conditions would likely exacerbate the already adverse impact on us and others in the financial services industry.
The California economy has been particularly hard hit, and the economic decline has been a major factor leading to the significant increase in the Company’s non-performing assets and loan charge-offs. Overall, during the past year, the general business environment and local market conditions have had an adverse effect on our business, and there can be no assurance that the environment will improve in the near term. Until conditions improve, it is expected that our business, financial condition and results of operations will be adversely affected.
We may have continuing losses and continuing variation in our quarterly results.
We reported a net consolidated loss of $24.5 million during the fourth quarter of 2009 and a net consolidated loss for the year ended December 31, 2009 of $42.5 million. These losses resulted primarily from our high level of non-performing assets and the resultant reduction in interest income and increased provision for loan losses. Total non-performing assets increased to $67.7 million at December 31, 2009, compared to $20.5 million at December 31, 2008, and we may suffer further losses as a result of credit-related factors. We also impaired and wrote off all goodwill and the core deposit intangible asset of $1.4 million during 2009 due to weakened market conditions and adverse economic conditions that had a negative impact on the Company’s valuation. In addition, several other factors affecting our business can cause significant variations in our quarterly results of operations. In particular, variations in the volume of our loan originations and sales, the differences between our costs of funds and the average interest rate earned on investments, the fair valuation of our junior subordinated debentures or other-than-temporary impairment charges in our investment securities portfolio could have a material adverse effect on our results of operations and financial condition. There can be no assurance that we will be profitable in the future.
Concentrations of real estate loans could subject us to increased risks in the event of a prolonged real estate recession or natural disaster.
Our loan portfolio is heavily concentrated in real estate loans, particularly commercial real estate. Approximately $1.0 billion or 66.9% and $1.2 billion or 69.6% of the Company’s loan portfolio were concentrated in commercial real estate and construction loans at December 31, 2009 and 2008, respectively. Although commercial loans generally provide for higher interest rates and shorter terms than single-family residential loans, such loans generally involve a higher degree of risk, as the ability of borrowers to repay these loans is often dependent upon the profitability of the borrowers’ businesses. During 2009 and 2008, the real estate market in Southern California deteriorated significantly, as evidenced by declining market values, reduced transaction volume, and increased foreclosure rates, and this deterioration resulted in an increase in the level of the Company’s nonperforming loans, particularly commercial real estate loans. The levels of nonperforming loans and assets generally, and of commercial real estate loans specifically, are set forth above under “-Our business has been and may continue to be adversely affected by volatile conditions in the financial markets and deteriorating economic conditions generally.” If trends in the Company’s market areas continue or worsen, the result will likely be reduced income, increased expenses, and less cash available for lending and other activities, which would have a material adverse impact on the Company’s financial condition and results of operations.
As the primary collateral for many of the Company’s loans rests on commercial real estate properties, deterioration in the real estate market in the areas the Company serves could reduce the value of the collateral for many of the Company’s loans and negatively impact the repayment ability of many of its borrowers. Such deterioration would likely also reduce the amount of loans the Company makes to businesses in the construction and real estate industry, which could negatively impact the Company’s business. Similarly, the occurrence of a natural disaster like those California has experienced in the past, including earthquakes, brush fires, and flooding, could impair the value of the collateral we hold for real estate secured loans and negatively impact the Company’s results of operations.
In addition, banking regulators are now giving commercial real estate loans greater scrutiny, due to risks relating to the cyclical nature of the real estate market and related risks for lenders with high concentrations of such loans. The regulators have required banks with higher levels of commercial real estate loans to implement enhanced underwriting, internal controls, risk management policies and portfolio stress testing, which has resulted in higher allowances for possible loan losses. Expectations for higher capital levels have also materialized.
Our provision for loan losses and net loan charge-offs have increased significantly and we may be required to make further increases in our provisions for loan losses and to charge off additional loans in the future, which could adversely affect our results of operations.
For the year ended December 31, 2009, we recorded a provision for loan losses and net loan charge-offs of $77.5 million and $57.1 million, respectively, compared to $26.2 million and $8.5 million for the same periods in 2008. We are experiencing elevated levels of loan delinquencies and credit losses. At December 31, 2009, our total non-performing assets had increased to $67.7 million compared to $20.5 million at December 31, 2008. If current weak economic conditions continue, particularly in the construction and real estate markets, we expect that we will continue to experience higher than normal delinquencies and credit losses, and if the recession is prolonged, we could experience significantly higher delinquencies and credit losses. As a result, we may be required to make further increases in our provision for loan losses and to charge off additional loans in the future, which could materially adversely affect our financial condition and results of operations.
We may experience loan and lease losses in excess of our allowance for loan and lease losses.
We are careful in our loan underwriting process in order to limit the risk that borrowers might fail to repay; nevertheless, losses can and do occur. We create an allowance for estimated loan and lease losses in our accounting records, based on estimates of the following:
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historical loss experience with our loans;
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evaluation of economic conditions;
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assessment of risk factors for loans with exposure to the economies of southern California and Pacific Rim countries;
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regular reviews of the quality mix and size of the overall loan portfolio;
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a detailed cash flow analysis for non-performing loans;
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regular reviews of delinquencies; and
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the quality of the collateral underlying our loans.
We maintain an allowance for loan and lease losses at a level that we believe is adequate to absorb any specifically identified losses as well as any other losses inherent in our loan portfolio at a given date. However, changes in economic, operating and other conditions, including changes in interest rates, which are beyond our control, may cause our actual loan losses to exceed our current allowance estimates. If actual losses exceed the amount reserved, it will have a negative impact on our profitability. In addition, the FDIC and the DFI, as part of their supervisory functions, periodically review our allowance for loan and lease losses. Such agencies may require us to increase our provision for loan and lease losses or to recognize further losses, based on their judgments, which may be different from those of our management. As reflected in the MOU between the Bank, the FDIC and the DFI, the Bank agreed to add $18.7 million to the allowance, and did so in the third quarter of 2009, in connection with its most recent regulatory examination. Any further increase in the allowance required by the FDIC or the DFI could also hurt our business.
Our use of appraisals in deciding whether to make a loan on or secured by real property does not ensure the value of the real property collateral.
In considering whether to make a loan secured by real property, we generally require an appraisal of the property. However, an appraisal is only an estimate of the value of the property at the time the appraisal is made. If the appraisal does not reflect the amount that may be obtained upon any sale or foreclosure of the property, we may not realize an amount equal to the indebtedness secured by the property.
All of our lending involves underwriting risks, especially in a competitive lending market.
At December 31, 2009, commercial real estate loans and construction loans represented 66.9% of the Company’s total loan portfolio; commercial lines and term loans to businesses represented 19.2% of the Company’s total loan portfolio; and SBA loans represented 3.2% of the Company’s total loan portfolio.
Real estate lending involves risks associated with the potential decline in the value of underlying real estate collateral and the cash flow from income producing properties. Declines in real estate values and cash flows can be caused by a number of factors, including adversity in general economic conditions, rising interest rates, changes in tax and other governmental and other policies affecting real estate holdings, environmental conditions, governmental and other use restrictions, development of competitive properties, and increasing vacancy rates. The Company’s dependence on commercial real estate loans increases the risk of loss both in the Company’s loan portfolio and with respect to any other real estate owned when real estate values decline. The Company seeks to reduce risk of loss through underwriting and monitoring procedures.
Commercial lending, even when secured by the assets of a business, involves considerable risk of loss in the event of failure of the business. To reduce such risk, the Company typically takes additional security interests in other collateral, such as real property, certificates of deposit or life insurance, and/or obtains personal guarantees.
We may not be able to continue to attract and retain banking customers, and our efforts to compete may reduce our profitability.
Competition in the banking industry in the markets we serve may limit our ability to continue to attract and retain banking customers. The banking business in our current and intended future market areas is highly competitive with respect to virtually all products and services. While our primary market area is generally dominated by a relatively small number of major banks with many offices operating over a wide geographic area, our three main competitors in our niche markets are three Korean-American banks of which two are comparable in size and the third is twice our asset size. These three competitors also focus their business strategies on Korean-American consumers and businesses. Primary competitors in the greater Chicago and Seattle metropolitan areas are also locally owned and operated Korean-American banks and subsidiaries of Korean banks. These competitors have branches located in many of the same neighborhoods as the Company, provide similar types of products and services and use the same Korean language publications and media for their marketing purposes. There is a high level of competition within this specific market. While major banks have not historically focused their marketing efforts on the Korean-American customer base in Southern California, their competitive influence could increase in the future. Such banks have substantially greater lending limits than the Company, offer certain services the Company cannot, and often operate with “economies of scale” that result in lower operating costs than the Company on a per loan or per asset basis.
In addition to competitive factors impacting our specific market niche, we are affected by more general competitive trends in the banking industry, including intra-state and interstate consolidation, competition from non-bank sources, and technological innovations. Technology and other changes are allowing parties to complete financial transactions that historically have involved banks through alternative methods. For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts or mutual funds. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as “disintermediation,” could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on the Company’s financial condition and results of operations.
In addition, with the increase in bank failures, customers increasingly are concerned about the extent to which their deposits are insured by the FDIC. Customers may withdraw deposits in an effort to ensure that the amount they have on deposit with their bank is fully insured. Decreases in deposits may adversely affect our funding costs and net income. Ultimately, competition can and does increase our cost of funds, reduce loan yields and drive down our net interest margin, thereby reducing profitability. It can also make it more difficult for us to continue to increase the size of our loan portfolio and deposit base, and could cause us to rely more heavily on wholesale borrowings, which are generally more expensive than deposits.
Our expenses have increased and are likely to continue to increase as a result of increases in FDIC insurance premiums.
Under the Federal Deposit Insurance Act, the FDIC, absent extraordinary circumstances, must establish and implement a plan to restore the deposit insurance reserve ratio to 1.15% of insured deposits at any time that the reserve ratio falls below 1.15%. Recent bank failures have significantly reduced the deposit insurance fund balance, which was in a negative position by the end of 2009, and the FDIC currently has seven years to bring the reserve ratio back to the statutory minimum. The FDIC expects insured institution failures to peak in 2010, which will result in continued charges against the Deposit Insurance Fund, and they have implemented a restoration plan that changes both its risk-based assessment system and its base assessment rates. As part of this plan, the
FDIC imposed a special assessment in 2009 and also required the prepayment of three years of FDIC insurance premiums at the end of 2009. See “Regulation and Supervision-Deposit Insurance” above. The prepayments are designed to help address liquidity issues created by potential timing differences between the collection of premiums and charges against the DIF, but it is generally expected that assessment rates will continue to increase in the near term due to the significant cost of bank failures and a relatively large number of troubled banks.
Recently enacted legislation and our participation in the TARP Capital Purchase Program may increase costs and limit our ability to pursue business opportunities.
The Emergency Economic Stabilization Act of 2008 (the “EESA”), as augmented by the American Recovery and Reinvestment Act of 2009 (the “Stimulus Bill”), was intended to stabilize and provide liquidity to the U.S. financial markets. The programs established or to be established under the EESA and the Troubled Asset Relief Program (“TARP Capital Purchase Program”) may result in increased regulation of the industry in general and/or TARP Capital Purchase Program participants in particular. Compliance with such regulations may increase the Company’s costs and limit its ability to pursue business opportunities.
If the Emergency Economic Stabilization Act of 2008 and other recently enacted government programs do not help stabilize the U.S. financial system, our operations could be adversely affected.
The EESA (as augmented by the Stimulus Bill) was intended to stabilize and provide liquidity to the U.S. financial markets. The U.S. Treasury and banking regulators have implemented a number of programs under this legislation and otherwise to address capital and liquidity issues in the banking system, including the TARP Capital Purchase Program. In addition, other regulators have taken steps to attempt to stabilize and add liquidity to the financial markets, such as the FDIC’s Temporary Liquidity Guarantee Program (the “TLGP”). While we did not “opt-out” of the TLGP, we do not currently intend to issue any guaranteed debt thereunder. We did participate in the TARP Capital Purchase Program.
It cannot currently be predicted what impact the EESA and other programs will ultimately have on the financial markets. The failure of the EESA and other programs to stabilize the financial markets and a worsening of current financial market conditions could materially and adversely affect our business, financial condition, results of operations, access to credit, or the trading price of our common stock.
The EESA and the Stimulus Bill are relatively new legislation and, as such, are subject to change and evolving interpretation. As a result, it is impossible to predict the effects that such changes will have on the effectiveness of the EESA or on our business, financial condition or results of operations.
We may be adversely affected by the soundness of other financial institutions.
Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks, and other institutional clients. Many of these transactions expose us to credit risk in the event of a default by a counterparty or client. In addition, our credit risk may be exacerbated when collateral held by us cannot be liquidated at prices sufficient to recover the full amount of the credit or derivative exposure due to us. Any such losses could adversely affect our business, financial condition or results of operations.
Liquidity risk could impair our ability to fund operations and jeopardize our financial condition.
Liquidity is essential to the Company’s business. An inability to raise funds through traditional deposits, brokered deposits, borrowings, the sale of securities or loans and other sources could have a substantial negative effect on the Company’s liquidity. The Company’s access to funding sources in amounts adequate to finance the
Company’s activities or the terms of which are acceptable could be impaired by factors that affect the Company specifically or the financial services industry or economy in general. The Company’s access to liquidity sources could be detrimentally impacted by a decrease in the level of the Company’s business activity as a result of a downturn in the markets in which the Company’s loans are concentrated. The Company’s ability to borrow could also be impaired by more general factors such as a disruption in the financial markets or negative views and expectations about the prospects for the financial services industry in light of the recent turmoil faced by banking organizations and the continued deterioration in credit markets.
The Company relies on commercial and retail deposits, brokered deposits, advances from the Federal Home Loan Bank of San Francisco (“FHLB”) and other borrowings to fund its operations. Although the Company has historically been able to replace maturing deposits and advances as necessary, it might not be possible to replace such funds in the future if, among other things, the Company’s results of operations or financial condition or the results of operations or financial condition of the FHLB or market conditions were to change.
Although the Company considers these sources of funds adequate for its liquidity needs, the Company may be compelled to seek additional sources of financing in the future. Likewise, the Company may seek additional debt in the future to achieve our business objectives, in connection with any future acquisitions or for other reasons, and additional borrowings may or may not be available and, if available, may not be so on favorable terms. Bank and holding company stock prices have been negatively affected by the recent adverse economic trend, as has the ability of banks and holding companies to raise capital or borrow in the debt markets compared to recent years. If additional financing sources are unavailable or are not available on reasonable terms, the Company’s financial condition, results of operations and future prospects could be materially adversely affected.
The Company actively monitors the depository institutions that hold its federal funds sold and due from banks cash balances. Access to the Company’s cash equivalents and federal funds sold could be impacted by adverse conditions in the financial markets. The Company’s emphasis is primarily on safety of principal, and the Company diversifies its due from banks and federal funds sold among counterparties to minimize exposure to any one of these entities. The financial conditions of the counterparties are routinely reviewed as part of the Company’s asset/liability management process. Balances in the Company’s accounts with financial institutions in the U.S. may exceed the FDIC insurance limits. While the Company monitors and adjusts the balances in our accounts as appropriate, these balances could be impacted if the financial institutions fail and could be subject to other adverse conditions in the financial markets.
In addition, due to the nature of the market the Company serves, a significant portion of its deposits are held by customers with ties to South Korea who may be inclined to transfer such deposits to South Korea depending on the relative value of the U. S. dollar and the South Korean currency. During the fourth quarter of 2008, the Company experienced a significant loss of deposits when customers transferred deposits to South Korea as a result of the devaluation of South Korean currency to the U. S. dollar. To date, these deposits have been replaced by retail deposits and wholesale funding. If an additional sustained withdrawal of deposits under similar circumstances should occur in the future, the Company’s liquidity position could be significantly and adversely impacted.
The value of securities in our investment portfolio may be negatively affected by continued disruptions in securities markets.
The market for some of the investment securities held in the Company’s portfolio has become extremely volatile over the past twelve months. Volatile market conditions may detrimentally affect the value of these securities, such as through reduced valuations due to the perception of heightened credit, liquidity risks and illiquid markets for certain securities. There can be no assurance that the declines in market value associated with these disruptions will not result in other than temporary impairments of these assets, which would lead to accounting charges that could have a material adverse effect on the Company’s net income and capital levels.
Our growth or future losses may require us to raise additional capital in the future, but that capital may not be available when it is needed or the cost of that capital may be very high.
We are required by applicable regulatory authorities to maintain adequate levels of capital to support our operations and the Bank has agreed in its MOU to maintain capital levels in excess of those required for banks generally (see “Recent Developments-Informal Regulatory Agreements” above). With the proceeds of the fourth quarter capital raises described above under “Recent Developments-Fourth Quarter Capital Raises,” we anticipate that our capital resources will satisfy our capital requirements for the foreseeable future. We may at some point, however, need to raise additional capital to support continued growth or be required by our regulators to increase our capital resources.
Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside our control, and on our financial condition and performance. Accordingly, we cannot make assurances that we will be able to raise additional capital if needed on terms that are acceptable to us, or at all. If we cannot raise additional capital when needed, our ability to further expand our operations could be materially impaired and our financial condition and liquidity could be materially and adversely affected. In addition, if we are unable to raise additional capital when required by our bank regulators, we may be subject to adverse regulatory action.
We may engage in FDIC-assisted transactions, which could present additional risks to our business.
We may have opportunities to acquire the assets and liabilities of failed banks in FDIC-assisted transactions. Although these FDIC-assisted transactions typically provide for FDIC assistance to an acquiror to mitigate certain risks, such as sharing exposure to loan losses and providing indemnification against certain liabilities of the failed institution, we are (and would be in future transactions) subject to many of the same risks we would face in acquiring another bank in a negotiated transaction, including risks associated with maintaining customer relationships and failure to realize the anticipated acquisition benefits in the amounts and within the timeframes we expect. In addition, because these acquisitions are structured in a manner that would not allow us the time and access to information normally associated with preparing for and evaluating a negotiated acquisition, we may face additional risks in FDIC-assisted transactions, including additional strain on management resources, management of problem loans, problems related to integration of personnel and operating systems and impact to our capital resources requiring us to raise additional capital. We cannot assure you that we will be successful in overcoming these risks or any other problems encountered in connection with FDIC-assisted transactions. Our inability to overcome these risks could have a material adverse effect on our business, financial condition and results of operations.
Financial services companies depend on the accuracy and completeness of information about customers and counterparties.
In deciding whether to extend credit or enter into other transactions, the Company may rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports and other financial information. The Company may also rely on representations of those customers, counterparties or other third parties, such as independent auditors, as to the accuracy and completeness of that information. Reliance on inaccurate or misleading financial statements, credit reports or other financial information could have a material adverse impact on the Company’s business and, in turn, on the Company’s financial condition and results of operations.
If our information systems were to experience a system failure or a breach in network security, our business and reputation could suffer.
The Company relies heavily on communications and information systems to conduct its business. The computer systems and network infrastructure we use could be vulnerable to unforeseen problems. The Company’s operations are dependent upon its ability to protect its computer equipment against damage from fire, power loss, telecommunications failure or a similar catastrophic event. In addition, the Company must be able to
protect its computer systems and network infrastructure against physical damage, security breaches and service disruption caused by the Internet or other users. Such computer break-ins and other disruptions would jeopardize the security of information stored in and transmitted through the Company’s computer systems and network infrastructure. The Company has policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of its information systems and with the help of third-party service providers, will continue to implement security technology and monitor and update operational procedures to prevent such damage. However, if such failures, interruptions or security breaches were to occur, they could result in damage to the Company’s reputation, a loss of customer business, increased regulatory scrutiny, or possible exposure to financial liability, any of which could have a material adverse effect on the Company’s financial condition and results of operations.
We depend on our executive officers and key personnel to implement our business strategy and could be harmed by the loss of their services.
The Company believes that its growth and future success will depend in large part upon the skills of its management team. The competition for qualified personnel in the financial services industry is intense, and the loss of the Company’s key personnel or an inability to continue to attract, retain or motivate key personnel could adversely affect the Company’s business. There can be no assurance that the Company will be able to retain its existing key personnel or to attract additional qualified personnel. In addition, as a result of our participation in the TARP Capital Purchase Program, we are subject to significant restriction on the types and amount of compensation we can pay to our senior executive officers and other highly compensated individuals. Such restrictions may make retention and hiring of our management team more difficult. The Company’s President and Chief Executive Officer joined the Company in January 2007; its Executive Vice President and Chief Financial Officer joined the Company in an acting capacity in February 2007 and as permanent Chief Financial Officer in April 2007; its Executive Vice President and General Counsel and Chief Risk Officer joined the Company in February 2007; its Senior Vice President and Chief Credit Officer joined the Company in 1991 as Senior Vice President and Manager of the SBA Department, and was promoted to his current position in April 2007; and its Senior Vice President and Chief Operations Officer joined the Company in July 2007. While the President and Chief Executive Officer, Jae Whan Yoo, has a three-year employment agreement for a term beginning in January 2010, his employment may be terminated by him or by the Company at any time. None of the Company’s other officers have employment agreements.
Our earnings are subject to interest rate risk, especially if rates fall.
Banking companies’ earnings depend largely on the relationship between the cost of funds, primarily deposits and borrowings, and the yield on earning assets, such as loans and investment securities. This relationship, known as the interest rate spread, is subject to fluctuation and is affected by the monetary policies of the Federal Reserve Board and the international interest rate environment, as well as by economic, regulatory and competitive factors which influence interest rates, the volume and mix of interest-earning assets and interest-bearing liabilities, and the level of nonperforming assets. Many of these factors are beyond the Company’s control. Fluctuations in interest rates affect the demand of customers for products and services. The Company is subject to interest rate risk to the degree that interest-bearing liabilities reprice or mature more slowly or more rapidly or on a different basis than interest-earning assets. Given the current volume and mix of interest-bearing liabilities and interest-earning assets, the interest rate spread could be expected to decrease during times of rising interest rates and, conversely, to increase during times of falling interest rates. Therefore, significant fluctuations in interest rates may have an adverse or a positive effect on results of operations.
We are subject to extensive regulation that could limit or restrict our activities.
The Company operates in a highly regulated industry and is subject to examination, supervision, and comprehensive regulation by various federal and state agencies. The Company’s compliance with these regulations is costly and restricts certain of its activities, including payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits and locations of offices.
The Company is also subject to capitalization guidelines established by its regulators, which require the Company to maintain adequate capital to support its growth.
The laws and regulations applicable to the banking industry could change at any time, and the Company cannot predict the effects of these changes on its business and profitability. Because government regulation greatly affects the business and financial results of all commercial banks and bank holding companies, the Company’s cost of compliance could adversely affect its ability to operate profitably.
The Sarbanes-Oxley Act of 2002, and the related rules and regulations promulgated by the Securities and Exchange Commission and NASDAQ that are now applicable to the Company, have increased the scope, complexity and cost of corporate governance, reporting and disclosure practices. In addition, as a participant in the TARP Capital Purchase Program, the Company is subject to certain additional restrictions on its dividend and repurchase activities and compensation arrangements, and the U.S. Congress or federal bank regulatory agencies could adopt additional regulatory requirements or restrictions in response to the threats to the financial system which may apply to all banking institutions, or may instead be more specifically targeted at TARP Capital Purchase Program participants.
If we are not able to successfully keep pace with technological changes affecting the industry, our business could be hurt.
The financial services industry is constantly undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better service clients and reduce costs. Our future success depends, in part, upon our ability to address the needs of our clients by using technology to provide products and services that will satisfy client demands, as well as create additional efficiencies within our operations. Some of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our clients. Failure to successfully keep pace with technological change in the financial services industry could have a material adverse impact on our business and, in turn, on our financial condition and results of operations.
We may incur additional costs for environmental clean up.
The cost of cleaning up or paying damages or penalties associated with environmental problems could increase the Company’s operating expenses. If a borrower defaults on a loan secured by real property, the Company will often purchase the property in foreclosure or accept a deed to the property surrendered by the borrower. The Company also could be compelled to assume the management responsibilities of commercial properties whose owners have defaulted on their loans. The Company also leases premises for its branch operations and corporate office in locations where environmental problems may exist. Although the Company has lending and facility leasing guidelines intended to identify properties with an unreasonable risk of contamination, hazardous substances may exist on some of these properties. As a result, environmental laws could force the Company to clean up the hazardous waste located on these properties (at the Company’s expense) and cost might exceed their fair market value. Further, even if environmental laws did not hold the Company responsible for the environmental clean up of such properties, it might be difficult or impossible to sell properties until the environmental problems were remediated.
Risks Related to Our Securities
The price of our common stock may fluctuate significantly, and this may make it difficult for you to sell shares of common stock at times or at prices you find attractive.
The trading price of our common stock may fluctuate widely as a result of a number of factors, many of which are outside our control. In addition, the stock market is subject to fluctuations in the share prices and trading volumes that affect the market prices of the shares of many companies. These broad market fluctuations could adversely affect the market price of our common stock. Among the factors that could affect our common stock price in the future are:
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formal regulatory action against us;
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actual or anticipated quarterly fluctuations in our operating results and financial condition;
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changes in revenue or earnings estimates or publication of research reports and recommendations by financial analysts;
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failure to meet analysts’ revenue or earnings estimates;
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speculation in the press or investment community;
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strategic actions by us or our competitors, such as acquisitions or restructurings;
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acquisitions of other banks or financial institutions, through FDIC-assisted transactions or otherwise;
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actions by institutional shareholders;
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fluctuations in the stock price and operating results of our competitors;
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general market conditions and, in particular, developments related to market conditions for the financial services industry;
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fluctuations in the stock price and operating results of our competitors;
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proposed or adopted regulatory changes or developments;
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anticipated or pending investigations, proceedings, or litigation that involve or affect us; and
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domestic and international economic factors unrelated to our performance.
The stock market and, in particular, the market for financial institution stocks, has experienced significant volatility. As a result, the market price of our common stock may be volatile. In addition, the trading volume in our common stock may fluctuate more than usual and cause significant price variations to occur. The trading price of the shares of our common stock and the value of our other securities will depend on many factors, which may change from time to time, including, without limitation, our financial condition, performance, creditworthiness and prospects, future sales of our equity or equity related securities, and other factors identified above in “Forward-Looking Statements” and elsewhere in this “RISK FACTORS” section. Current levels of market volatility are unprecedented. The capital and credit markets have been experiencing volatility and disruption for more than a year. In recent months, the volatility and disruption have reached unprecedented levels. In some cases, the markets have produced downward pressure on stock prices and credit availability for certain issuers without regard to those issuers’ underlying financial strength. A significant decline in our stock price could result in substantial losses for individual shareholders and could lead to costly and disruptive securities litigation.
The Company is currently prohibited from paying cash dividends on its capital stock without the prior approval of federal banking regulators and the U.S. Treasury Department, and there can be no assurance that the Company will be able to pay dividends in the future.
The Company has entered into an MOU with the FRB pursuant to which the Company must obtain the prior approval of the FRB in order to pay cash dividends. See “Recent Developments-Informal Regulatory Agreements” above. In addition, under the terms of the Series A Preferred Stock issued to the U.S. Treasury
Department on December 12, 2008 under the TARP Capital Purchase Program, the Company must obtain the prior approval of the U.S. Treasury Department prior to paying any dividends on its capital stock before December 12, 2011. Accordingly, without the prior approval of federal and state banking regulators and the U.S. Treasury Department, the Company cannot pay any cash dividends on either the common stock or the Series B Preferred Stock. The prior approval of the FRB is also required for the payment of dividends on the Series A Preferred Stock, or the payment of interest on the Company’s subordinated debt securities. In view of its current capital levels following the two private placements which closed in the fourth quarter of 2009, it is anticipated that the Company will likely receive approval to pay the dividends on the Series A Preferred Stock, although no assurance can be given that such approvals will be granted. Any failure to pay such dividends or interest when due could adversely affect the market value of our common stock.
Moreover, during any period in which the Company has deferred payment of interest otherwise due and payable on its subordinated debt securities, or any unpaid dividends on the Series A Preferred Stock, the Company may not make any dividends or distributions with respect to its capital stock, including the common stock. The Company’s ability to pay dividends is further limited by California corporation law.
Notwithstanding the foregoing legal limitations, the Board of Directors retains in its full discretion the authority to declare dividends, and there can be no assurance that the Board will authorize any dividends on the common stock in the future.
The Company relies heavily on the payment of dividends from its subsidiary, Center Bank, and such dividends are subject to federal and state regulatory requirements and approvals.
The Company’s ability to pay dividends and to service its own obligations depends on the Bank’s ability to pay dividends to the Company, as the Company has no other independent source of significant income. However, as a result of the MOU and banking regulatory requirements generally, the Bank is limited in its ability to pay cash dividends and must obtain prior regulatory approval in order to do so.
As a general matter, the payment of dividends by the Bank is affected by the requirement to maintain adequate capital pursuant to the capital adequacy guidelines issued by the FDIC. All banks and bank holding companies are required to maintain a minimum ratio of qualifying total capital to total risk-weighted assets of 8%, at least one-half of which must be in the form of Tier 1 capital, and a ratio of Tier 1 capital to average adjusted assets of 4%. If (i) any of these required ratios are increased; (ii) the total of risk-weighted assets of a bank increases significantly; and/or (iii) a bank’s income decreases significantly, a bank may decide to or be required to retain a greater portion of its earnings to achieve and maintain the required capital or asset ratios, thereby reducing the amount of funds available for the payment of dividends by a bank to its parent holding company. In addition, the FDIC has the power to prohibit a bank from paying dividends if, in its view, such payments would constitute unsafe or unsound banking practices.
The MOU the Bank has entered into with the FDIC and the DFI requires the development of a capital plan that includes obtaining a minimum Tier 1 leverage capital ratio of not less than 9% and a total risk-based capital ratio of not less than 13% by December 31, 2009, and maintaining such minimum levels while the MOU remains in effect. The Bank’s regulatory capital ratios as of December 31, 2009 exceeded these requirements. Also under the Bank’s MOU, the Bank must receive prior approval from the FDIC to pay dividends to the Company, and under the Company’s MOU with the FRB, the Company must receive the prior approval of the FRB to receive dividends from the Bank.
The Bank’s ability to pay dividends to the Company is also limited by California corporation law and the California Financial Code. As a result of the Bank’s recent financial performance, the Bank is required by the California Financial Code to obtain the prior approval of the DFI to pay dividends to the Company. Further, whether dividends are paid and their frequency and amount will depend on the financial condition and performance, and the discretion of the Board of Directors of the Bank.
The foregoing restrictions on dividends paid by the Bank may limit the Company’s ability to obtain funds from such dividends for its cash needs, including funds for payment of its debt service requirements and operating expenses and for payment of cash dividends to the Company’s shareholders.
There will be a significant number of shares of our common stock eligible for future sale, which may depress our stock price.
The market price of our common stock could decline as a result of sales of substantial amounts of our common stock in the public market after the conversion of the Series B Preferred Stock which was sold in the private placement which closed on December 31, 2009 (the “December Private Placement”), or even as a result of the perception that such sales could occur.
The Company also issued 3,360,000 shares of common stock in the previous private placement which closed on November 30, 2009 (the “November Private Placement”), which shares will also be eligible for resale as described below. In addition, the Company may issue 85,045 additional shares to investors in the November Private Placement upon shareholder approval thereof. The shares of common stock in the November Private Placement were sold at a price per share of $3.71 to non-affiliated investors and $4.69 to certain directors and officers of the Company. The difference in the purchase price was necessary to comply with NASDAQ Listing Rule 5635(c). The Company intends to seek shareholder approval of the November Private Placement at a special meeting to be held on March 24, 2010, so that all investors in the November Private Placement may be treated equally. If such approval is obtained, 85,045 additional shares would be issued to the directors and officers who invested in the November Private Placement, in order to effectuate this result.
Assuming that the 73,500 shares of Series B Preferred Stock sold in the December Private Placement are converted into common stock based on the initial conversion price of $3.75 per share, which will occur if shareholder approval of the conversion is obtained as currently anticipated at the special meeting scheduled for March 24, 2010 (when and as adjourned), approximately 19,600,000 additional shares of common stock will be issued. (The number of shares of common stock into which each share of Series B Preferred Stock would be converted would be determined by dividing the $1,000 per share liquidation preference by the initial conversion price of $3.75 per share.) Assuming further that the November Private Placement is approved by shareholders at the same meeting, so that the additional 85,045 shares described above will be issued, there will be an aggregate of approximately 39,874,072 shares of our common stock outstanding immediately following such conversion and issuance. All of such shares will be eligible for sale, except that our affiliates would have to comply with the provisions of Rule 144 with respect to resale of shares held by them, the Common Stock to be issued upon conversion of the Series B Preferred Stock may initially be restricted securities, and the shares of common stock issued and to be issued in connection with the November Private Placement are also initially restricted securities. We filed a registration statement with the SEC on February 25, 2010, to register both the Series B Preferred Stock and the shares of Common Stock to be issued upon the conversion of the Series B Preferred Stock. Following the effectiveness of such registration statement, all such shares would also be eligible for resale. If such registration statement becomes effective prior to shareholder approval of the conversion, the shares of common stock to be issued upon the conversion will be freely tradable immediately upon issuance. If not, it is anticipated that they will become so shortly after the conversion. We have also committed to filing a registration statement with the SEC by May 31, 2010, to register the shares of common stock issued and to be issued in connection with the November Private Placement, and intend to do so in March 2010.
In addition, as of February 1, 2010, there were 760,245 shares eligible for sale upon the exercise of options granted and currently outstanding (vested and unvested) under our 2006 Stock Incentive Plan, as amended (the “Plan”); 2,228,531 shares available for future grant under the Plan; and 432,290 shares subject to the Warrant issued to the U.S. Treasury Department in connection with the Company’s participation in the TARP Capital Purchase Program.
If shareholders do not approve the conversion of the Series B Preferred Stock into common stock, the conversion price of the Series B Preferred Stock will be adjusted downward, and the market price of the common stock could be adversely affected if the Company is unable to pay any scheduled dividends on the Series B Preferred Stock.
While it is anticipated that the shareholders will approve the conversion of the Series B Preferred Stock into common stock at a special meeting to be held for this purpose on March 24, 2010 (subject to adjournment and reconvening for a period of up to 45 days in accordance with the Bylaws if necessary to obtain the required vote), there can be no guarantee that such shareholder approval will be obtained within this time frame or in the future. If shareholder approval is not obtained at this special meeting, when and as adjourned, the initial conversion price of the Series B Preferred Stock of $3.75 per share will be decreased by 10%. The shares of Series B Preferred Stock would remain outstanding and, for so long as such shares remain outstanding, we would be required to pay dividends on the Series B Preferred Stock, on a non-cumulative basis, at an annual rate of 12%. We are currently restricted in our ability to pay dividends by the terms of an MOU with the FRB, and Center Bank’s ability to pay dividends to us is restricted by both this MOU and by its own MOU with the FDIC and the DFI. Accordingly, there is no assurance that we will be able to pay such dividends in the near future. If we are unable to pay such dividends as scheduled, the market perception could have a serious adverse impact on the price of our common stock.
The FDIC’s recently adopted Statement of Policy on the Acquisition of Failed Insured Depository Institutions may restrict our activities and those of certain investors in us.
On August 26, 2009, the FDIC adopted the final Statement of Policy on the Acquisition of Failed Insured Depository Institutions (the “Statement”). The Statement purports to provide guidance concerning the standards for more than de minimis investments in acquirers of deposit liabilities and the operations of failed insured depository institutions. The Statement applies to private investors in a company, including any company acquired to facilitate bidding on failed banks or thrifts that is proposing to, directly or indirectly, assume deposit liabilities, or such liabilities and assets, from the resolution of a failed insured depository institution. By its terms, the Statement does not apply to investors with 5% or less of the total voting power of an acquired depository institution or its bank or thrift holding company (provided there is no evidence of concerted action by these investors). When applicable, among other things, covered investors (other than mutual funds that are open-ended investment companies registered under the Investment Company Act of 1940 and that issue redeemable securities allowing investors to redeem on demand) are prohibited by the Statement from selling their securities in the relevant institution for three years. In addition, covered investors must disclose to the FDIC information about the investors and all entities in the ownership chain, including information as to the size of the capital fund or funds, its diversification, the return profile, the marketing documents, the management team and the business model, as well as such other information as is determined to be necessary to assure compliance with the Statement. Furthermore, among other restrictions, the acquired institution must maintain a ratio of Tier 1 common equity to total assets of at least 10% for a period of three years from the time of acquisition; thereafter, the institution must maintain capital such that it is “well capitalized” during the remaining period of ownership by the covered investor. In addition, under the Statement, covered investors employing ownership structures utilizing entities that are domiciled in Secrecy Law Jurisdictions (as defined in the Statement) would not be eligible to own a direct or indirect interest in an insured depository institution, subject to certain exceptions.
It is anticipated that the proceeds of the December Private Placement may be used in part for potential acquisitions involving the purchase of the assets and liabilities of failed banking institutions in FDIC assisted transactions. Accordingly, the Statement may be applicable to private investors in us and, in the event of any such private investors covered by the Statement, will be applicable to us. Furthermore, because the applicability of the Statement depends in large part on the specific investor, we may not know at any given point of time whether the Statement applies to any investor and, accordingly, to us. Each investor must make its own determination concerning whether the Statement applies to it and its investment in us. Each investor is cautioned to consult its own legal advisors concerning such matters. We cannot assure investors that the Statement will not be applicable to us.
Your investment may be diluted because of the ability of management to offer stock to others and stock options.
The shares of the Company do not have preemptive rights. This means that you may not be entitled to buy additional shares if shares are offered to others in the future. We are authorized to issue 40,000,000 shares of common stock and 10,000,000 shares of preferred under our Articles of Incorporation. As of February 1, 2010 we had 20,189,027 shares of our common stock outstanding, 55,000 shares of our Series A Preferred Stock outstanding, and 73,500 shares of Series B Preferred Stock, outstanding. Assuming the conversion of the shares of Series B Preferred Stock into the common stock at the initial conversion price without any adjustments and the issuance of the additional 85,045 shares upon shareholder approval of the November Private Placement, the Company would have approximately 39,874,072 shares of common stock outstanding.
Nothing restricts management’s ability to offer additional shares of stock for fair value to others in the future. In addition, when our directors, executive officers and other employees exercise outstanding stock options, your ownership in the Company will be diluted. As of February 1, 2010 there were outstanding options to purchase an aggregate of 760,245 shares of our common stock with an average exercise price of $16.93 per share. There were also an additional 2,228,261 shares available remaining for grant of options or restricted stock awards under our 2006 Stock Incentive Plan, as amended. In addition, assuming shareholder approval of the November Private Placement, we expect to issue 85,045 additional shares to certain investors in the November Private Placement for no additional consideration. See “There will be a significant number of shares of our common stock eligible for future sale, which may depress our stock price” in this Risk Factors section above.
Shares of our preferred stock eligible for future issuance and sale could also have a dilutive effect on the market for the shares of our common stock. Although our board of directors has no present intent to issue additional shares of preferred stock following the Private Placement, such shares could be issued in the future. If such shares of preferred stock are made convertible into shares of common stock, there could be a dilutive effect on the shares of common stock then outstanding. In addition, shares of preferred stock may be provided a preference over holders of common stock upon our liquidation or with respect to the payment of dividends, in respect of voting rights or in the redemption of our common stock. The rights, preferences, privileges and restrictions applicable to any series or preferred stock would be determined by resolution of our board of directors. We also have a Warrant outstanding to the U S. Treasury Department to purchase 432,290 shares of the Company’s authorized but unissued common stock at an exercise price of $9.54 per share until December 12, 2018.
The holders of our Series A perpetual preferred stock have rights that are senior to those of our common shareholders.
In December 2008, the Company issued and sold $55.0 million worth of its Series A Preferred Stock to the U.S. Treasury Department. The terms of the Series A Preferred Stock could reduce investment returns to the Company’s common shareholders by restricting dividends, diluting existing shareholders’ ownership interests, and restricting capital management practices. The Company’s board of directors suspended its quarterly cash dividends beginning in the first quarter of 2009, and unless the Series A Preferred Stock has been redeemed, the Company will not be able to resume paying cash dividends without the consent of the U.S. Treasury Department. The Company will also be prohibited paying any dividends on its common stock in the event of any unpaid dividends on the Series A Preferred Stock. The Series A Preferred Stock also ranks senior to the Company’s common stock on liquidation. The liquidation amount of the Series A Preferred Stock is $1,000 per share. The Series B Preferred Stock ranks pari passu to the outstanding Series A Preferred Stock, which means that if all dividends payable on the Series B Preferred Stock have not been paid in full, any dividend declared on the Series A Preferred Stock shall be declared and paid pro rata with respect to the Series B Preferred Stock.
If we are unable to redeem our Series A Preferred Stock by December 12, 2013, the cost of this capital to us will increase substantially.
If we are unable to redeem our Series A Preferred Stock prior to December 12, 2013, the cost of this capital to us will increase substantially on that date, from 5% per annum (approximately $2.7 million annually) to 9% per annum (approximately $5.0 million annually). Depending on our financial condition at the time, this increase in the annual dividend rate on the Series A Preferred Stock could have a material negative effect on our earnings.
The holders of our junior subordinated debentures have rights that are senior to those of the shareholders.
As of December 31, 2008, we had $18.0 million in junior subordinated debentures outstanding that were issued to our statutory trust. The trust purchased the junior subordinated debentures from us using the proceeds from the sale of trust preferred securities to third party investors. Payments of the principal and interest on the trust preferred securities are conditionally guaranteed by the Company to the extent not paid or made by each trust, provided the trust has funds available for such obligations.
The junior subordinated debentures are senior to our shares of common stock, Series A Preferred Stock and Series B Preferred Stock. As a result, we must make payments on the junior subordinated debentures (and the related trust preferred securities) before any dividends can be paid on our common stock or preferred stock and, in the event of bankruptcy, dissolution or liquidation, the holders of the debentures must be satisfied before any distributions can be made to shareholders. If certain conditions are met, we have the right to defer interest payments on the junior subordinated debentures (and the related trust preferred securities) at any time or from time to time for a period not to exceed 20 consecutive quarters in a deferral period, during which time no dividends may be paid to holders of our common stock or any series of preferred stock.
Our directors and executive officers control a large amount of our stock, and your interests may not always be the same as those of the board and management.
As of February 1, 2010, our directors and executive officers together with their affiliates beneficially owned approximately 17.0% of the Company’s outstanding voting stock (not including vested option shares). As a result, if all of these shareholders were to take a common position, they might be able to affect the election of directors as well as the outcome of corporate actions requiring shareholder approval, such as the approval of mergers or other business combinations. Such concentration may also have the effect of delaying or preventing a change in control of our company.
In some situations, the interests of our directors and executive officers may be different from the shareholders. However, our directors and executive officers have a fiduciary duty to act in the best interest of the shareholders, rather than in their own best interests, when considering a proposed business combination or any of these types of matters.
Provisions in our articles of incorporation may delay or prevent changes in control of our corporation or our management.
These provisions make it more difficult for another company to acquire us, which could reduce the market price of our common stock and the price that you receive if you sell your shares in the future. These provisions include the following:
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no cumulative voting in the election of directors; and
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The requirement that our board of directors consider the potential social and economic effects on our employees, depositors, customers and the communities we serve as well as certain other factors, when evaluating a possible tender offer, merger or other acquisition of the Company.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
There are no material unresolved written comments that were received from the SEC’s Staff 180 days or more before the end of the Company’s fiscal year 2009 relating to the Company’s periodic or current reports filed under the Securities Exchange Act of 1934.
ITEM 2.
ITEM 2. PROPERTIES
Properties
The Company’s headquarters are located at 3435 Wilshire Boulevard, Los Angeles, California 90010. The Company leases approximately 25,000 square feet, which includes a ground floor branch and administrative offices located on the third, seventh and twentieth floor of the building. The lease term expires in 2011.
As of December 31, 2009, the Company operated full-service branches at seventeen leased locations (including the branch described in the previous paragraph). Expiration dates of the Company’s leases range from February 2010 to September 2019. The Company owns two facilities, the Olympic and Western branches, with carrying values of $0.9 million and $2.2 million, respectively, at December 31, 2009. Certain properties currently leased have renewal options, which could extend the use of the facility for additional specified terms. In the opinion of management, all properties are adequately covered by insurance and existing facilities are considered adequate for present and anticipated future use.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
From time to time, the Company is a party to claims and legal proceedings arising in the ordinary course of business. It is management’s opinion that the resolution of any such claims or legal proceedings would not have a material adverse effect on the Company’s financial condition or results of operations.
ITEM 4.
ITEM 4. RESERVED
PART II
ITEM 5.
ITEM 5. MARKET FOR COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Trading History
Center Financial’s common stock is listed on the NASDAQ Global Select Market under the symbol “CLFC”. The information in the following table indicates the high and low sales prices and approximate volume of trading for the Company’s common stock for the periods indicated, based upon information provided by the NASDAQ Stock Market, LLC.
Holders
As of March 11, 2010, there were approximately 180 shareholders of record of the common stock, and about 1,900 street name holders.
Dividends
As a bank holding company which currently has no significant assets other than its equity interest in the Bank, Center Financial’s ability to pay dividends primarily depends upon the dividends received from the Bank. The dividend practice of the Bank, like the Company’s dividend practice, will depend upon its earnings, financial position, current and anticipated cash requirements and other factors deemed relevant by the Bank’s board of directors at that time. In addition, the Bank and the Company have each entered into MOUs with the respective regulatory agency or agencies, pursuant to which both the Bank and the Company must obtain prior regulatory approval to pay dividends. See “Item 1 - BUSINESS-Recent Developments-Informal Regulatory Agreements” above.
From October 2003 to January 2009, Center Financial paid quarterly cash dividends to its shareholders. Center Financial paid cash dividends of 4 cents per share throughout 2006 and in January and April 2007, and 5 cents per share from July 2007 to January 2009. On March 25, 2009, the Company’s board of directors suspended its quarterly cash dividends based on adverse economic conditions and a reduction in the Company’s earnings. The board of directors determined that this is a prudent, safe and sound practice to preserve capital, and does not expect to resume the payment of cash dividends in the foreseeable future. Unless the preferred stock issued to the U.S. Treasury Department in the TARP Capital Purchase Program has been redeemed, the Company will not be permitted to resume paying cash dividends without the consent of the U.S. Treasury Department until December 2011. In addition, the Bank and the Company have each entered into MOUs with the respective regulatory agency or agencies, pursuant to which both the Bank and the Company must obtain prior regulatory approval to pay dividends. See Note 20-Regulatory Matters. Once the Company is no longer restricted in its ability to pay cash dividends by any specific regulatory requirements, the amount of any such dividends will be determined each quarter by our board of directors in its discretion, based on the factors described in the next paragraph. No assurance can be given that future performance will justify the payment of dividends in any particular quarter.
The Bank’s ability to pay cash dividends is also subject to certain legal limitations. Under California law, banks may declare a cash dividend out of their net profits up to the lesser of retained earnings or the net income for the last three fiscal years (less any distributions made to shareholders during such period), or with the prior written approval of the Commissioner of Financial Institutions, in an amount not exceeding the greatest of (i) the retained earnings of the Bank, (ii) the net income of the Bank for its last fiscal year or (iii) the net income of the Bank for its current fiscal year. Since the Bank’s net loss for 2009 exceeded its combined earnings for 2008 and 2007, in addition to the regulatory approval requirements of the MOU, the Bank will need to obtain the prior written approval of the Commissioner to pay any dividends until the Bank’s net income for the previous three fiscal years is again greater than the amount of any such dividend. In addition, under federal law, banks are prohibited from paying any dividends if after making such payment they would fail to meet any of the minimum regulatory capital requirements. The federal regulators also have the authority to prohibit banks from engaging in any business practices which are considered to be unsafe or unsound, and in some circumstances the regulators might prohibit the payment of dividends on that basis even though such payments would otherwise be permissible.
Center Financial’s ability to pay dividends is also limited by state corporation law. The California General Corporation Law allows dividends to the company’s shareholders if the company’s retained earnings equal at least the amount of the proposed dividend. If a California corporation does not have sufficient retained earnings available for the proposed dividend, it may still pay a dividend to its shareholders if immediately after giving effect to the dividend the sum of the company’s assets (exclusive of goodwill and deferred charges) would be at least equal to 125% of its liabilities (not including deferred taxes, deferred income and other deferred liabilities) and the current assets of the company would be at least equal to its current liabilities, or, if the average of its earnings before taxes on income and before interest expense for the two preceding fiscal years was less than the average of its interest expense for the two preceding fiscal years, at least equal to 125% of its current liabilities. In addition, during any period in which Center Financial has deferred payment of interest otherwise due and payable on its subordinated debt securities, or any unpaid dividends on the preferred stock issued to the U.S. Treasury Department, it may not make any dividends or distributions with respect to its capital stock. See “Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations-Capital Resources.”
Securities Authorized for Issuance under Equity Compensation Plans
The following table provides information as of December 31, 2009 with respect to stock options and restricted stock awards outstanding and available under our 2006 Stock Incentive Plan, as amended, which is our only equity compensation plan other than an employee benefit plan meeting the qualification requirements of Section 401(a) of the Internal Revenue Code:
Performance Graph
The graph below compares the yearly percentage change in cumulative total shareholders’ return on the Company’s stock with the cumulative total return of (i) of the NASDAQ market index; (ii) all banks and bank holding companies listed on NASDAQ; and (iii) an index comprised of banks and bank holding companies located throughout the United States with total assets of between $1.0 billion and $5.0 billion. The latter two peer group indexes were compiled by SNL Financial of Charlottesville, Virginia. The Company reasonably believes that the members of the third group listed above constitute peer issuers for the period from December 31, 2004 through December 31, 2009. The graph assumes an initial investment of $100 and reinvestment of dividends. The graph is not necessarily indicative of future price performance.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table presents selected historical financial information concerning the Company, which should be read in conjunction with the Company’s audited consolidated financial statements, including the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” included elsewhere herein. All per share information has been adjusted for dividends declared by the Company.
Net loans represent total gross loans less the allowance for loan losses, deferred fees, and discount on SBA loans.
Net income divided by average total assets.
Net income divided by average shareholders’ equity.
Represents the weighted average yield on interest-earning assets less the weighted average cost of interest-bearing liabilities.
Represents net interest income as a percentage of average interest-earning assets.
Represents the ratio of non-interest expense to the sum of net interest income before provision for loan losses and total non-interest income.
Nonperforming loans consist of non-accrual loans and loans past due 90 days or more.
Nonperforming assets consist of non-performing loans and other real estate owned.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This discussion presents Management’s analysis of the Company’s financial condition and results of operations as of, and for each of the years in the three-year period ended December 31, 2009, and includes the statistical disclosures required by SEC Guide 3 (“Statistical Disclosure by Bank Holding Companies”). The discussion should be read in conjunction with the financial statements of the Company and the notes related thereto which appear elsewhere in this Form 10-K Annual Report (See Item 8 below). All share and per share information set forth herein has been adjusted to reflect stock splits and stock dividends declared by the Company from time to time.
Critical Accounting Policies
Accounting estimates and assumptions discussed in this section are those that the Company considers to be the most critical to an understanding of its financial statements because they inherently involve significant judgments and uncertainties. The financial information contained in these statements is, to a significant extent, based on approximate measures of the financial effects of transactions and events that have already occurred. These critical accounting policies are those that involve subjective decisions and assessments and have the greatest potential impact on the Company’s results of operations. Management has identified its most critical accounting policies to be those relating to the following: investment securities, loan sales, allowance for loan losses, OREO, impaired loans, deferred income taxes and share-based compensation. The following is a summary of these accounting policies. In each area, the Company has identified the variables most important in the estimation process. The Company has used the best information available to make the estimations necessary to value the related assets and liabilities. Actual performance that differs from the Company’s estimates and future changes in the key variables could change future valuations and impact net income.
Investment Securities
Investment securities generally must be classified as held-to-maturity, available-for-sale or trading. The appropriate classification is based partially on the Company’s ability to hold the securities to maturity and largely on management’s intentions with respect to either holding or selling the securities. The classification of investment securities is significant since it directly impacts the accounting for unrealized gains and losses on securities. Unrealized gains and losses on trading securities flow directly through earnings during the periods in which they arise, whereas with respect to available-for-sale securities, they are recorded as a separate component of shareholders’ equity (accumulated comprehensive other income or loss) and do not affect earnings until realized. The fair values of the Company’s investment securities are generally determined by reference to quoted market prices and reliable independent sources.
To determine whether a debt security is other-than temporarily impaired, for debt securities, management must assess whether (a) it has the intent to sell the security and (b) it is more likely than not that it will be required to sell the security prior to its anticipated recovery. These steps are done before assessing whether the entity will recover the cost basis of the investment. Previously, this assessment required management to assert it has both the intent and the ability to hold a security for a period of time sufficient to allow for an anticipated recovery in fair value to avoid recognizing an other-than-temporary impairment. In instances where a determination is made that an other-than-temporary impairment exists but the investor does not intend to sell the debt security and it is not more likely than not that it will be required to sell the debt security prior to its anticipated recovery, the other-than temporary impairment need to be recognized in the statement of operations. The other-than-temporary impairment is separated into (a) the amount of the total other-than-temporary impairment related to a decrease in cash flows expected to be collected from the debt security (the credit loss) and (b) the amount of the total other-than-temporary impairment related to all other factors. The amount of the total other-than-temporary impairment related to the credit loss is recognized in earnings. The amount of the total other-than-temporary impairment related to all other factors is recognized in other comprehensive income.
Loan Sales
Certain Small Business Administration loans and other loans that the Company has the intent to sell prior to maturity are designated as held for sale typically at origination and recorded at the lower of cost or market value, on an aggregate basis. Upon management’s decision, certain loans in the portfolio may be reclassified to the held for sale category prior to any commitment by the Company to sell the loans. Such decision is usually made to rebalance the loan portfolio and to better manage the Company’s liquidity and capital resources. A valuation allowance is established if the market value of such loans is lower than their cost, and operations are charged or credited for valuation adjustments. A portion of the premium on sale of loans is recognized as other operating income at the time of the sale. The remaining portion of the premium relating to the portion of the loan retained is deferred and amortized over the remaining life of the loan as an adjustment to yield. Servicing assets or
liabilities are recorded when loans are sold with servicing retained, based on the present value of the contractually specified servicing fee, net of servicing costs, over the estimated life of the loan, using a discount rate based on the related note rate plus 1 to 2%. Net servicing assets, or servicing assets net of servicing liabilities, are amortized in proportion to and over the period of estimated future servicing income. Management periodically evaluates the net servicing asset for impairment, which is the carrying amount of the net servicing asset in excess of the related fair value. Impairment, if it occurs, is recognized as a write-down in the period of impairment.
Allowance for Loan Losses
The Company’s allowance for loan loss methodologies incorporate a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan losses that management believes is appropriate at each reporting date. Quantitative factors include the Company’s historical loss experience, delinquency and charge-off trends, collateral values, changes in nonperforming loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers’ sensitivity to interest rate movements and borrowers’ sensitivity to quantifiable external factors including commodity and finished good prices as well as acts of nature such as earthquakes, floods, fires, etc. that occur in a particular period. Qualitative factors include the general economic environment in the Company’s markets and, in particular, the state of certain industries. Size and complexity of individual credits, loan structure, extent and nature of waivers of existing loan policies and pace of portfolio growth are other qualitative factors that are considered in its methodologies. As the Company adds new products, increases the complexity of the loan portfolio and expands the geographic coverage, the Company will enhance the methodologies to keep pace with the size and complexity of the loan portfolio. Changes in any of the above factors could have significant impact to the loan loss calculation. The Company believes that its methodologies continue to be appropriate given its size and level of complexity. Detailed information concerning the Company’s loan loss methodology is contained in “Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations-Allowance for Loan Losses.”
OREO
The Company records the property at the lower of its carrying value or its fair value less anticipated disposal costs. Any write-down of OREO is charged to earnings. The Company may make loans to potential buyers of OREO to facilitate the sale of OREO. In those cases, all loans made to such buyers must be reviewed under the same guidelines as those used for making customary loans, and must conform to the terms and conditions consistent with the Company’s loan policy. Any deviations from this policy must be specifically noted and reported to the appropriate lending authority. The Company follows ASC 360-20, Real Estate Sales, when accounting for loans made to facilitate the sale of OREO. Profit on real estate sales transactions shall not be recognized by the full accrual method until all of the following criteria are met:
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A sale is consummated;
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The buyer’s initial and continuing investments are adequate to demonstrate a commitment to pay for the property;
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The seller’s receivable is not subject to future subordination; and
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The seller has transferred to the buyer the usual risks and rewards of ownership in a transaction that is in substance a sale and does not have a substantial continuing involvement with the property.
Impaired Loans
Loans are measured for impairment when it is probable that not all amounts, including principal and interest, will be collected in accordance with the contractual terms of the loan agreement. The amount of impairment and any subsequent changes are recorded through the provision for loan losses as an adjustment to
the allowance for loan losses. Impairment is measured either based on the present value of the loan’s expected future cash flows or the estimated fair value of the collateral less related liquidation costs. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
The Company evaluates consumer loans for impairment on a pooled basis. These loans are considered to be smaller balance, homogeneous loans, and are evaluated on a portfolio basis accordingly.
Deferred Taxes
Deferred income taxes are provided for using an asset and liability approach. Deferred income tax assets and liabilities represent the tax effects, based on current tax law, of future deductible or taxable amounts attributable to events that have been recognized in the consolidated financial statements.
A valuation allowance has been established against deferred tax assets due to an uncertainty of realization. The valuation allowance is reviewed in each period to analyze whether there is a sufficient positive or negative evidence to support a change in management’s judgment about the realizability of the related deferred tax assets.
Share-based Compensation
Beginning January 1, 2006 as discussed in Note 14 to the consolidated financial statements, the Company is required to recognize compensation expense for all share-based payments made to employees based on the fair value of the share-based payment on the date of grant. The Company elected to use the modified prospective method for adoption, which requires compensation expense to be recorded for all unvested stock options beginning in the first quarter of adoption. For all unvested options outstanding as of January 1, 2006, the previously measured but unrecognized compensation expense, based on the fair value at the original grant date, is recognized on a straight-line basis in the Consolidated Statements of Operations over the remaining vesting period. For share-based payments granted subsequent to January 1, 2006, compensation expense, based on the fair value on the date of grant, is recognized in the Consolidated Statements of Operations on a straight-line basis over the vesting period. In determining the fair value of stock options, the Company uses the Black-Scholes option-pricing model that employs the following assumptions:
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Expected volatility-based on the weekly historical volatility of our stock price, over the expected life of the option.
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Expected term of the option-based on historical employee stock option exercise behavior, the vesting terms of the respective option and a contractual life of ten years.
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Risk-free rate-based upon the rate on a zero coupon U.S. Treasury bill, for periods within the contractual life of the option, in effect at the time of grant.
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Dividend yield-calculated as the ratio of historical dividends paid per share of common stock to the stock price on the date of grant.
The Company’s stock price volatility and option lives involve management’s best estimates at that time, both of which impact the fair value of the option calculated under the Black-Scholes methodology and, ultimately, the expense that will be recognized over the life of the option.
Executive Overview
Consolidated net loss for the year ended December 31, 2009 was $42.5 million and consolidated net loss available to common shareholders was $45.5 million, or loss of $2.66 per diluted common share compared to consolidated net income of $220,000, consolidated net income available to common shareholders of $65,000 and
$0.00 per diluted common share for the year ended December 31, 2008. The following were significant factors related to 2009 results as compared to 2008:
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The 2009 provision for loan losses increased $51.3 million to $77.5 million compared to $26.2 million in 2008, due primarily to charge-offs and the risk assessment of the loan portfolio. Management’s assessment of the credit risk inherent in the portfolio is based on a migration, quantitative and qualitative analyses, and other historical factors and trends.
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The Company’s efficiency ratio for 2009 improved to 61.3% compared to 69.1% for 2008 due to non-recurring OTTI expense of $9.9 million as a reduction of income and the KEIC litigation settlement expense of $7.5 million incurred in 2008. Decrease in salaries and employee benefit expenses by $5.9 million, or 25.0%, offset by the increases in regulatory assessment by $2.2 million, or 171.5% and OREO related expenses by $1.8 million, or 2,590% contributed to the improvement in efficiency ratio.
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Net interest income before provision for loan losses for 2009 decreased by 17.9% or $13.4 million to $61.2 million as compared to 2008. The decrease was primarily due to reduction in net earning assets of $9.7 million and margin compression of $3.6 million. Reduction in net earning assets, mainly loans, was driven by de-leveraging strategy throughout the year.
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The net interest margin for the years ended December 31, 2009, 2008 and 2007 was 3.03%, 3.80%, and 4.23%, respectively. The 77 basis point decrease in net interest margin in 2009 was due primarily to a reduction in the Federal Reserve lending rates by the FOMC during the year and to a lesser extent, a change in the loan portfolio mix resulting in a higher portion of the loan originations being variable rate in 2008 as compared to 2007. Interest income on non-accrual loans amounting to $3.8 million and $0.5 million were not recognized during 2009 and 2008, respectively.
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The return on average assets and return on average equity for 2009 decreased to (1.96)% and (20.29)%, respectively, compared to 0.01% and 0.13% in 2008. These decreases were due to the consolidated net losses primarily resulting from the compression of net interest margins and the increase in the loan loss provision.
The following are important factors in understanding the Company’s financial condition and liquidity:
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During the fourth quarter of 2009, the Company raised an aggregate of $86.3 million in gross proceeds from the successful consummation of two private placements. The first was for 3,360,000 shares of common stock for gross proceeds of $12.8 million, and the second was for 73,500 shares of Mandatorily Convertible Non-Cumulative Non-Voting Perpetual Preferred Stock, Series B, for gross proceeds of $73.5 million. See “Item 1 - Business-Recent Developments-Fourth Quarter Capital Raises” above.
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Non-performing assets increased to $67.7 million at December 31, 2009 from $20.5 million at December 31, 2008, an increase of $47.3 million or 231%. The largest component of this increase was non-performing commercial real estate and construction loans representing $36.0 million of the increase. There was an increase in non-performing assets, and the ratio of non-performing assets as a percent of total loans and other real estate owned was 4.39% at December 31, 2009 compared to 1.19% at December 31, 2008.
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The ratio of non-accrual loans to total loans increased to 4.12% at December 31, 2009 compared to 1.19% at December 31, 2008. The ratio of the allowance for loan losses to total nonperforming loans decreased to 90% at December 31, 2009, as compared to 187% at December 31, 2008, and the ratio of the allowance for loan losses to total gross loans increased to 3.81% at December 31, 2009 compared to 2.22% at December 31, 2008.
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Net loans declined $200.2 million or 11.9% to $1.48 billion at December 31, 2009 as compared to $1.68 billion at December 31, 2008. The decrease in net loans was primarily due to the strategic
reduction of the loan portfolio and the increase in the allowance for loan losses in 2009. The reduction of the loan portfolio was mainly comprised of net decreases in commercial real estate loans of $127.0 million, or 11.2%; real estate construction loans of $41.0 million, or 66.1% and commercial loans of $39.1 million, or 11.7%.
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Deposits increased 9.0% to $1.75 billion at December 31, 2009, from $1.60 billion at December 31, 2008, largely due to increases in customer deposits accomplished through the Bank’s deposit campaigns. Deposit growth consists of the increases in money market accounts of $54.2 million, non interest-bearing demand deposit of $42.0 million, savings accounts of $33.9 million, NOW accounts of $26.8 million, and jumbo time deposits of $42.5 million. The Company borrows funds through the Federal Home Loan Bank, Treasury Tax and Loan Investment Program. Other borrowings decreased $44.6 million or 23.1% to $148.4 million at December 31, 2009 from $193.0 million at December 31, 2008.
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As a result of the aforementioned decline in loans and increase in deposits, the ratio of net loans to total deposits decreased to 84.6% at December 31, 2009 as compared to 104.7% at December 31, 2008.
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On March 25, 2009, the Company’s board of directors suspended its quarterly cash dividend of $0.05 from the first quarter of 2009 based on adverse economic conditions and reduction in earnings of the Company.
Results of Operations
Net Interest Income
The Company’s earnings depend largely upon its net interest income, which is the difference between the income received from its loan portfolio and other interest-earning assets and the interest paid on its deposits and other funding liabilities. The Company’s net interest income is affected by the change in the level and the mix of interest-earning assets and interest-bearing liabilities, referred to as volume changes. The Company’s net interest income is also affected by changes in the yields earned on assets and rates paid on liabilities, referred to as rate changes. Interest rates charged on loans are affected principally by the demand for such loans, the supply of money available for lending purposes, and competitive factors. Those factors are, in turn, affected by general economic conditions and other factors beyond the Company’s control, such as federal economic policies, the general supply of money in the economy, legislative tax policies, governmental budgetary matters and the actions of the Federal Reserve Board. Interest rates on deposits are affected primarily by rates charged by competitors.
The following table sets forth, for the periods indicated, the dollar amount of changes in interest earned and interest paid for interest-earning assets and interest-bearing liabilities and the amount of change attributable to (i) changes in average daily balances (volume) and (ii) changes in interest rates (rate):
Loans are net of the allowance for loan losses, deferred fees and discount on SBA loans retained. Loan fees included in loan income were approximately $0.7 million, $1.4 million and $2.1 million for the years ended December 31, 2009, 2008 and 2007, respectively. Amortized loan fees have been included in the calculation of net interest income. Non-accrual loans have been included in the table for computation purposes, but the foregone interest of such loans is excluded.
Interest income on a tax equivalent basis for tax-advantaged investments was not included in the computation of yields. Such income amounted to $0, $85,000 and $87,000 for the years ended December 31, 2009, 2008 and 2007, respectively.
Net interest income was $61.2 million, $74.6 million and $76.3 million for the years ended December 31, 2009, 2008 and 2007, respectively. The 2009 decrease in net interest income of $13.4 million, or 17.9% was due to a sharp decline in interest rates during the comparable periods. This decline was mostly attributed to the Federal Open Market Committee of the Federal Reserve System (“FOMC”) decreasing interest rates over the comparable periods. The 2008 decrease in net interest income of $1.7 million, or 2.2% was principally due to compression of our net interest margin primarily resulting from a series of rate decrease by FOMC, which caused an immediate reduction in the variable rate loan portfolio and a delayed reduction of the Company’s costs of its portfolio of time deposits.
Net Interest Margin
The following table shows the Company’s average balances of assets, liabilities and shareholders’ equity; the amount of interest income and interest expense; the average yield or rate for each category of interest-earning assets and interest-bearing liabilities; and the net interest spread and the net interest margin for the periods indicated:
Loans are net of the allowance for loan losses, deferred fees and discount on SBA loans retained. Loan fees included in loan income were approximately $0.7 million, $1.4 million and $2.1 million for the years ended December 31, 2009, 2008 and 2007, respectively. Amortized loan fees have been included in the calculation of net interest income. Non-accrual loans have been included in the table for computation purposes, but the foregone interest of such loans is excluded.
Interest income on a tax equivalent basis for tax-advantaged investments was not included in the computation of yields. Such income amounted to $0, $85,000 and $87,000 for the years ended December 31, 2009, 2008 and 2007, respectively.
Represents the weighted average yield on interest-earning assets less the weighted average cost of interest-bearing liabilities.
Represents net interest income before the provision for loan losses measured as a percentage of average interest-earning assets.
The net interest margin for the years ended December 31, 2009, 2008 and 2007 was 3.03%, 3.80%, and 4.23%, respectively. The 77 basis point decrease in net interest margin in 2009 was due primarily to a reduction in the Federal Reserve lending rates by the FOMC during the year and to a lesser extent, a change in the loan portfolio mix resulting in a higher portion of the loan originations being variable rate in 2008 as compared to 2007.
The 43 basis point decrease in net interest margin in 2008 was due primarily to a reduction in the Federal Reserve lending rates by the FOMC during the year and to a lesser extent, a change in the loan portfolio mix resulting in a higher portion of the loan originations being variable rate in 2008 as compared to 2007. In addition, the decrease in demand deposits and the increases in time deposits and in other borrowed funds contributed to the decrease in the net interest margin.
The average yield on loans decreased to 5.89% in 2009 compared to the decrease to 6.88% in 2008 from 8.25% in 2007, a decrease of 99 and 137 basis points, respectively. The declining loan yields in 2009 were attributable to (i) increase in variable rate loans; (ii) adjustable and variable rate loans repricing to lower current market interest rates; and (iii) interest income on non-accrual loans not recognized in the amount of $3.8 million during 2009 as compared to $0.5 million in 2008 . The lower yields on loans for 2008 were a result of (i) increase in variable rate loans; and (ii) a reduction of 400 basis points in the fed funds rate in 2008.
The average yield on the investment portfolio was 3.90% in 2009, as compared to 4.85% and 4.83% in 2008 and 2007, respectively, a decrease of 95 basis points and an increase of 2 basis points, respectively. The decrease in the investment portfolio yield for 2009 was attributed to maturities and calls of securities with weighted average yields greater than the remaining portfolio, and also due to reinvestments made at lower market yields than the overall portfolio yield. The increase in the investment portfolio yield for 2008 was due mainly to a generally higher yield curve at the time of purchase and management’s decision to extend the portfolio duration.
The Company’s overall cost of interest bearing liabilities decreased to 2.62% in 2009 from 3.67% and 4.88% in 2008 and 2007, respectively. The decrease in cost of interest bearing liabilities for 2009 was primarily a result of a decrease in the average rate paid on the certificate of deposit, money market and savings portfolios due to the portfolios repricing to lower market rates. The decrease in 2008 was primarily due to deposit portfolios repricing to lower market rates following a series of FOMC’s interest rate reductions.
The Company offers a wide variety of retail deposit account products to both consumer and commercial deposit customers. Time deposits, which are the Company’s highest cost deposits, consist primarily of retail fixed-rate certificates of deposit, and comprised 44.7% and 49.5% of the deposit portfolio at December 31, 2009 and 2008, respectively. The ratio of noninterest-bearing deposits to total deposits was 20.2% and 19.3% at December 31, 2009, and 2008, respectively. All other deposits, which include interest-bearing checking accounts called Negotiable Order Withdrawal (NOW), savings and money market accounts, accounted for the remaining 35.2% and 31.2% of the deposit portfolio at December 31, 2009 and 2008, respectively.
Deposit growth remains challenging as the Company continues to experience heightened market competition. Deposits increased 9.0% to $1.75 billion at December 31, 2009, from $1.60 billion at December 31, 2008, largely due to increases in customer deposits accomplished through the Bank’s deposit campaigns. Deposit growth consists of the increases in money market accounts of $54.2 million, non interest-bearing demand deposit
of $42.0 million, savings accounts of $33.9 million, NOW accounts of $26.8 million, and jumbo time deposits of $42.5 million. These increases were partially offset by decreases in non jumbo time deposits of $55.5 million. The decrease in non jumbo time deposits is primarily due to $47.4 million in brokered time deposits maturing in 2009. Jumbo time deposits amounted to $524.4 million while non jumbo time deposits amounted to $256.0 million including $121.0 million in brokered time deposits. Total time deposits amounted to $780.4 million and represented 44.7% of total deposits at December 31, 2009. Total money market accounts were $492.9 million or 28.2% including $139.2 million in brokered deposits. All other deposits represent 27.1% of total deposits at December 31, 2009. Total brokered deposit balance at December 31, 2009 was $260.2 million.
The Company’s ratio of average interest earning assets to interest bearing liabilities has remained relatively stable at 124.5%, 127.3% and 131.4% for 2009, 2008 and 2007, respectively.
Provision for Loan Losses
The Company sets aside an allowance for potential loan losses through charges to earnings, which are reflected in the consolidated statements of operations as the provision for loan losses. Specifically, the provision for loan losses represents the amount charged against current period earnings to achieve an allowance for loan losses that in management’s judgment is adequate to address inherent risks in the Company’s loan portfolio.
Due primarily to an increase in net charge-offs and an increase in the level of non-performing loans, the provision for loan losses increased to $77.5 million for the year ended December 31, 2009, compared to $26.2 million and $6.5 million for 2008 and 2007, respectively. During 2009, net charge-offs were $57.1 million as compared to $8.5 million and $3.4 million in 2008 and 2007, respectively. While management believes that the allowance for loan losses of 3.81% of total loans was adequate at December 31, 2009, future additions to the allowance will be subject to continuing evaluation of estimated and known, as well as inherent, risks in the loan portfolio. The procedures for monitoring the adequacy of the allowance, as well as detailed information concerning the allowance itself, are included below under “-Allowance for Loan Losses”.
Non-interest Income
The following table sets forth the various components of the Company’s non-interest income for the periods indicated:
Non-interest income increased 154.8%, or $8.5 million, to $14.0 million for the year ended December 31, 2009 compared to $5.5 million for the year ended December 31, 2008. The 2009 increase in non-interest income was primarily due to the OTTI loss of securities available for sale of $9.9 million incurred in 2008 which did not incur in 2009. For the year ended December 31, 2009 non-interest income as a percentage of average earning
assets increased to 0.69% compared to 0.28% and 0.75% for the years ended December 31, 2008 and 2007, respectively. The fluctuation in these ratios was mainly due to unusual decline in the non-interest income in 2008 while average earning assets have increased from $1.8 billion at December 31, 2007 to $2.0 billion at both December 31, 2008 and 2009. The primary sources of recurring non-interest income continued to be customer service fee charges on deposit accounts, fees from trade finance transactions and wire transfer service fees.
Customer service fees increased $355,000, or 4.6%, from 2008 to 2009, and increased $0.7 million, or 10.3%, from 2007 to 2008. These increases were due to management’s efforts to provide better services while charging higher fees for the services. Customer service fees amounted to 57.3% of total non-interest income in 2009, compared to 139.6% and 51.3% in 2008 and 2007, respectively.
Fee income from trade finance transactions decreased $254,000, or 10.1%, from 2008 to 2009, and $101,000, or 3.9%, from 2007 to 2008. While management continues efforts to increase the Company’s Asia Pacific trade financing, the overall trading activities in the region has been negatively affected by the global weakening economy. As a result of the lower volume, fee income from trade finance transactions amounted to 16.2% of total non-interest income for 2009, as compared to 45.9% and 19.4% in 2008 and 2007, respectively.
Fee income from wire transfer transactions decreased $33,000, or 2.9% from 2008 to 2009 whereas it increased $254,000, or 28.3%, from 2007 to 2008. The increase in deposit accounts both in the number of account and amounts in 2009 contributed to the relatively high level of such fee income in 2009. Slight decrease in such fee income was due to the unusually high level of wire transfer activities in 2008 where a significant increase in wire transfer activities to South Korea occurred due to significant changes in the foreign exchange rate in favor of US customers especially during the second half of 2008. As a result, wire transfer fee income represented 8.0% of total non-interest income for 2009, as compared to 21.0% and 6.6% in 2008 and 2007, respectively.
There was no sale of SBA loans during the year 2009 whereas the gain on sale of loans increased $399,000, or 64.6%, from 2007 to 2008. The Company sold $42.1 million of its SBA loans and $23.4 million of its non-SBA loans realizing gains of $1.0 million in 2008. The gain on sale of loans amounted to 7.0% of total non-interest income for 2008. Due to less activity in the secondary market especially during 2009, the Company did not execute any sales. During 2008, the Company sold those loans as a part of the Company’s strategy to de-leverage the balance sheet to improve the capital level. Management will evaluate on a quarterly basis whether to sell SBA loans or hold them in the loan portfolio.
Loan service fees decreased $543,000, or 40.0%, from 2008 to 2009, and decreased $363,000, or 21.1%, from 2007 to 2008. The decreases in 2009 and 2008 were primarily due to the significant reduction in loan originations during each of the years compared to prior years. As a result, loan service fees amounted to 5.8% of total non-interest income for 2009, compared to 24.7% and 12.7% in 2008 and 2007, respectively.
The Company recorded $0 and $9.9 million to impairment losses on available for sale securities in 2009 and 2008, respectively. The Company determined that there was no OTTI in the fair value for the corporate trust preferred security in 2009 compared to $9.9 million impairment that was other than temporary in 2008.
Other income increased $95,000, or 5.7%, from 2008 to 2009 and decreased $394,000, or 19.1%, from 2007 to 2008.
Non-interest Expense
The following table sets forth the non-interest expenses for the periods indicated:
Non-interest expense decreased $9.3 million, or 16.7 % from 2008 to 2009 and increased $7.6 million, or 16.0% from 2007 to 2008. The 2009 decrease in non-interest expense was mainly due to the reduction in salaries and employee benefits of $5.9 million offset by the increase in regulatory assessment expenses of $2.2 million, OREO related expenses of $1.9 million and impairment charges of goodwill and intangible asset of $1.4 million. The non-recurring KEIC litigation settlement expense of $7.5 million incurred in 2008 also contributed to the decrease in non-interest expense in 2009. The 2008 increase in non-interest expense was mainly due to the KEIC litigation settlement expense of $7.5 million. As a result, non-interest expense as a percentage of average earning assets decreased to 2.28% in 2009, compared to 2.82% and 2.64% for 2008 and 2007, respectively.
The efficiency ratio, defined as the ratio of non-interest expense to the sum of net interest income before provision for loan losses and non-interest income, was 61.3% for the year ended December 31, 2009, compared to 69.1% and 53.1% for the years ended December 31, 2008 and 2007, respectively. The decrease in the efficiency ratio from 2008 to 2009 was a result of the increase in non-interest expense due primarily to OTTI charges and KEIC settlement expenses in 2008 (as discussed in Note 13 to the consolidated financial statements), combined with the decrease in net interest income before provision for loan losses in 2009. The increase in the efficiency ratio from 2007 to 2008 was a result of the increase in non-interest expense due primarily to KEIC settlement expenses in 2008, combined with the decrease in net interest income before provision for loan losses in 2008.
Salaries and employee benefits decreased $5.9 million, or 25.0%, from 2008 to 2009, and $1.9 million, or 7.5%, from 2007 to 2008. The decrease in 2009 was mainly due to reduction in the number of employees throughout the year and reduction in performance compensation and certain benefit expenses. The number of total full-time equivalent employees decreased from 311 to 265 during 2009. The decrease in 2008 was mainly due to reduction in the number of employees throughout the year and reduction in performance compensation. The number of total full-time equivalent employees decreased from 363 to 311 during 2008.
Occupancy expense increased $396,000, or 8.8%, from 2008 to 2009, and $304,000, or 7.3%, from 2007 to 2008. The increases in 2009 and 2008 were due mainly to an increase in rent, property insurance and amortization of tenant improvements. The Company opened a new branch in Diamond Bar, California in March 2008.
Data processing expense increased $111,000, or 5.1%, from 2008 to 2009, and $107,000, or 5.2%, from 2007 to 2008. The increase in 2008 was due to the opening of new branches in 2008 and 2007.
Legal fees decreased $1.1 million, or 50.7%, from 2008 to 2009, and increased $710,000, or 47.6%, from 2007 to 2008. The decrease in legal fees from 2008 to 2009 and the increase in legal fees from 2007 to 2008 were due primarily to KEIC litigation activities prior to the settlement in August of 2008.
Accounting and other professional service fees increased $267,000, or 19.6%, from 2008 to 2009, and decreased $368,000, or 21.3%, from 2007 to 2008. The increase in 2009 was due to additional services provided relating to extended SEC filings and SEC Staff letter responses during the year. The decrease in 2008 was due to management’s effort on cost containment throughout the year.
Business promotion and advertising expense decreased by $474,000, or 24.9%, from 2008 to 2009, and by $490,000, or 20.5%, from 2007 to 2008. The 2008 and 2009 decreases were the result of management’s effort to contain promotion and advertisement expenses to cope with the slow economy and reduced loan origination activities.
Regulatory assessment expense increased $2.2 million, or 171.5%, from 2008 to 2009, and $500,000, or 65.4%, from 2007 to 2008. The increases were due to the FDIC’s rate increase and one-time special assessment in 2009 (see the related discussion in Item 1, Business-Deposit Insurance) and a steady increase in customer deposits.
OREO related expenses increased to $1.9 million in 2009 from virtually none in 2008 due to the increase in acquired properties during the year. The Company acquired 7 properties during the year and held 5 properties at December 31, 2009.
Impairment of goodwill and intangible asset of $1.4 million was recognized in 2009 due to weakened market conditions and the adverse economic conditions which had a negative impact on the Company’s valuation.
Provision for Income Taxes
For the years ended December 31, 2009, 2008 and 2007, the income tax (benefit) provision was $(5.8) million, $(1.6) million and $13.6 million, representing effective tax rates of approximately (12.1)%, (115.4)% and 38.3%, respectively. The primary reasons for the difference from the statutory federal tax rate of 35.0% for 2009, 2008 and 2007 are the reductions related to tax advantaged investments in low-income housing, municipal obligations, dividend exclusions, treatment of share-based payments amortization, increase in cash surrender value of bank owned life insurance, and California enterprise zone interest deductions and hiring credits, whereas, for 2009, valuation allowance contributed to the difference in addition to the elements described above.
The Company generally reduces taxes utilizing the tax credits from investments in the low-income housing projects. However, none of such credit was utilized for the year ended December 31, 2009 compared to $1.2 million and $744,000 for the years ended December 31, 2008 and 2007, respectively. The Company’s net deferred tax asset increased significantly during 2009 and 2008 due primarily to increases in the allowance for loan losses. To the extent that the allowance for loan losses is not allocable to specific loans, it represents future tax benefits which would be realized when actual charge-offs are made against the allowance. As a result of the loss incurred during 2009, management has assessed, by year, the future reversal of all temporary differences to
determine which deductions would be available to carry back to tax years with taxable income or could be utilized by projected future taxable income. As a result of this analysis, management has determined that a portion of the Company’s net deferred tax asset does not meet the more likely than not criteria for realization. Accordingly, the Company has recorded a valuation allowance of $16.3 million. The net deferred tax asset valuation allowance includes a valuation allowance for capital losses, established in 2008, due to the uncertainty surrounding the realization of the benefits of these losses that may result from future capital gain.
Deferred income tax assets or liabilities reflect the estimated future tax effects attributable to differences as to when certain items of income or expense are reported in the financial statements versus when they are reported in the tax returns. The Company’s deferred tax assets were $11.6 million as of December 31, 2009 and $19.9 million as of December 31, 2008. As of December 31, 2009, the Company’s deferred tax assets were primarily due to the allowance for loans losses and impairment losses on securities available for sale.
Financial Condition
Summary
Total assets increased by $136.2 million, or 6.6%, to $2.19 billion at December 31, 2009 compared to $2.06 billion at December 31, 2008. The increase in total assets was mainly due to a $187.7 million increase in investment securities and a $134.6 million increase in cash and cash equivalents offset by a $200.2 million reduction in net loans. Net loans (including loans held for sale), investment securities, and money market and short-term investments as a percentage of total assets were 67.5%, 17.6% and 2.4%, respectively, as of December 31, 2009, as compared to 81.6%, 9.6% and 0.1%, respectively, as of December 31, 2008.
Total assets decreased by $24.1 million, or 1.2%, to $2.06 billion at December 31, 2008 compared to $2.08 billion at December 31, 2007. The decrease in total assets was mainly due to a $110.3 million reduction in net loans offset by a $43.0 increase in investment securities and a $29.9 million increase in cash and cash equivalents. Net loans (including loans held for sale), investment securities, and money market and short-term investments as a percentage of total assets were 81.6%, 9.6% and 0.1%, respectively, as of December 31, 2008, as compared to 86.0%, 8.6% and 0.1%, respectively, as of December 31, 2007.
Loan Portfolio
The Company’s loan portfolio represents the largest single portion of earning assets, substantially greater than the investment portfolio or any other asset category. The quality and diversification of the Company’s loan portfolio are important considerations when reviewing the Company’s results of operations. The Company offers a range of products designed to meet the credit needs of its borrowers. The Company’s lending activities consist of commercial real estate lending, construction loans, commercial business and trade finance loans, and consumer loans.
As of December 31, 2009 and 2008, gross loans represented 70.2% and 83.6%, respectively, of total assets. The largest volume decreases among loan categories in 2009 were commercial real estate, real estate construction, commercial business and trade finance loans, which decreased $127.0 million, $41.0 million, $39.1 million, and $24.2 million, respectively. The decrease in the loan portfolio was mainly the result of management’s decision to de-leverage the balance sheet through sales of commercial real estate loans during the year. The sales gave the Company an opportunity to balance the concentrations in the loan portfolio. The loan portfolio composition table below reflects the gross and net amounts of loans outstanding as of December 31 of each year from 2005 to 2009.
As of December 31, 2009, no single industry or business category represented more than 10% of the loan portfolio. The Company also monitors the diversification of collateral of the real estate loan portfolio by area, by type of building, and by the type of building usage.
The following table sets forth the composition of the Company’s loan portfolio as of the dates indicated:
Real estate commercial loans are loans secured by first deeds of trust on real estate.
Includes advances on trust receipts, clean advances, cash advances, acceptances discounted, and documentary negotiable advances under commitments.
Includes SBA loans held for sale of $23.3 million, $9.9 million, $41.5 million, $18.5 million and $12.7 million, at the lower of cost or fair value, at December 31, 2009, 2008, 2007, 2006 and 2005, respectively.
Consists of term fed funds sold for maturity of greater than 1 day, transactions in process and overdrafts.
Commercial Real Estate Loans. Real estate lending involves risks associated with the potential decline in the value of the underlying real estate collateral and the cash flow from the income producing properties. Declines in real estate values and cash flows can be caused by a number of factors, including adversity in general economic conditions, rising interest rates, changes in tax and other governmental and other policies affecting real estate holdings, environmental conditions, governmental and other use restrictions, development of competitive properties and increasing vacancy rates. The Company’s dependence on real estate values increases the risk of loss both in the Company’s loan portfolio and with respect to any other real estate owned when real estate values decline.
The Company offers commercial real estate loans secured by industrial buildings, retail stores or office buildings, where the property’s repayment source generally comes from tenants or businesses that fully or partially occupy the building. When real estate collateral is owner-occupied, the value of the real estate collateral must be supported by a formal appraisal in accordance with applicable regulations, subject to certain exceptions. The majority of the properties securing these loans are located in Los Angeles County and Orange County in California.
The Company has established general underwriting guidelines for commercial property real estate loans typically requiring a maximum loan-to-value (“LTV”) ratio of 65%. The Company’s underwriting policies also generally require that the properties securing commercial real estate loans have debt service coverage ratios of at least 1.25:1 for investor-owned property. Additionally, for owner-occupied properties, the Company expects additional debt service capacity from the business itself. As additional security, the Company generally requires personal guarantees when commercial real estate loans are extended to corporations, limited partnerships and other legal entities.
Commercial real estate loans are, in most cases, secured by first deeds of trust, generally for terms extending generally no more than seven years, and are amortized over periods of up to 25 years. The majority of the commercial real estate loans currently being originated contain interest rates tied to the Company’s prime rate that adjusts with changes in the national prime rate. The Company also extends commercial real estate loans with fixed rates.
Payments on loans secured by such properties are often dependent on the successful operation or management of the properties. Repayment of such loans may therefore be affected by adverse conditions in the real estate market or the economy. The Company seeks to minimize these risks in a variety of ways, including limiting the size of such loans and strictly scrutinizing the properties securing the loans. The Company generally obtains loan guarantees from financially capable parties. The Company’s lending personnel inspect substantially all of the properties collateralizing the Company’s real estate loans before such loans are made.
As of December 31, 2009, commercial real estate loans totaled $1.0 billion, representing 65.5% of total loans, compared to $1.1 billion or 66.0% of total loans at December 31, 2008. The percentage of commercial real estate loans to total loans in 2008 remained similar even with a reduction in the balance due to the overall decrease in total loans as compared to 2008.
Real Estate Construction Loans. The Company finances the construction of various projects within the Company’s market area, including motels, industrial buildings, tax-credit low-income apartment complexes and single-family residences. The future condition of the local economy could negatively impact the collateral values of such loans.
The Company’s construction loans typically have the following characteristics: (i) maturity of two years or less; (ii) a floating interest rate based on the Company’s prime rate; (iii) advance of anticipated interest cost during construction; (iv) advance of fees; (v) first lien position on the underlying real estate; (vi) average LTV ratio of 65%; and (vii) recourse against the borrower or guarantor in the event of default. The Company does not participate in joint ventures or make equity investments in connection with its construction lending.
Construction loans involve additional risks compared to loans secured by existing improved real property. These risks include the following: (i) the uncertain value of the project prior to completion; (ii) the inherent uncertainty in estimating construction costs, which is often beyond the control of the borrower; (iii) construction delays and cost overruns; and (iv) the difficulty in accurately evaluating the market value of the completed project.
As a result of these uncertainties, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project rather than on the ability of the borrower or guarantor to repay principal and interest. If the Company is forced to foreclose on a project prior to or at completion due to a default, there can be no assurance that the Company will be able to recover all of the unpaid balance of and its accrued interest on the construction loan.
Real estate construction loans totaled $21.0 million or 1.4% of total loans and $62.0 million or 3.6% of total loans at December 31, 2009 and 2008, respectively. The Company’s real estate construction portfolio varies from year to year as management is selective in financing construction projects given the unique credit risk associated with these types of loans and the timing of the completion of construction and associated loan payoffs.
Commercial Business Loans. The Company offers commercial loans for intermediate and short-term credit. Commercial loans may be unsecured, partially secured or fully secured. The majority of the originations of commercial loans are in Los Angeles County or Orange County, California. The Company originates commercial business loans to facilitate term working capital and to finance business acquisitions, fixed asset purchases, accounts receivable and inventory financing. These term loans to businesses generally have terms of up to five years, have interest rates tied to the Company’s prime rate and may be secured in whole or in part by owner- occupied real estate or time deposits at the Company. For a term loan, the Company typically requires monthly
payments of both principal and interest. In addition, the Company grants commercial lines of credit to finance accounts receivable and inventory on a short-term basis, usually one year or less. Short-term business loans are generally intended to finance current transactions and typically provide for principal payments with interest payable monthly. The Company requires a complete re-analysis before considering any extension. The Company finances primarily small and middle market businesses in a wide spectrum of industries. In general, it is the Company’s intent to take collateral whenever possible regardless of the purpose of the loan. Collateral may include liens on inventory, accounts receivable, fixtures and equipment and in some cases leasehold improvements and real estate. As a matter of policy, the Company generally requires all principals of a business to be co-obligors on all loan instruments, and all significant shareholders of corporations to execute a specific debt guaranty. All borrowers must demonstrate the ability to service and repay not only the debt with the Company but also all outstanding business debt, exclusive of collateral, on the basis of historical earnings or reliable projections.
Commercial loans typically involve relatively large loan balances and are generally dependent on the businesses’ cash flows and thus may be subject to adverse conditions in the general economy or in a specific industry.
As of December 31, 2009 and 2008, commercial business loans totaled $295.3 million and $334.4 million, respectively. Commercial business loans decreased slightly as a percentage of total loans to 19.2% at December 31, 2009 from 19.4% at December 31, 2008.
Trade Finance Loans. For the purpose of financing overseas transactions, the Company provides short term trade financing to local borrowers in connection with the issuance of letters of credit to overseas suppliers/sellers. In accordance with these letters of credit, the Company extends credit to the borrower by providing assurance to the borrower’s foreign suppliers that payment will be made upon shipment of goods. Upon shipment of goods, and when the foreign suppliers negotiate the letters of credit, the borrower’s inventory is financed by the Company under the approved line of credit facility. The underwriting procedure for this type of credit is the same as for commercial business loans.
As of December 31, 2009, trade finance loans totaled $39.3 million, compared to $63.5 million as of December 31, 2008. While management continues efforts to increase the Company’s Asia Pacific trade, the Company has experienced significant and increasing competition for such loans from larger financial institutions and peer banks. These loans as a percentage of total loans decreased to 2.6% at December 31, 2009 as compared to 3.7% at December 31, 2008.
Small Business Administration (SBA) Loans. The Company provides financing for various purposes for small businesses under guarantee of the Small Business Administration, a federal agency created to provide financial assistance for small businesses. The Company is a Preferred SBA Lender with full loan approval authority on behalf of the SBA. It also participates in the SBA’s Export Working Capital Program. SBA loans consist of both real estate and business loans. The SBA guarantees on such loans currently range from 75% to 80% of the principal and accrued interest. Under certain circumstances, the guarantee of principal and interest may be less than 75%. In general, the guaranteed percentage is less than 75% for loans over $1.0 million. The Company typically requires that SBA loans be secured by first or second lien deeds of trust on real property. SBA loans have terms ranging from 7 to 25 years depending on the use of proceeds. To qualify for an SBA loan, a borrower must demonstrate the capacity to service and repay the loan, exclusive of the collateral, on the basis of historical earnings or reliable projections.
During 2009 and 2008, the Company originated $20.8 million, and $39.9 million, respectively, in SBA loans. No SBA loans were sold in 2009 as compared to sales of $42.1 million of SBA loans in 2008. The Company usually sells the guaranteed portion of the SBA loans and retains the loan servicing obligation, for a fee. The primary reason for the decrease was the lower premiums due to less activity in the secondary market for SBA loans. As of December 31, 2009, the Company was servicing $113.0 million of sold SBA loans, compared to $131.2 million as of December 31, 2008. SBA loans as a percentage of total loans increased to 3.2% in 2009 as compared to 2.2% in 2008 primarily due to the origination of SBA loans without sales in 2009.
Consumer Loans. Consumer loans, also termed loans to individuals, are extended for a variety of purposes. Most are to finance the purchase of automobiles. Other consumer loans include secured and unsecured personal loans, home equity lines, overdraft protection loans and unsecured lines of credit. The Company grants a small portfolio of credit card loans, mainly to the owners of its corporate customers. Management assesses the borrower’s ability to repay the debt through a review of credit history and ratings, verification of employment and other income, review of debt-to-income ratios and other measures of repayment ability. Although creditworthiness of the applicant is of primary importance, the underwriting process also includes a comparison of the value of the security, if any, to the proposed loan amount. The Company generally makes these loans in amounts of 80% or less of the value of collateral. An appraisal is obtained from a qualified real estate appraisal for substantially all loans secured by real estate. Most of the Company’s consumer loans are repayable on an installment basis.
Consumer loans are generally unsecured or secured by rapidly depreciating assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance, because the collateral is more likely to suffer damage, loss or depreciation. The remaining deficiency often does not warrant further collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, the collection of loans to individuals is dependent on the borrower’s continuing financial stability, and thus is more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, various federal and state laws, including federal and state bankruptcy and insolvency laws, often limit the amount which a lender can recover on consumer loans. Consumer loans may also give rise to claims and defenses by consumer loan borrowers against the lender on these loans, such as the Company, and a borrower may be able to assert against such assignee claims and defenses that it has against the seller or the underlying collateral.
Consumer loans decreased to 4.8 % as of December 31, 2009 as compared to 5.1% of total loans as of December 31, 2008. Automobile loans are the largest component of consumer loans, representing 45% and 57% of total consumer loans as of December 31, 2009 and 2008, respectively.
Loan Maturities and Sensitivity to Changes in Interest Rates
The following table shows the maturity distribution of the Company’s outstanding loans as of December 31, 2008. In addition, the table shows the distribution of such loans with floating interest rates and those with fixed interest rates. The table includes nonperforming loans of $63.5 million.
Includes advances on trust receipts, clean advances, cash advances, acceptances discounted and documentary negotiable advances under commitments.
Other consists of term Fed Funds sold for maturity of greater than 1 day, transactions in process and overdrafts.
Nonperforming Assets
Nonperforming assets are defined as loans on non-accrual status, loans 90 days or more past due but not on non-accrual status, Other Real Estate Owned (“OREO”), and Troubled Debt Restructurings (“TDR”). TDRs are considered non-performing assets for regulatory purposes even though they are fully performing, and they are required to be disclosed in the following table. Performing TDRs of $4.4 million at December 31, 2009 are not considered nonperforming assets for purposes of computing the ratio of nonperforming assets as a percentage of total gross loans and OREO. Management generally places loans on non-accrual status when they become 90 days past due, unless they are both fully secured and in process of collection. OREO consists of real property acquired through foreclosure or similar means that management intends to offer for sale. Loans may be restructured by management when a borrower has experienced some change in financial status causing an inability to meet the original repayment terms, where the Company believes the borrower will eventually overcome those circumstances and repay the loan in full.
Management’s classification of a loan as non-accrual is an indication that there is reasonable doubt as to the full collectibility of principal or interest on the loan. At this point, the Company stops recognizing income from the interest on the loan and reverses any uncollected interest that had been accrued but unpaid. The remaining balance of the loan will be charged off if the loan deteriorates further due to a borrower’s bankruptcy or similar financial problems, unsuccessful collection efforts or a loss classification by regulators and/or internal credit examiners. These loans may or may not be collateralized, but collection efforts are continuously pursued.
The Company owned five OREO properties at December 31, 2009 compared to none at December 31, 2008. The Company records the property at the lower of its carrying value or its fair value less anticipated disposal costs. Any write-down of OREO is charged to earnings. The Company may make loans to potential buyers of OREO to facilitate the sale of OREO. In those cases, all loans made to such buyers must be reviewed under the same guidelines as those used for making customary loans, and must conform to the terms and conditions consistent with the Company’s loan policy. Any deviations from this policy must be specifically noted and reported to the appropriate lending authority. Profit on real estate sales transactions shall not be recognized by the full accrual method until all of the following criteria are met:
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A sale is consummated;
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The buyer’s initial and continuing investments are adequate to demonstrate a commitment to pay for the property;
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The seller’s receivable is not subject to future subordination; and
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The seller has transferred to the buyer the usual risks and rewards of ownership in a transaction that is in substance a sale and does not have a substantial continuing involvement with the property.
The restructuring of a debt is considered a TDR when the Company, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower that the Company would not otherwise grant. TDRs may include changing repayment terms, reducing the stated interest rate or reducing the amounts of principal and/or interest due or extending the maturity date. The restructuring of a loan is intended to recover as much of the Company’s investment as possible and to achieve the highest yield possible. At December 31, 2009 and 2008, TDRs amounted to $27.1 million and $0, respectively.
The following table provides information with respect to the components of the Company’s nonperforming assets as of the dates indicated:
The TDRs are not included in nonperforming assets for purposes of computing the ratio of nonperforming assets as a percentage of total gross loans and OREO.
SBA guaranteed portion of nonperforming loans is included in all ratios.
Nonperforming loans totaled $63.5 million at December 31, 2009, an increase of $46.5 million as compared to $20.5 million at December 31, 2008. Nonperforming loans as a percentage of total loans increased to 4.12% at December 31, 2009 as compared to 1.19% at December 31, 2008. Gross interest income of approximately $3.8 million would have been recorded for the year ended December 31, 2009 if these loans had been paid in accordance with their original terms and had been outstanding throughout the applicable period then ended or, if not outstanding throughout the applicable period then ended, since origination. The increase in 2009 resulted primarily from the increases in nonperforming commercial real estate loans, construction loans and commercial business loans during the year due to a weakening economy. The increase in nonperforming commercial real estate loans was due to the deterioration in the overall economy and its adverse impact on the commercial real estate market in Southern California. At December 31, 2009, SBA non-accrual loans represented 7.5% of total nonperforming loans. The guaranteed portion of nonperforming SBA loans of $2.8 million consists of $1.0 million of SBA loans and $1.8 million of trade finance loans under the Export Working Capital Program (“EWCP”) through which a 75% guarantee is provided by SBA. At December 31, 2009, total nonperforming assets were $64.9 million, net of the SBA guaranteed portion, representing 4.16% of total loans and other real estate owned.
Nonperforming loans totaled $20.5 million at December 31, 2008, an increase of $14.2 million as compared to $6.3 million at December 31, 2007. Nonperforming loans as a percentage of total loans increased to 1.19% at December 31, 2008 as compared to 0.35% at December 31, 2007. The increase in 2008 resulted primarily from the increases in nonperforming commercial real estate loans and construction loans during the year due to a weakening economy. The increase in the nonperforming commercial real estate loans was mainly due to two loans which were for a retail shopping center in the Inland Empire and an assisted living center in Pasadena, both in California. At December 31, 2008, SBA non-accrual loans represented 7.5% of total nonperforming loans. The
guaranteed portion of nonperforming SBA loans of $2.1 million consists of $287,000 of SBA loans and $1.8 million of trade finance loans under the Export Working Capital Program (“EWCP”) through which a 75% guarantee is provided by SBA. At December 31, 2008, total nonperforming assets, net of the SBA guaranteed portion, were $18.3 million, representing 1.19% of total loans and other real estate owned.
The following table provides information on impaired loans for the periods indicated:
Loans are considered impaired when it is probable that the Company will be unable to collect all amounts due as scheduled according to the contractual terms of the loan agreement, including contractual interest payments and contractual principal payments. The amount of impairment is based on the present value of expected future cash flows discounted at the loan’s effective interest rate, a loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent. Loans are identified for specific allowances from information provided by several sources including asset classification, third party reviews, delinquency reports, periodic updates to financial statements, public records, and industry reports. All loan types are subject to impairment evaluation for a specific allowance once identified as impaired. During the second half of 2008 and throughout 2009, the decline in the overall economy was a major contributor to the increase in impaired loans. As of December 31, 2009, impaired loans with specific reserves in the amount of $22.0 million were primarily comprised of commercial real estate loans of $16.8 million and construction real estate loans of $4.1 million with specific reserves of $1.9 million and $0.5 million, respectively. Specific reserves of each type of loans represented 11.3% and 13.2% of impaired loans in the respective type of loans. Total specific reserves of $2.7 million represented 12.0% of total impaired loans with specific reserves of $22.0 million.
Allowance for Loan Losses
The following table sets forth the composition of the allowance for loan losses as of dates indicated:
The Company’s allowance for loan loss methodologies incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan loss that management believes is appropriate at each reporting date. Quantitative factors include the Company’s historical loss experience, delinquency and charge-off trends, collateral values, changes in nonperforming loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers’ sensitivity to interest rate movements and to quantifiable external factors including commodity and finished good prices as well as acts of nature (earthquakes, floods, fires, etc.) that occur in a particular period. Qualitative factors include the general economic environment in the Company’s markets and, in particular, the state of certain industries. Size and complexity of individual credits, loan structure, extent and nature of waivers of existing loan policies and pace of portfolio growth are other qualitative factors that are considered in its methodologies. As the Company adds new products, increases the complexity of the loan portfolio, and expands its geographic coverage, the Company will enhance the methodologies to keep pace with the size and complexity of the loan portfolio. Changes in any of the above factors could have significant impact to the allowance for loan loss calculation. The Company believes that its methodologies continue to be appropriate given its size and level of complexity.
The allowance for loan losses reflects management’s judgment of the level of allowance adequate to provide for probable losses inherent in the loan portfolio as of the date of the consolidated statements of financial condition. On a quarterly basis, the Company assesses the overall adequacy of the allowance for loan losses, utilizing a disciplined and systematic approach which includes the application of a specific allowance for identified problem loans, a formula allowance for identified graded loans and an allocated allowance for large groups of smaller balance homogenous loans.
Allowance for Specifically Identified Problem Loans. A specific allowance is established for impaired loans. A loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. The specific allowance is determined based on the present value of expected future cash flows discounted at the loan’s effective interest rate, except that as a practical expedient, the Company may measure impairment based on a loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent. The Company measures impairment based on the fair value of the collateral, adjusted for the cost related to liquidation of the collateral.
Formula Allowance for Identified Graded Loans. Non-homogenous loans such as commercial real estate, construction, commercial business, trade finance and SBA loans that are not subject to the allowance for specifically identified loans discussed above are reviewed individually and subject to a formula allowance. The formula allowance is calculated by applying loss factors to outstanding Pass, Special Mention, Substandard and Doubtful loans. The evaluation of the inherent loss for these loans involves a high degree of uncertainty, subjectivity and judgment because probable loan losses are not identified with a specific loan. In determining the formula allowance, the Company relies on a mathematical calculation that incorporates a six-quarter rolling average of historical losses, which has been adjusted from the twelve quarter analysis used historically. The Company started using the six-quarter rolling average beginning in the fourth quarter of 2008 to better reflect directional consistency in its allowance for loan losses, instead of the twelve-quarter rolling average that the Company had been historically applying. As a result, the two most recent quarters were weighted at 65% of the total loss factor as compared to 39% under the previous methodology. This shortening of the historical period is believed to properly reflect the current market environment and the loss trends in the loan portfolio. Current quarter losses are measured against previous quarter loan balances to develop the loss factor. Loans risk rated Pass, Special Mention and Substandard for the most recent three quarters are adjusted to an annual basis as follows:
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the most recent quarter is weighted 4/1;
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the second most recent is weighted 4/2;
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the third most recent is weighted 4/3.
The formula allowance may be further adjusted to account for the following qualitative factors which have been established at a minimum of 50 basis points:
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Changes in lending policies and procedures, including underwriting standards and collection, charge-off, and recovery practices;
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Changes in national and local economic and business conditions and developments, including the condition of various market segments;
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Changes in the nature and volume of the loan portfolio;
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Changes in the experience, ability, and depth of lending management and staff;
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Changes in the trend of the volume and severity of past due and classified loans, and trends in the volume of non-accrual loans and troubled debt restructurings, and other loan modifications;
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Changes in the quality of the Company’s loan review system and the degree of oversight by the directors;
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The existence and effect of any concentrations of credit, and changes in the level of such concentrations; and
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The effect of external factors such as competition and legal and regulatory requirements on the level of estimated losses in the Company’s loan portfolio.
Allowance for Large Groups of Smaller Balance Homogenous Loans. The portion of the allowance allocated to large groups of smaller balance homogenous loans is focused on loss experience for the pool rather than on an analysis of individual loans. Large groups of smaller balance homogenous loans mainly consist of consumer loans to individuals. The allowance for groups of performing loans is based on historical losses over a six-quarter period. In determining the level of allowance for delinquent groups of loans, the Company classifies groups of homogenous loans based on the number of days delinquent and other qualitative factors and trends.
The table below summarizes the activity in the Company’s allowance for loan losses for the periods indicated.
Net of deferred loan fees and discount on SBA loans sold.
The process of assessing the adequacy of the allowance for loan losses involves judgmental discretion, and eventual losses may therefore differ from the most recent estimates. Further, the Company’s independent loan review consultants, as well as the Company’s external auditors, the FDIC and the California Department of Financial Institutions review the allowance for loan losses as an integral part of their examination process. In addition, a special loan review was performed by an independent third party as part of the Company’s capital raising efforts.
The balance of the allowance for loan losses increased to $58.5 million as of December 31, 2009 compared to $38.2 million as of December 31, 2008. This increase was mainly due to the higher credit risk, based on the management’s assessment, inherent in the portfolio resulting from the weak economy as indicated by the increases in charge-offs and nonperforming loans.
Total charge-offs increased to $57.8 million for 2009 from $8.9 million for 2008. Charge-offs for 2009 were primarily in the following industries: real estate development for 46.2%, general merchandise wholesalers for 16.5%, hospitality for 11.9%, and others including restaurants and retail business for 25.4%. The Company continued to provide loan loss provisions to adequately address the inherent credit risk in the loan portfolio as of December 31, 2009. The Company provides an allowance for the credits based on the migration analysis and other qualitative factors and trends. The ratio of the allowance for loan losses to nonperforming loans decreased to 96% at December 31, 2009 as compared to 187% and 327% in 2008 and 2007, respectively.
Management is committed to maintaining the allowance for loan losses at a level that is considered commensurate with estimated and known risks in the portfolio. Although the adequacy of the allowance is reviewed quarterly, management performs an ongoing assessment of the risks inherent in the portfolio. As of December 31, 2009, management believes the allowance to be adequate based on its assessment of the estimated and known risks in the portfolio, migration analysis of charge-off history and other qualitative factors and trends.
However, no assurance can be given that economic conditions, which adversely affect the Company’s service areas or other circumstances, will not result in an increase in the loan loss provision or loan losses. Nonperforming assets were $67.7 million as of December 31, 2009 compared to $20.5 million as of December 31, 2008. The 2009 increase was primarily due to the weakening economic trends in our markets.
The provision for loan losses in 2009, 2008, and 2007 was $77.5 million, $26.2 million and $6.5 million, respectively. The increase in 2009, 2008 and 2007 was due to the increasing credit risk inherent in the loan portfolio. Total charge-offs in 2009, 2008 and 2007 were $57.8 million, $8.9 million and $3.6 million, respectively. There were twelve charge-offs of more than $1.0 million representing $34.0 million, or 43.9% of total charge-offs in 2009 compared to one charge-off of more than $1.0 million representing 11.1% of total charge-offs in 2008. Net charge-offs were $57.1 million, $8.5 million and $3.4 million in 2009, 2008 and 2007, respectively.
Allocation of Allowance for Loan Losses
The following table provides a breakdown of the allowance for loan losses by category as of the dates indicated:
During 2009 the allowance for loan losses increased by $20.4 million or 53.4% from 2008 as compared to the increase of $17.7 million or 86.4% from 2007 to 2008. The increases in 2009 were primarily due to the increases of $20.3 million or 124.4% for commercial real estate loans, $4.9 million or 43.6% for commercial loans, $1.0 million or 130.2% for SBA loans and $0.8 million or 64.7% for consumer loans as compared to 2008. The allowance for loan losses provided by loan type at December 31, 2009 was 1.6% for construction real estate loans, 62.6% for commercial real estate loans, 27.4% for commercial loans, 2.1% for trade finance loans, 2.9% for SBA loans and 3.3% for consumer loans as compared to 18.1%, 42.8%, 29.3%, 4.89%, 1.9% and 3.1% at December 31, 2008, respectively.
The allocated allowance for construction real estate loans decreased by $6.0 million, or 86.3%, to $0.9 million at December 31, 2009, compared to $6.9 million at December 31, 2008. Real estate construction loans represented 1.4% of the loan portfolio and 1.6% of the allocated allowance for loan losses at December 31, 2009.
The allocated allowance for commercial real estate loans increased 124.4% to $36.7 million at December 31, 2009, compared to $16.3 million at December 31, 2008. Real estate commercial loans represented 65.5% of the loan portfolio and 62.6% of the allocated allowance for loan losses at December 31, 2009.
The allocated allowance for commercial business loans increased by $4.9 million, or 43.6%, to $16.1 million at December 31, 2009, compared to $11.2 million at December 31, 2008. Commercial business loans represented 19.2% of the loan portfolio and 27.4% of the allocated loan loss allowance at December 31, 2009.
The allocated allowance for trade finance loans decreased by $0.5 million, or 31.5%, to $1.3 million at December 31, 2009, compared to $1.8 million at December 31, 2008. Trade finance loans represented 2.6% of the loan portfolio and 2.1% of allocated loan loss allowance at December 31, 2009.
The Company has considered and evaluated recent trends in the loan portfolio in the determination of its allocation of allowance for loan losses in the periods discussed above. The historical risk factors were reviewed based on six-quarter weighted average instead of twelve-quarter to better reflect directional consistency and adequately address the trends regarding the weakening economy including increasing unemployment and jobless claims.
Investment Portfolio
The following table summarizes the amortized cost, fair value, and distribution of the Company’s investment securities as of the dates indicated:
The Company’s investment securities portfolio is classified into two categories: Held-to-Maturity or Available-for-Sale. The Company had no investment securities in trading securities category for any of the reported periods. The Company classifies securities that it has the ability and intent to hold to maturity as held-to-maturity securities, to be sold only in the event of concerns with an issuer’s credit worthiness, a change in tax law that eliminates their tax-exempt status, or other infrequent situations. All other securities are classified as available-for-sale. The securities classified as held-to-maturity are presented at net amortized cost and available-for-sale securities are carried at their estimated fair values.
The Company aims to maintain an investment portfolio with an adequate mix of fixed-rate and adjustable-rate securities with relatively short maturities to minimize overall interest rate risk. The Company’s investment securities portfolio consists of U.S. Treasury securities, U.S. Government agency securities, U.S. Government sponsored enterprise debt securities, mortgage-backed securities, corporate debt, and U.S. Government sponsored enterprise equity securities. The mortgage backed securities and collateralized mortgage obligations (“CMO”) are all agency-guaranteed residential mortgages. The Company regularly models, evaluates and analyzes each agency CMO’s to capture its unique allocation of principal and interest.
The Company performs regular impairment analyses on the investment securities portfolio. If the Company determines that a decline in fair value is other-than-temporary, an impairment write-down is recognized in current earnings. Other-than-temporary declines in fair value are assessed based on the duration the security has been in a continuous unrealized loss position, the severity of the decline in value, the rating of the security and the Company’s ability and intent on holding the securities until the fair values recover. The securities that have been in a continuous unrealized loss position for twelve months or longer at December 31, 2009 had investment grade ratings upon purchase. The issuers of these securities have not, to the Company’s knowledge, established any cause for default on these securities and the various rating agencies have reaffirmed these securities’ long-term investment grade status at December 31, 2009. These securities have fluctuated in value since their purchase dates as market interest rates have fluctuated. However, the Company has the ability and the intention to hold these securities until their fair values recover to cost. Because the Company has the ability and the intent to hold these investments until recovery of fair value, which may be at maturity, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2009.
The Company owns one collateralized debt obligation (“CDO”) security that is backed by trust preferred securities (“TRUPS”) issued by banks and thrifts. The Company recognized an OTTI impairment during 2008 of $9.9 million to reduce the CDO TRUPS to fair value of $1.1 million at December 31, 2008. As of April 1, 2009, the noncredit related portion of the previous OTTI of $1.6 million was reinstated to the amortized cost of the security. At December 31, 2009, the fair value of the security was $2.4 million due to the decline in the fair value which is considered temporary. The methodologies for measuring fair value of this security are discussed in Note 18 to the consolidated financial statements.
The CDO TRUPS securities market for the past several quarters has been severely impacted by the liquidity crunch and concern over the banking industry. If the weight of the evidence indicates the market is not orderly, a reporting entity shall place little, if any, weight compared with other indications of fair value on that transaction price when estimating fair value or market risk premiums. Factors that were considered to determine whether there has been a significant decrease in the volume and level of activity for the CDO TRUPS securities market when compared with normal activity include:
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There are few recent transactions.
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Price quotations are not based on current information.
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Price quotations vary substantially either over time or among market makers.
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Indexes that were previously highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability.
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There is a significant increase in implied liquidity risk premiums. Yields or performance indicators (such as delinquency rates or loss severities) for observed transactions or quoted prices when compared with the reporting entity’s estimate of expected cash flows, considering all available market data about credit and other nonperformance risk for the asset or liability.
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There is a wide bid-ask spread or significant increase in the bid-ask spread.
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There is a significant decline or absence of new market issuances for the asset or liability.
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Little information is publicly available.
The fair values of securities available for sale are generally determined by reference to the average of at least two quoted market prices obtained from independent external brokers or prices obtained from independent external pricing service providers who have experience in valuing these securities. In obtaining such valuation information from third parties, the Company has reviewed the methodologies used to develop the resulting fair values.
The Company’s Level 3 securities available for sale include one CDO TRUPS security. The fair value of the CDO TRUPS security has traditionally been based on the average of at least two quoted market prices obtained
from independent brokers. However, as a result of the global financial crisis and illiquidity in the U.S. markets, the market for these securities has become increasingly inactive since mid-2007. The current broker price for the CDO TRUPS securities is based on forced liquidation or distressed sale values in very inactive markets that may not be representative of the economic value of these securities. As such, the fair value of the CDO TRUPS security has been below cost since the advent of the financial crisis. Additionally, most, if not all, of these broker quotes are nonbinding.
The Company considered whether to place little, if any, weight on transactions that are not orderly when estimating fair value. Although length of time and severity of impairment are among the factors to consider when determining whether a security that is other than temporarily impaired, the CDO TRUPS securities have only exhibited deep declines in value since the credit crisis began. The Company therefore believes that this is an indicator that the decline in price is primarily the result of the lack of liquidity in the market for these securities.
The Company regularly reviews the composition of the investment portfolio, taking into account market risks, the current and expected interest rate environment, liquidity needs, and overall interest rate risk profile and strategic goals. On a quarterly basis, the Company evaluates each security in the portfolio with an individual unrealized loss to determine if that loss represents an other-than-temporary impairment.
The Company considers the following factors in evaluating the securities: whether the securities were guaranteed by the U.S. government or its agencies and the securities’ public ratings, if available, and how those two factors affect credit quality and recovery of the full principal balance, the relationship of the unrealized losses to increases in market interest rates, the length of time the securities have had temporary impairment, and the Company’s intent and ability to hold the securities for the time necessary to recover the amortized cost. The Company also considers the payment performance, delinquency history and credit support of the underlying collateral for certain securities in the portfolio.
The Company continues to utilize Moody’s Analytics to compute the fair value of the CDO TRUPS security. Moody’s continues to update their valuation process. During the third quarter, Moody’s made changes to refine and improve the estimate of default probabilities to better align the valuation methodology with industry practices.
In order to determine the appropriate discount rate used in calculating fair values derived from the income method for the CDO TRUPS security, certain assumptions were made using an exit pricing approach related to the implied rate of return which have been adjusted for general change in market rates, estimated changes in credit quality and liquidity risk premium, specific nonperformance and default experience in the collateral underlying the securities.
The Moody’s Analytics Discounted Cash flow Valuation analysis uses 3-month London Inter-Bank Offered Rate (“LIBOR”) + 300 basis points as a discount rate (to reflect illiquidity-the credit component of the discount rate is embedded in the credit analysis). Approximating the appropriate yield premium for the illiquidity of a CDO TRUPS security has proved to be difficult and management found it more useful to measure the price impact for this illiquidity discount. The table below illustrates this.
There are three maturity assumptions since the final maturity on the CDO TRUPS securities can be no longer than thirty years but may be less than that as well. From the percentage impact in the 300 basis points column, an illiquidity discount of 300 basis points seems to be sufficient and reasonable based on management’s opinion in consideration of current market conditions. The maturity date on the Company’s CDO TRUPS security is October 3, 2032 and that would put the price impact for illiquidity at a 45% to 59% discount as of December 31, 2009.
The spread over LIBOR does not include a credit spread as the probable credit outlook is included in the underlying cash flows. The spread over LIBOR only reflects a liquidity discount. The discount rate that reflects expectations about future defaults is appropriate if using contractual cash flows of a loan. That same rate is not used if using expected (probability-weighted) cash flows because the expected cash flows already reflect assumptions about future defaults; instead, a discount rate that is commensurate with the risk inherent in the expected cash flows should be used.
In addition to the fair value computation of Moody’s Analytics, the Company considers additional factors to determine any OTTI for the CDO TRUPS security including review of trustee reports, monitoring of “break in yield” tests, analysis of current defaults and deferrals and the expectation for future defaults and deferrals. The Company reviews the key financial characteristics for individual issuers (commercial banks or thrifts) in the CDO TRUPS security and tracked issuer participation in the U.S. Treasury Department’s Capital Purchase Program (“CPP”). Also, the Company considers capital ratios, leverage ratios, nonperforming loan and nonperforming asset ratios, in addition to the review of changes to the credit ratings. The credit ratings of the Company’s CDO TRUPS security are “Ca” (Moody’s) and “CC” (Fitch) as of December 31, 2009.
The cash flow projection for the purpose of assessing OTTI incorporates certain credit events in the underlying collaterals and prepayment assumptions. The projected issuer default rates are assumed at a rate equivalent to 75 basis points applied annually and have a 15% recovery factor after 2 years from the initial default date. The principal is assumed to be prepaying at 1% annually and at 100% at maturity. There were no changes in the assumptions used in the cash flow analysis during the current quarter from the prior quarter.
The Company did not experience an adverse change in cash flows. Furthermore, the CDO TRUPS security experienced no credit ratings deterioration during the third quarter from the prior quarter. As such, based on all of these factors, the Company determined that there was no OTTI adjustment in the fourth quarter. The risk of future OTTI will be highly dependent upon the performance of the underlying issuers. The Company does not have the intention to sell and does not believe it will be required to sell the CDO TRUPS security.
As of December 31, 2009, investment securities totaled $370.4 million or 16.9% of total assets, compared to $182.7 million or 8.9% of total assets at December 31, 2008. The increase in the investment portfolio was primarily due to growth in U.S. agency debentures and government sponsored entities mortgage-backed securities of $187.7 million and part of the Company’s strategy to mitigate interest rate risk, assist in meeting pledge requirements, credit risk diversification, and to increase liquidity.
As of December 31, 2009, available-for-sale securities totaled $370.4 million, compared to $173.8 million as of December 31, 2008. Available-for-sale securities as a percentage of total assets increased to 16.9% as of December 31, 2009 from 8.5% as of December 31, 2008. Held-to-maturity securities decreased to $0 as of December 31, 2009, from $8.9 million as of December 31, 2008. The Company sold $4.7 million (at book value) of its municipal holdings in the held-to-maturity category and reclassified the remaining $3.8 million (at fair value) to available-for-sale category during the first quarter of 2009. The composition of available-for-sale and held-to-maturity securities was 100.0% and 0% as of December 31, 2009, compared to 95.1% and 4.9% as of December 31, 2008, respectively. For the year ended December 31, 2009, the yield on the average investment portfolio was 3.90%, representing a decrease of 95 basis points as compared to 4.85% for 2008.
The investment securities purchased by the Company generally include U.S. agency and government sponsored entities (“GSE”), mortgage-backed securities (“MBS”) and collateralized mortgage obligations (“CMO”) as well as agency debentures. The Company increased its holdings of Ginnie Mae (“GNMA”) securities during the quarter since GNMA securities are backed by the full faith and credit of the U.S. government and carry a zero risk weight for regulatory capital purposes. Although the investment yields on GNMA securities are generally lower than other comparable “non-GNMA” labeled securities, the Company believes that the purchases of GNMA securities are a prudent risk-reduction strategy.
As of December 31, 2009, the Company had total fair value of $83.3 million of securities with unrealized losses of $1.0 million as compared to total fair value of $33.3 million and unrealized losses of $0.7 million at
December 31, 2008. At December 31, 2009, the market value of securities which have been in a continuous loss position for 12 months or more totaled $3.3 million, with an unrealized loss of $323,000 compared to $7.6 million with an unrealized loss of $276,000 at December 31, 2009 and 2008, respectively.
The following table summarizes, as of December 31, 2009, the contractual maturity characteristics of the investment portfolio, by investment category. Expected remaining maturities may differ from remaining contractual maturities because obligors may have the right to prepay certain obligations with or without penalties.
Interest Earning Short-Term Investments
The Company invests its short-term excess available funds in overnight Fed Funds and money market funds. As of December 31, 2009 and 2008, the Company had $145.8 million and $50.4 million, respectively, invested in overnight Fed Funds. As of December 31, 2009 and 2008, the amounts invested in money market funds and interest-bearing deposits in other banks were $2.6 million and $2.6 million, respectively. The investment in Fed Funds averaged $181.0 million and $6.1 million for the year ended December 31, 2009 and 2008, respectively. Interest earned on these funds resulted in effective yields of 0.23% and 1.71% in 2009 and 2008, respectively.
Other Assets
The Company’s investment in the FHLB stock totaled $15.6 million and $15.6 million as of December 31, 2009 and 2008, respectively. FHLB stock is required in order to utilize a borrowing facility when needed. The Company did not purchase any additional FHLB stock in 2009 whereas the Company purchased $1.6 million of additional shares during 2008 due to the FHLB’s membership stock requirement for its member banks based on the member’s December 31 regulatory financial data and on current advances outstanding.
Member banks own investments in stocks issued by the FHLB. The FHLBs are government-sponsored entities (“GSE”). In January 2009 the FHLB suspended the payment of stock dividends starting from the first quarter of 2009 and temporarily ceased to repurchase excess capital stock. However, the Company received cash dividends during the fourth quarter of 2009 and the first quarter of 2010.
Federal Home Loan Bank stock is recorded at cost and is periodically reviewed for impairment based on the ultimate recovery of par value. No ready market exists for the FHLB stock and is only redeemable by the FHLB. It has no quoted market value and is carried at cost. The cost approximates fair market value based upon the redemption requirements of the FHLB, and this investment is not considered impaired at December 31, 2009.
However, stricter capital requirements for the FHLB system could adversely impact the value of the FHLB stock in the future.
When evaluating FHLB stock for impairment, its value should be determined based on the ultimate recoverability of the par value rather than by recognizing temporary declines in value. In summary,
1) A decline in market values of the FHLBs’ assets does not necessarily equate to an economic decline in net assets. The focus is on economic losses rather than market losses, which Moody’s notes can be absorbed.
2) FHLBs are meeting their debt obligations. Although the responsibility to repay debt may be shared among FHLBs in the event that one FHLB cannot pay, to date, an FHLB has never been required to pay the consolidated obligation of another FHLB.
3) With the exception of the Housing Act, enacted July 20, 2008, there are no pending legislative or regulatory changes that would impact the customer base of the FHLBs.
4) Because the FHLBs’ primary source of funds is debt obligations, the Moody’s conclusion-that the credit ratings are not expected to change-is one of the important factors to consider. There has been a preference in the market for shorter-term, high-quality investments, resulting in the FHLB discount notes trading at lower rates relative to LIBOR and reducing short-term funding costs. Although this investor preference for shorter-term investments has been an increase in longer-term FHLB debt costs, FHLBs have been issuing long-term debt and are obtaining funding on terms that appear to be acceptable to them. Additionally, if needed, the FHLBs have an additional source of liquidity beyond traditional debt obligations: the secured funding available to the GSEs through the U.S. Treasury. Under their lending agreements, the FHLB may borrow based on pledging eligible collateral.
Based on the observations noted above, Company has concluded that FHLB stock is not impaired at December 31, 2009 and the Company will ultimately recover the par value of the investments in this stock, which is held for long periods of time.
Pacific Coast Bankers Bank (“PCBB”) also requires its members to purchase PCBB stock. No ready market exists for the PCBB stock and is only redeemable by PCBB. The Bank holds 4,000 shares at $15 (split 10 for 1 in October 2008) and the book value of PCBB common shares as of December 31, 2009 was $29.00 per share. There has not been any adverse change in the financial position or condition of PCBB and the investment is not considered impaired at December 31, 2009.
Investments in affordable housing partnerships, totaling $11.5 million and $12.9 million as of December 31, 2009 and 2008, respectively, represent limited partnership interests owned by the Company in affordable housing projects for lower income tenants. Investments in these projects enable the Company to obtain CRA credit and federal and state income tax credits, as previously discussed in “Provision for Income Taxes.”
In addition, the Company invested $10.0 million in bank owned life insurance (“BOLI”) in December 2003. The policies were purchased from MassMutual, Midland National Life, and New York Life, and totaled $10 million at purchase. BOLI is an insurance policy with a single premium paid at policy commencement. Its initial cash surrender value is equivalent to the premium paid, and the value grows through non-taxable increases in its cash surrender value through interest earned on the policy, net of the cost of insurance plus any death benefits ultimately received by the Company. The cash surrender value of BOLI as of December 31, 2009 and 2008 was $12.4 million and $12.0 million, respectively. The Company reviews the insurance carriers annually and based on the recent assessment, the investment is not considered impaired at December 31, 2009.
Even though BOLI and the investment in affordable housing partnerships generally enhance profitability, they are not classified as interest-earning assets.
Cash on hand and balances due from correspondent banks represent the largest component of the Company’s non-earning assets. Cash on hand and balances due from correspondent banks represented 1.6% and 2.2% of total assets at December 31, 2009 and 2008, respectively. The outstanding balance of cash and due from banks was $34.3 million and $45.1 million as of December 31, 2009 and 2008, respectively. The ratio of average cash and due from banks to average total assets increased to 10.7% for 2009 as compared to 2.5% for 2008.
The Company maintained balances at correspondent banks to cover daily in-clearings and other activities. The average reserve balance requirements were approximately $7.8 million and $6.3 million as of December 31, 2009 and 2008, respectively, most of which was covered by cash on hand and vault cash held (no additional balances were maintained with the Federal Reserve Bank for this purpose).
A significant component of non-earning assets is Premises and Equipment, which is stated at cost less accumulated depreciation and amortization. Depreciation is charged to income over the estimated useful lives of the assets and leasehold improvements are amortized over the terms of the related leases, or the estimated useful lives of the improvements, whichever is shorter. Depreciation expenses were $2.2 million and $2.1 million in 2009 and 2008, respectively. The net book value of the Company’s premises and equipment totaled $13.4 million at December 31, 2009, an increase of $1.1 million, compared to $14.7 million at December 31, 2008.
Prepaid regulatory assessment fees-On November 12, 2009, the FDIC adopted a final rule amending the assessment regulations to require insured depository institutions to prepay their quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012, on December 30, 2009, along with each institution’s risk-based assessment for the third quarter of 2009. The Company’s prepaid assessment for FDIC amounted to $11.4 million. The prepaid regulatory assessment includes prepaid annual assessment for the DFI of approximately $90,000 at December 31, 2009.
Other assets decreased by $0.5 million to $4.8 million as of December 31, 2009 compared to $5.3 million at December 31, 2008. The decrease principally reflects a receipt of $1.0 million in a long-term receivable as a result of the KEIC litigation settlement.
Deposits
The composition and cost of the Company’s deposit base are important components in analyzing its net interest margin and balance sheet liquidity characteristics, both of which are discussed in greater detail in other sections herein. Net interest margin is improved to the extent that growth in deposits can be concentrated in historically lower-cost core deposits, namely non-interest-bearing demand, NOW accounts, savings accounts and money market deposit accounts. Liquidity is impacted by the volatility of deposits or other funding instruments, or in other words their propensity to leave the institution for rate-related or other reasons. Potentially, the most volatile deposits in a financial institution are large certificates of deposit (e.g., generally time deposits with balances exceeding $100,000). Because these deposits (particularly when considered together with a customer’s other specific deposits) may exceed FDIC insurance limits, depositors may select shorter maturities to offset perceived risk elements associated with such deposits.
Deposits consist of the following as of the dates indicated:
The following table summarizes the composition of deposits as a percentage of total deposits as of the dates indicated:
The Company offers a wide variety of retail deposit account products to both consumer and commercial deposit customers. Time deposits, which are the Company’s highest cost deposits, consist primarily of retail fixed-rate certificates of deposit, and comprised 44.7% and 49.5% of the deposit portfolio at December 31, 2009 and 2008, respectively. The ratio of non-interest- bearing deposits to total deposits was 20.2% and 19.3% at December 31, 2009, and 2008, respectively. All other deposits, which include interest-bearing checking accounts (NOW), savings and money market accounts, accounted for the remaining 35.2% and 31.2% of the deposit portfolio at December 31, 2009 and 2008, respectively.
Deposit growth remains challenging as the Company continues to experience heightened market competition. Deposits increased 9.0% to $1.75 billion at December 31, 2009, from $1.60 billion at December 31, 2008, largely due to increases in customer deposits accomplished through the Bank’s deposit campaigns. Deposit growth consists of the increases in money market accounts of $54.2 million, non interest-bearing demand deposit of $42.0 million, savings accounts of $33.9 million, NOW accounts of $26.8 million, and jumbo time deposits of $42.5 million. These increases were partially offset by decreases in non jumbo time deposits of $55.5 million. The decrease in non jumbo time deposits is primarily due to $47.4 million in brokered time deposits maturing in 2009. Jumbo time deposits amounted to $524.4 million while non jumbo time deposits amounted to $256.0 million including $121.0 million in brokered time deposits. Total time deposits amounted to $780.4 million and represented 44.7% of total deposits at December 31, 2009. Total money market accounts were $492.9 million or 28.2% including $139.2 million in brokered deposits. All other deposits represent 27.1% of total deposits at December 31, 2009. Total brokered deposit balances were $260.2 million and $372.2 million at December 31, 2009 and 2008, respectively.
As of December 31, 2009 and 2008, time deposits of $100,000 or more totaled $524.4 million and $481.3 million, respectively, representing 30.0% of the total deposit portfolio at each date. These accounts, consisting primarily of consumer deposits and deposits from the State of California, had a weighted average interest rate of 1.99% and 3.29% at December 31, 2009 and 2008, respectively.
The following table provides the remaining maturities of the Company’s time deposits in denominations of $100,000 or greater as of December 31, 2009 and 2008:
The Company’s average deposit cost decreased to 1.99% during 2009 from 2.85% in 2008.
Information concerning the average balance and average rates paid on deposits by deposit type for the past three fiscal years is contained in the Distribution, Rate, and Yield table in the previous section entitled “Results of Operations-Net Interest Margin”.
Other Borrowed Funds
The Company regularly uses FHLB advances as an alternate funding source to provide operating liquidity and to fund loan originations. As of December 31, 2009, the Company borrowed $146.8 million as compared to $192.2 million at December 31, 2008 from the FHLB with note terms from less than 1 year to 15 years. Notes of 10-year and 15-year terms are amortizing at the predetermined schedules over the life of the notes. Of the $146.8 million outstanding, $145.0 million is composed of six fixed rate term advances, each with an option to be called by the FHLB after the lockout dates varying from 6 months to 2 years. If market interest rates are higher than the advances’ stated rates at that time, the advances will be called by the FHLB and the Company will be required to repay the FHLB. If market interest rates are lower after the lockout period, then the advances will not be called by the FHLB. If the advances are not called by the FHLB, then they will mature on the maturity date ranging from 4 years to 10 years. The Company may repay the advances with a prepayment penalty at any time. If the advances are called by the FHLB, there is no prepayment penalty.
The Company regularly uses FHLB advances as an alternate funding source to provide operating liquidity and to fund loan originations.
Under the FHLB borrowing agreement, the Company has pledged under a blanket lien all qualifying commercial and residential loans as collateral with a total carrying value of $812.9 million at December 31, 2009 as compared to $1.0 billion at December 31, 2008.
Total interest expense on FHLB borrowings was $6.9 million and $9.3 million for the years ended December 31, 2009 and 2008, respectively, reflecting average interest rates of 4.30% and 3.62%, respectively.
The Company also regularly uses short-term borrowing from the U.S. Treasury to manage Treasury Tax and Loan payments. Notes issued to the U.S. Treasury amounted to $1.6 million as of December 31, 2009 compared to $0.8 million as of December 31, 2008. Interest expense on these borrowings was $0 and $9,000 in 2009 and 2008, respectively, reflecting average interest rates of 0.00% and 1.21%, respectively. The details of these borrowings for the years 2009, 2008, and 2007 are presented in Note 9 to the Consolidated Financial Statements in Item 8 herein.
In addition, the issuance of a long-term subordinated debenture at the end of 2004 in connection with the issuance of $18.6 million in “pass-through” trust preferred securities provided an additional source of funding. (See Note 11 to the Financial Statements in Item 8 herein).
Short-term borrowings principally include overnight fed funds purchased and advances from the FHLB. The details of these borrowings for the years 2009, 2008, and 2007 are presented below:
Contractual Obligations
The following table presents, as of December 31, 2009, the Company’s significant fixed and determinable contractual obligations, within the categories described below, by payment date. These contractual obligations, except for the operating lease obligations, are included in the Consolidated Statements of Financial Condition. The payment amounts represent those amounts contractually due to the recipient.
Includes principal payments only. The debentures will mature on January 7, 2034. The debentures may be redeemed by the debenture issuer, in whole or in part, on any January 7, April 7, July 7 or October 7 on or after January 7, 2009 at the redemption price, upon not less than 30 nor more than 60 days’ notice to holders of such debentures.
Off-Balance Sheet Arrangements
The Company may also have liabilities under certain contractual agreements contingent upon the occurrence of certain events.
As part of its service to its small to medium-sized business customers, the Company from time to time issues formal commitments and lines of credit. These commitments can be either secured or unsecured and 90% are short-term, or less than one year. They may be in the form of revolving lines of credit for seasonal working capital needs. However, these commitments may also take the form of standby letters of credit and commercial letters of credit. Commercial letters of credit facilitate import trade. Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party.
Total unused commitments to extend credit were $187.1 million and $220.1 million at December 31, 2009 and 2008, respectively. Unused commitments represented 12.2% and 12.8% of outstanding gross loans at December 31, 2009 and 2008, respectively. The Company’s standby letters of credit and commercial letters of credit at December 31, 2009 were $21.3 million and $22.2 million, respectively, as compared to $11.3 million and $21.5 million, respectively, at December 31, 2008.
Liabilities for losses on outstanding commitments of $246,000 and $263,000 were reported separately in other liabilities at December 31, 2009 and 2008.
A discussion of significant contractual arrangements under which the Company may be held contingently liable, including guarantee arrangements, is included in Note 13-“Commitments and Contingencies” and Note 17-“Financial Instruments with Off-Balance Sheet Risk” to the Consolidated Financial Statements Item 8 herein.
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 mitigate the impact of inflation on its net interest margin through the 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 non-interest expenses has not been significant for the periods covered in this Annual Report.
Market Risk and Asset Liability Management
Market risk is the risk of loss from adverse changes in market prices and rates. The Company’s market risk arises primarily from interest rate risk inherent in its lending, investment and deposit taking activities. The Company’s profitability is affected by fluctuations in interest rates. A sudden and substantial change in interest rates may adversely impact the Company’s earnings to the extent that the interest rates borne by assets and liabilities do not change at the same speed, to the same extent or on the same basis. To that end, management actively monitors and manages its interest rate risk exposure.
The Company’s strategy for asset and liability management is formulated and monitored by the Company’s Asset/Liability Board Committee (the “Board Committee”). This Board Committee is composed of four non-employee directors and the President. The Board Committee meets quarterly to review and adopt recommendations of the Asset/Liability Management Committee (“ALCO”).
The ALCO consists of executive and manager level officers from various areas of the Company including lending, investment, and deposit gathering, in accordance with policies approved by the board of directors. The primary goal of the Company’s ALCO is to manage the financial components of the Company’s balance sheet to optimize the net income under varying interest rate environments. The focus of this process is the development, analysis, implementation, and monitoring of earnings enhancement strategies, which provide stable earnings and capital levels during periods of changing interest rates.
The ALCO meets regularly to review, among other matters, the sensitivity of the Company’s assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, and maturities of investments and borrowings. The ALCO also approves and establishes pricing and funding decisions with respect to overall asset and liability composition, and reports regularly to the Board Committee and the board of directors.
Interest Rate Risk
Interest rate risk occurs when assets and liabilities reprice at different times as interest rates change. In general, the interest the Company earns on its assets and pays on its liabilities are established contractually for specified periods of time. Market interest rates change over time and if a financial institution cannot quickly adapt to changes in interest rates, it may be exposed to volatility in earnings. For instance, if the Company were to fund long-term fixed rate assets with short-term variable rate deposits, and interest rates were to rise over the term of the assets, the short-term variable deposits would rise in cost, adversely affecting net interest income. Similar risks exist when rate sensitive assets (for example, prime rate based loans) are funded by longer-term fixed rate liabilities in a falling interest rate environment.
The Company’s overall strategy is to minimize the adverse impact of immediate incremental changes in market interest rates (rate shock) on net interest income and economic value of equity. Economic value of equity (“EVE”) is defined as the present value of assets, minus the present value of liabilities and off-balance sheet instruments. The attainment of this goal requires a balance between profitability, liquidity and interest rate risk exposure. To minimize the adverse impact of changes in market interest rates, the Company simulates the effect of instantaneous interest rate changes on net interest income and EVE on a quarterly basis. The table below shows the estimated impact of changes in interest rates on our net interest income and market value of equity as of December 31, 2009 and 2008, respectively, assuming a parallel shift of 100 to 300 basis points in both directions.
The percentage change represents net interest income for twelve months in a stable interest rate environment versus net interest income in the various rate scenarios.
The percentage change represents economic value of equity of the Company in a stable interest rate environment versus economic value of equity in the various rate scenarios.
All interest-earning assets and interest-bearing liabilities are included in the interest rate sensitivity analysis at December 31, 2009 and 2008, respectively. At December 31, 2009 and 2008, respectively, our estimated changes in net interest income and economic value of equity were within the ranges established by the Board of Directors.
The primary analytical tool used by the Company to gauge interest rate sensitivity is a simulation model used by many community banks, which is based upon the actual maturity and repricing characteristics of interest-rate-sensitive assets and liabilities. The model attempts to forecast changes in the yields earned on assets and the rates paid on liabilities in relation to changes in market interest rates. As an enhancement to the primary simulation model, other factors are incorporated into the model, including prepayment assumptions and market rates of interest provided by independent broker/dealer quotations, an independent pricing model, and other available public information. The model also factors in projections of anticipated activity levels of the Company’s product lines. Management believes that the assumptions it uses to evaluate the vulnerability of the Company’s operations to changes in interest rates approximate actual experience and considers them reasonable; however, the interest rate sensitivity of the Company’s assets and liabilities and the estimated effects of changes in interest rates on the Company’s net interest income and EVE could vary substantially if different assumptions were used or if actual experience were to differ from the historical experience on which they are based.
Liquidity
The objective of liquidity risk management is to ensure that the Company has the continuing ability to maintain cash flows that are adequate to fund operations and meet its other obligations on a timely and cost-effective basis in various market conditions. Changes in the composition of its balance sheet, the ongoing diversification of its funding sources, risk tolerance levels and market conditions are among the factors that influence the Company’s liquidity profile. The Company establishes liquidity guidelines and maintains contingency liquidity plans that provide for specific actions and timely responses to liquidity stress situations.
As a means of augmenting the liquidity sources, the Company has available a combination of borrowing sources comprised of FHLB advances, federal funds lines with various correspondent banks, and access to the
wholesale markets. The Company believes these liquidity sources to be stable and adequate. At December 31, 2009, the Company was not aware of any information that was reasonably likely to have a material adverse effect on our liquidity position.
The liquidity of the Company is primarily dependent on the payment of cash dividends by its subsidiary, Center Bank, subject to limitations imposed by the laws of the State of California.
As part of the Company’s liquidity management, the Company utilizes FHLB borrowings to supplement our deposit source of funds. Therefore, there could be fluctuations in these balances depending on the short-term liquidity and longer-term financing need of the Company. The Company’s primary sources of liquidity are derived from financing activities, which include customer and broker deposits, federal funds facilities, and advances from the Federal Home Loan Bank of San Francisco.
Because the Company’s primary sources and uses of funds are deposits and loans, respectively, the relationship between net loans and total deposits provides one measure of the Company’s liquidity. Typically, if the ratio is over 100%, the Company relies more on borrowings, wholesale deposits and repayments from the loan portfolio to provide liquidity. Alternative sources of funds such as FHLB advances and brokered deposits and other collateralized borrowings provide liquidity as needed from liability sources are an important part of the Company’s asset liability management strategy.
As of December 31, 2009, the Company’s liquidity ratio, which is the ratio of available liquid funds to net deposits and short term liabilities, was 23.5%, compared to 8.0% at December 31, 2008. The Company’s liquidity ratio increased as a result of increase in cash and other short-term marketable assets during 2009. Total available liquidity as of December 31, 2009 and 2008 was $411.6 million and $132.6 million, respectively, mainly consisting of cash holdings or balances in due from banks, overnight fed funds sold, money market funds and unpledged available-for-sale securities.
The Company’s net non-core fund dependence ratio was 42.09% under applicable regulatory guidelines, which assumes all certificates of deposit over $100,000 (“Jumbo CD’s”) as volatile sources of funds. The Company has identified approximately $290 million of Jumbo CD’s as stable and core sources of funds based on past historical analysis. The net non-core fund dependence ratio was 30.8% assuming this $290 million is stable and core fund sources and certain portions of money market account as volatile. The net non-core fund dependence ratio is the ratio of net short-term investments less non-core liabilities divided by long-term assets. All of the ratios were in compliance with internal guidelines as of and for the year ended December 31, 2009.
At December 31, 2009, the Company had available $60 million in federal funds lines, $270 million FHLB borrowings, and $85 million with FRB totaling $415 million of available funding sources. This does not include the Company’s ability to purchase wholesale brokered deposits. Additionally, $171 million in investment securities may be pledged as collateral for repurchase agreements and other credit facilities. The Company’s application for the Borrower In Custody arrangement was approved by the Federal Reserve Bank of San Francisco in January 2009. Collateral held in such an arrangement may be used to secure advances and/or credit for the discount window program and will provide the Company with additional source of liquidity.
Capital Resources
Shareholders’ equity as of December 31, 2009 was $256.1 million, compared to $214.6 million as of December 31, 2008. The increase in capital primarily resulted from the fourth quarter capital raises described below, offset by the net consolidated loss for the year and dividends on the preferred stock issued under the TARP Capital Purchase Program. During the fourth quarter of 2009, the Company raised an aggregate of $86.3 million in gross proceeds from the successful consummation of two private placements. The first was for 3,360,000 shares of common stock for gross proceeds of $12.8 million, and the second was for 73,500 shares of Mandatorily Convertible Non-Cumulative Non-Voting Perpetual Preferred Stock, Series B, for gross proceeds of $73.5 million. See “Item 1 - Business-Recent Developments-Fourth Quarter Capital Raises” above.
As part of the TARP Capital Purchase Program, the Company entered into a purchase agreement with the U.S. Treasury Department on December 12, 2008, pursuant to which the Company issued and sold 55,000 shares of fixed-rate cumulative perpetual preferred stock for a purchase price of $55 million and 10-year warrants to purchase 864,780 shares of the Company’s common stock at an exercise price of $9.54 per share. The Company will pay the U.S. Treasury Department a five percent dividend annually for each of the first five years of the investment and a nine percent dividend thereafter until the shares are redeemed.
The Company issued trust preferred securities of $18 million in 2004 through its wholly owned subsidiary, Center Capital Trust I. On March 1, 2005, the Federal Reserve Board adopted a final rule that allows the continued inclusion of trust preferred securities in the Tier I capital of bank holding companies. However, under the final rule, after a five-year transition period, the aggregate amount of trust preferred securities and certain other capital elements that represent Tier I capital would be limited to 25 percent of Tier I capital elements, net of goodwill. Trust preferred securities currently make up 6.7% of the Company’s Tier I capital. Shareholders’ equity is also affected by increases and decreases in unrealized losses on securities classified as available-for-sale and share-based compensation expense.
The Company is committed to maintaining capital at a level sufficient to assure shareholders, customers and regulators that the Company is financially sound and able to support its growth from its retained earnings. From October 2003 to January 2009 Center Financial paid quarterly cash dividends to its shareholders. In accordance with this policy, the Company paid quarterly cash dividends of 5 cents per share in 2008, for a total of $3.3 million.
On March 25, 2009, the Company’s board of directors suspended its quarterly cash dividends based on adverse economic conditions and reduction in earnings of the Company. The Company has determined that this is a prudent, safe and sound practice to preserve capital. The Company would be required to obtain the U.S. Treasury Department’s approval to reestablish common stock dividend in the future until it has redeemed the preferred stock issued under TARP CPP. The Company is also required to obtain prior approval of the FRB to pay dividends pursuant to MOU with the FRB (see “Item 1 - Business-Recent Developments-Informal Regulatory Agreements” above).
The Company is subject to risk-based capital regulations adopted by the federal banking regulators. These guidelines are used to evaluate capital adequacy and are based on an institution’s asset risk profile and off-balance sheet exposures. The risk-based capital guidelines assign risk weightings to assets both on and off-balance sheet and place increased emphasis on common equity. According to the regulations, institutions whose Tier I risk based capital ratio, total risk based capital ratio and leverage ratio meet or exceed 6%, 10% and 5%, respectively, are deemed to be “well-capitalized.” As of December 31, 2009, all of the Company’s capital ratios were above the minimum regulatory requirements for a “well-capitalized” institution.
The MOU the Bank has entered into with the FDIC and the DFI requires the development of a capital plan that includes obtaining a minimum Tier 1 leverage capital ratio of not less than 9% and a total risk-based capital ratio of not less than 13% by December 31, 2009, and maintaining such minimum levels while the MOU remains in effect. The Bank’s regulatory capital ratios as of December 31, 2009 exceeded these requirements.
The following table compares Center Financial’s and the Bank’s actual capital ratios at December 31, 2009 and 2008, to those required by regulatory agencies for capital adequacy and well-capitalized classification purposes:
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information concerning quantitative and qualitative disclosures about market risk called for by Item 305 of Regulation S-K is included as part of Item 7 above. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Market Risk”, “Asset Liability Management”, “Interest Rate Risk” and “Interest Rate Sensitivity”.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following financial statements and independent registered public accounting firm’s reports are included herein:
Page
I.
Report of Independent Registered Public Accounting Firm
II.
Consolidated Statements of Financial Condition
III.
Consolidated Statements of Operations
IV.
Consolidated Statement of Shareholders’ Equity and Comprehensive Income (Loss)
V.
Consolidated Statements of Cash Flows
VI.
Notes to Consolidated Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
Center Financial Corporation
We have audited the accompanying consolidated statements of financial condition of Center Financial Corporation (a California corporation) and subsidiaries as of December 31, 2009 and 2008, and the related consolidated statements of operations, shareholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended December 31, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these 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 Center Financial Corporation as of December 31, 2009 and 2008, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2009 in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 14, Center Financial Corporation adopted a new accounting pronouncement in 2008 resulting in a change in accounting method for deferred compensation and postretirement benefit aspects of endorsement split-dollar life insurance arrangements.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Center Financial Corporation’s internal control over financial reporting as of December 31, 2009, 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 12, 2010 expressed an unqualified opinion on the effectiveness of Center Financial Corporation’s internal control over financial reporting.
/s/ GRANT THORNTON LLP
Los Angeles, California
March 12, 2010
CENTER FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
See accompanying notes to consolidated financial statements.
CENTER FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
YEAR ENDED DECEMBER 31,
See accompanying notes to consolidated financial statements.
CENTER FINANCIAL CORPORATION
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY
AND COMPREHENSIVE INCOME (LOSS)
YEARS ENDED DECEMBER 31, 2009, 2008, AND 2007
(Continued)
See accompanying notes to consolidated financial statements.
CENTER FINANCIAL CORPORATION
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY
AND COMPREHENSIVE INCOME (LOSS)-(Continued)
YEAR ENDED DECEMBER 31,
(Concluded)
See accompanying notes to consolidated financial statements.
CENTER FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31,
(Continued)
See accompanying notes to consolidated financial statements.
CENTER FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS-(Continued)
YEAR ENDED DECEMBER 31,
(Concluded)
See accompanying notes to consolidated financial statements.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. THE BUSINESS OF CENTER FINANCIAL CORPORATION
Center Financial Corporation (“Center Financial”) was incorporated on April 19, 2000 and acquired all of the issued and outstanding shares of Center Bank (the “Bank”) in October 2002. Currently, Center Financial’s direct subsidiaries include the Bank and Center Capital Trust I. Center Financial exists primarily for the purpose of holding the stock of the Bank and of other subsidiaries. Center Financial and the Bank are collectively referred to herein as the “Company.”
The Bank is a California state-chartered and Federal Deposit Insurance Corporation (“FDIC”) insured financial institution, which was incorporated in 1985 and commenced operations in March 1986. The Bank changed its name from California Center Bank to Center Bank in December 2002. The Bank’s headquarters are located at 3435 Wilshire Boulevard, Suite 700, Los Angeles, California 90010. The Bank provides comprehensive financial services for small to medium sized business owners, primarily in Southern California. The Bank specializes in commercial loans, most of which are secured by real property, to small business customers. In addition, the Bank is a Preferred Lender of Small Business Administration (“SBA”) loans and provides trade finance loans. The Bank’s primary market is the greater Los Angeles metropolitan area, including Los Angeles, Orange, San Bernardino, and San Diego counties, primarily focused in areas with high concentrations of Korean-Americans. The Bank currently has 19 full-service branch offices, 16 of which are located in Los Angeles, Orange, San Bernardino, and San Diego counties. The Bank opened all California branches as de novo branches, and one branch in Chicago, Illinois by acquisition in 2004. The Bank opened one new branch in the Seattle area of Washington in November 2007, and one new branch in Diamond Bar, California in March 2008. The Bank also operates one Loan Production Office (“LPO”) in Seattle. Effective February 17, 2009, the Company closed five LPO’s in Denver, Washington D.C., Atlanta, Dallas and Northern California.
In December 2003, Center Financial formed a wholly owned subsidiary, Center Capital Trust I, a Delaware statutory business trust, for the exclusive purpose of issuing and selling trust preferred securities.
Center Financial’s principal source of income is generally dividends from the Bank and equity earnings in the Bank. The expenses of Center Financial, including interest on junior subordinated debentures issued to Center Capital Trust I, legal and accounting professional fees and NASDAQ listing fees have been and will generally be paid by the cash on hand or from dividends paid by the Bank.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation and Consolidation
The consolidated financial statements include the accounts of Center Financial and the Bank. Intercompany transactions and accounts have been eliminated in consolidation. Center Capital Trust I is not consolidated as described in Note 11.
The consolidated financial statements are presented in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and general practices within the banking industry.
Significant Group Concentration of Credit Risk
Most of the Company’s activities are with customers located within the greater Los Angeles region. Note 3 discusses the Company’s investment securities and Note 4 discusses the Company’s lending activities.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Use of Estimates in the Preparation of Consolidated Financial Statements
The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to determination of the valuation of investment securities, the allowance for loan losses, the valuation of foreclosed real estate, deferred tax assets and the results of litigation.
Reclassifications
Reclassifications have been made to the prior year financial statements to conform to the current presentation.
Cash and Cash Equivalents
Cash and cash equivalents include cash and due from banks, overnight federal funds sold, money market funds, and interest-bearing deposits in other banks, all of which have original maturities of less than 90 days.
The Company is required to maintain minimum reserve balances in cash with the Federal Reserve Bank. The average reserve balance requirement was approximately $7.8 million and $6.3 million during 2009 and 2008, respectively. The Company did not have a restricted balance in its due from banks at December 31, 2009 and 2008, respectively.
Investment Securities
Investment securities are classified into three categories and accounted for as follows:
(i) securities the Company has the intent and ability to hold to maturity are classified as “held-to-maturity” and reported at amortized cost;
(ii) securities that are bought and held principally for the purpose of selling them in the near future are classified as “trading securities” and reported at fair value. Unrealized gains and losses are recognized in earnings; and
(iii) securities not classified as held to maturity or trading securities are classified as “available-for-sale” and reported at fair value. Unrealized gains and losses are reported as a separate component of accumulated other comprehensive income in shareholders’ equity, net of tax.
Accreted discounts and amortized premiums on investment securities are included in interest income, using the interest method, and unrealized and realized gains or losses related to holding or selling of securities are calculated using the specific identification method. Any declines in the fair value of securities held to maturity or securities available for sale below their cost that are deemed to be other than temporary are reflected in the Consolidated Statements of Operations as realized losses.
Federal Home Loan Bank and Other Equity Stock
As a member of the Federal Home Loan Bank (“FHLB”) of San Francisco, the Company is required to own common stock in the FHLB based upon the Company’s balance of residential mortgage loans, mortgage-backed securities, and outstanding advances. The Company’s investment in FHLB stock totaled $15.6 million as of both December 31, 2009 and 2008, respectively. In addition, the Company had invested $60,000 in Pacific Coast
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Bankers’ Bank stock as of December 31, 2009 and 2008. The instruments are carried at cost in the Consolidated Statements of Financial Condition.
Loans
Interest on loans is credited to income as earned and is accrued only if deemed collectible. Accrual of interest is discontinued when a loan is over 90 days delinquent or if management believes that collection is highly uncertain. Generally, payments received on non-accrual loans are recorded as principal reductions. Interest income is recognized after all principal has been repaid or an improvement in the condition of the loan has occurred that would warrant resumption of interest accruals.
Nonrefundable fees, net of certain direct costs associated with the origination of loans, are deferred and recognized as an adjustment of the loan yield over the life of the loan. Other loan fees and charges, representing service costs for the prepayment of loans, delinquent payments, or miscellaneous loan services, are recorded as income when collected.
Certain Small Business Administration (“SBA”) loans that the management has the intent to sell before maturity are designated as held for sale at origination and recorded at the lower of cost or market value, determined on an aggregate basis. A valuation allowance is established if the market value of such loans is lower than their cost, and operations are charged or credited for valuation adjustments. On loans sold, the Company allocates the carrying value of such loans between the portion sold and the portion retained, based upon estimates of their relative fair values at the time of sale. The difference between the adjusted carrying value and the face amount of the portion retained is amortized to interest income over the life of the related loan using the interest method.
Servicing assets and servicing liabilities are recognized when loans are sold with servicing retained. The servicing assets, net of servicing liabilities, are included in other assets in the accompanying consolidated statements of financial condition and are recorded based on the present value of the contractually specified servicing fee, net of servicing cost, over the estimated life of the loan, using a discount rate of the related note rate plus 2 percent. The servicing asset is amortized in proportion to and over the period of estimated servicing income. Management periodically evaluates the servicing asset for impairment, which is the carrying amount of the servicing asset in excess of the related fair value. The fair value of servicing assets was determined using a weighted average discount rate of 10 percent and prepayments speed of 14.7 percent and 16.3 percent at December 31, 2009 and 2008, respectively. Impairment, if it occurs, is recognized in a valuation allowance in the period of the impairment.
Allowance for Loan Losses
Loan losses are charged, and recoveries are credited to the allowance account. Additions to the allowance account are charged to the provision for loan losses. The allowance for loan losses is maintained at a level considered adequate by management to absorb inherent losses in the loan portfolio. The adequacy of the allowance for loan losses is determined by management based upon an evaluation and review of the loan portfolio, consideration of historical loan loss experience, current economic conditions, and changes in the composition of the loan portfolio, analysis of collateral values, and other pertinent factors. While management uses available information to recognize possible losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. 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 additional allowance based on their judgments about information available to them at the time of their examination.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Loans are measured for impairment when it is probable that not all amounts, including principal and interest, will be collected in accordance with the contractual terms of the loan agreement. The amount of impairment and any subsequent changes are recorded through the provision for loan losses as an adjustment to the allowance for loan losses. Impairment is measured either based on the present value of the loan’s expected future cash flows or the estimated fair value of the collateral if the loan is collateral dependent. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
The Company evaluates consumer loans for impairment on a pooled basis. These loans are considered to be smaller balance, homogeneous loans, and are evaluated on a portfolio basis accordingly.
Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization of premises and equipment are computed on the straight-line method over the following estimated useful lives:
Buildings
30 years
Furniture, fixture, and equipment
5 to 10 years
Computer equipment
3 years
Leasehold improvements
life of lease or improvements, whichever is shorter
Other Real Estate Owned
Other real estate owned (“OREO”), which represents real estate acquired through foreclosure in satisfaction of commercial and real estate loans, is stated at fair value less estimated selling costs of the real estate. Loan balances in excess of the fair value of the real estate acquired at the date of acquisition are charged to the allowance for loan losses. Any subsequent decline in the fair value of OREO is recognized as a charge to operations and a corresponding increase to the valuation allowance of OREO. Gains and losses from sales and net operating expenses of OREO are included in current operations.
Investments in Affordable Housing Partnerships
The Company owns limited partnership interests in projects of affordable housing for lower income tenants. The investments in which the Company has significant influence are recorded using the equity method of accounting. For those investments in limited partnerships for which the Company does not have a significant influence, such investments are accounted for using the cost method of accounting and the annual amortization is based on the proportion of tax credits received in the current year to the total estimated tax credits to be allocated to the Company. The tax credits are recognized in the consolidated financial statements to the extent they are utilized on the Company’s tax returns.
Long Term Subordinated Debentures
The Company established Center Capital Trust I in December 2003 (the “Trust”) as a statutory business trust, which is a wholly owned subsidiary of the Company. In the private placement transaction, the Trust issued $18.0 million of floating rate (3-month LIBOR plus 2.85%) capital securities representing undivided preferred beneficial interests in the assets of the Trust which consist primarily of a junior subordinated debenture in the approximate principal amount of $18.6 million from Center Financial. The Trust also issued common securities
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
to Center Financial for $557,000 to purchase additional subordinated debentures. The Company is the owner of all the beneficial interests represented by the common securities of the Trust. The purpose of issuing the capital securities was to provide the Company with a cost-effective means of obtaining Tier I capital for regulatory purposes. The Trust is not consolidated into the accounts of the Company. Long-term subordinated debt of $18.6 million represents liabilities of the Company to the Trust.
Income Taxes
Deferred income taxes are provided for using an asset and liability approach. Deferred income tax assets and liabilities represent the tax effects, based on current tax law, of future deductible or taxable amounts attributable to events that have been recognized in the consolidated financial statements.
As a result of the loss incurred during 2009, management has assessed, by year, the future reversal of all temporary differences to determine which deductions would be available to carry back to tax years with taxable income or could be utilized by projected future taxable income. As a result of this analysis, management has determined that a portion of the Company’s net deferred tax asset does not meet the more likely than not criteria for realization. Accordingly, the Company has recorded a valuation allowance of $16.3 million. The net deferred tax asset valuation allowance includes a valuation allowance for capital losses, established in 2008, due to the uncertainty surrounding the realization of the benefits of these losses that may result from future capital gain.
Stock-Based Compensation
Beginning January 1, 2006 (see Note 14), the Company recognizes compensation expense for all share-based payments made to employees and directors based on the fair value of the share-based payment on the date of grant. The Company elected to use the modified prospective method for adoption, which requires compensation expense to be recorded for all unvested stock options beginning in the first quarter of adoption. For all unvested options outstanding as of January 1, 2006, the previously measured but unrecognized compensation expense, based on the fair value at the original grant date, is recognized on a straight-line basis in the Consolidated Statements of Operations over the remaining vesting period. For share-based payments granted subsequent to January 1, 2006, compensation expense, based on the fair value on the date of grant, is recognized in the Consolidated Statements of Operations on a straight-line basis over the vesting period. In determining the fair value of stock options, the Company uses the Black-Scholes option-pricing model that employs the following assumptions:
•
Expected volatility-based on the weekly historical volatility of our stock price, over the expected life of the option.
•
Expected term of the option-based on historical employee stock option exercise behavior, the vesting terms of the respective option and a contractual life of ten years.
•
Risk-free rate of return-based upon the rate on a zero coupon U.S. Treasury bill, for periods within the contractual life of the option, in effect at the time of grant.
•
Dividend yield-calculated as the ratio of historical dividends paid per share of common stock to the stock price on the date of grant.
The Company’s stock price volatility and option lives involve management’s best estimates at that time, both of which impact the fair value of the option calculated under the Black-Scholes methodology and, ultimately, the expense that will be recognized over the life of the option.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Preferred Stock and Common Stock Warrants
The Company issued and sold 55,000 shares of fixed-rate cumulative perpetual preferred stock and a 10-year warrant (“Warrant”) to purchase 864,780 shares of the Company’s common stock at an exercise price of $9.54 per share to the U.S. Treasury Department on December 12, 2008. The Company will pay the U.S. Treasury Department a five percent dividend annually for each of the first five years of the investment and a nine percent dividend thereafter until the shares are redeemed. The cumulative dividend for the preferred stock is accrued for and payable on February 15, May 15, August 15 and November 15 of each year.
As a result of “qualified equity offerings” (as defined in the Securities Purchase Agreement with the U.S. Treasury Department) in the fourth quarter of 2009 aggregating in excess of $55 million (specifically $86.3 million) in gross proceeds, the number of shares underlying the Warrant was reduced to 432,290.
On December 29, 2009, the Company entered into Securities Purchase Agreements with a limited number of institutional and other accredited investors, including insiders to sell a total of 73,500 shares of Mandatorily Convertible Non-Cumulative Non-Voting Perpetual Preferred Stock, Series B, without par value (the “Series B Preferred Stock”) at a price of $1,000 per share, for an aggregate gross purchase price of $73,500,000, which closed on December 31, 2009, and the Company issued an aggregate of 73,500 shares of Series B Preferred Stock upon its receipt of consideration in cash.
Earnings (Loss) per Common Share
Basic earnings (loss) per share (“EPS”) exclude dilution and are computed by dividing earnings available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if options, awards or warrants were exercised or vested which resulted in the issuance of common stock that then shared in the earnings. Exercise of options is not assumed if the result would be anti-dilutive such as when a loss from continuing operations is reported. In the calculation of EPS, distribution to preferred shareholders including dividends to preferred shareholders and accretion of preferred stock discount is deducted from net earnings (loss) to arrive at the net income (loss) available to common shareholders.
Comprehensive Income (Loss)
Accounting principles generally require that recognized revenue, expenses, gains, and losses be included in net income (loss). Although certain changes in assets and liabilities, such as unrealized gains and losses on securities available for sale, are reported as a separate component of the shareholders’ equity section of the Consolidated Statements of Financial Condition, such items, along with net income (loss), are components of comprehensive income (loss).
Recent Accounting Pronouncements
In June 2009, the Financial Accounting Standards Board (“FASB”) issued an accounting pronouncement establishing the FASB Accounting Standards Codification (the “ASC” or “Codification”) as the exclusive authoritative reference for nongovernmental U.S. GAAP for use in financial statements issued for interim and annual periods ending after September 15, 2009, except for SEC rules and interpretive releases, which are also authoritative GAAP for SEC registrants. The Codification superseded all non-SEC accounting and reporting standards. All other non-grandfathered, non-SEC accounting literature not included in the Codification is now nonauthoritative. The Company adopted this new accounting pronouncement beginning with the quarterly period ended September 30, 2009, as required, and adoption did not have a material impact on the Company’s consolidated financial statements taken as a whole.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
In April 2009, the FASB issued three related accounting pronouncements intended to provide additional application guidance and enhance disclosures regarding fair value measurements and impairments of securities. In particular, these pronouncements: (1) provide guidelines for making fair value measurements more consistent with the existing accounting principles when the volume and level of activity for the asset or liability have decreased significantly; (2) enhance consistency in financial reporting by increasing the frequency of fair value disclosures and (3) modify existing general standards of accounting for and disclosure of other-than-temporary impairment (“OTTI”) losses for impaired debt securities.
The fair value measurement guidance of these pronouncements reaffirms the need for entities to use judgment in determining if a formerly active market has become inactive and in determining fair values when markets have become inactive. The changes to fair value disclosures relate to financial instruments that are not currently reflected on the balance sheet at fair value. Prior to these pronouncements, fair value disclosures for these instruments were required for annual statements only. These disclosures now are required to be included in interim financial statements. The general standards of accounting for OTTI losses were changed to require the recognition of an OTTI loss in earnings only when an entity (1) intends to sell the debt security; (2) more likely than not will be required to sell the security before recovery of its amortized cost basis or (3) does not expect to recover the entire amortized cost basis of the security. In situations when an entity intends to sell or more likely than not will be required to sell the security, the entire OTTI loss must be recognized in earnings. In all other situations, only the portion of the OTTI losses representing the credit loss must be recognized in earnings, with the remaining portion being recognized in other comprehensive income, net of deferred taxes.
All three pronouncements were effective for interim periods ending after June 15, 2009. The Company adopted the provisions of these pronouncements during the quarter ended June 30, 2009.
In May 2009, the FASB issued an accounting pronouncement establishing general standards of accounting for and disclosure of subsequent events, which are events occurring after the balance sheet date but before the date the financial statements are issued or available to be issued. In particular, the pronouncement requires entities to recognize in the financial statements the effect of all subsequent events that provide additional evidence of conditions that existed at the balance sheet date, including the estimates inherent in the financial preparation process. Entities may not recognize the impact of subsequent events that provide evidence about conditions that did not exist at the balance sheet date but arose after that date. This pronouncement was effective for interim and annual reporting periods ending after June 15, 2009. The Company adopted provisions of this pronouncement during the quarter ended June 30, 2009.
In June 2009, the FASB issued two related accounting pronouncements changing the accounting principles and disclosures requirements related to securitizations and special-purpose entities. These eliminate the Qualified Special Purpose Entity (“QSPE”) concept, creates more stringent conditions for reporting a transfer of a portion of a financial asset as a sale, clarifies the derecognition criteria, revises how retained interests are initially measured, and removes the guaranteed mortgage securitization recharacterization provisions. They also require reporting entities to evaluate former QSPE’s for consolidation, changes the approach to determining a primary beneficiary of Variable Interest Entity (“VIE”) from a quantitative assessment to a qualitative assessment designed to identify a controlling financial interest, and increases the frequency of required reassessments to determine whether a company is the primary beneficiary of a VIE. It also clarifies, but does not significantly change, the characteristics that identify a VIE. These pronouncements are effective as of the beginning of a company’s first fiscal year that begins after November 15, 2009 (January 1, 2010 for calendar year-end companies), and for subsequent interim and annual reporting periods. The disclosure requirements must be applied to transfers that occurred before and after its effective date. Early adoption is prohibited. The Company determined, based on its current assessment, that the impact of adopting these pronouncements will not be material on the consolidated financial statements.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
In January 2010, the FASB issued FASB Accounting Standards Update (“ASU”) 2010-06, Improving Disclosures about Fair Value Measurements, which amends ASC 820 to require additional disclosures regarding fair value measurements. Specifically, the ASU requires disclosure of the amounts of significant transfers between Level 1 and Level 2 of the fair value hierarchy and the reasons for these transfers; the reasons for any transfers in or out of Level 3; and information in the reconciliation of recurring Level 3 measurements about purchases, sales, issuances and settlements on a gross basis. In addition to these new disclosure requirements, the ASU also amends ASC 820 to clarify certain existing disclosure requirements. For example, the ASU clarifies that reporting entities are required to provide fair value measurement disclosures for each class of assets and liabilities. Previously separate fair value disclosures were required for each major category of assets and liabilities. ASU 2010-06 also clarifies the requirement to disclose information about both the valuation techniques and inputs used in estimating Level 2 and Level 3 fair value measurements. Except for the requirement to disclose information about purchases, sales, issuances, and settlements in the reconciliation of recurring Level 3 measurements on a gross basis, these disclosures are effective for the quarter ended March 31, 2010. The requirement to separately disclose purchases, sales, issuances, and settlements of recurring Level 3 measurements becomes effective for the Company for the quarter ended March 31, 2011. The Company is currently assessing the impact of the adoption on the consolidated financial statements.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
3. INVESTMENT SECURITIES
The following is a summary of the investment securities at December 31, 2009 and 2008:
Accrued interest and dividends receivable on investment securities totaled $1.5 million and $1.2 million at December 31, 2009 and 2008, respectively. For the years ended December 31, 2009, 2008, and 2007, proceeds from sales of securities available for sale amounted to $5.0 million, $3.5 million and $0, respectively, with net realized losses of $55,000 (gross loss of $129,000 net of gain of $74,000), $0 and $0, respectively.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The amortized cost and estimated fair value of investment securities at December 31, 2009, by contractual maturity, are shown below. Although mortgage-backed securities and collateralized mortgage obligations have contractual maturities through 2037, expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Additionally, the U.S. government sponsored enterprises, which issued preferred stock with no maturity, have the right to call these obligations at par.
U.S. government agencies, U.S. Government sponsored enterprise securities, U.S. Treasury, and mortgage-backed securities with a total carrying value of $191.6 million (available-for-sale at fair market value of $191.6 million) and $150.0 million (available-for-sale at fair market value of $146.1 million and held-to-maturity at amortized cost of $3.9 million), respectively, were pledged to secure deposits from the State of California, borrowing lines, and interest rate swap agreements, or were pledged for other purposes as required and permitted by law as of December 31, 2009 and 2008, respectively.
The following tables show the Company’s investment securities with gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2009 and 2008.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
As of December 31, 2009, the Company had securities with total fair value of $83.3 million and unrealized losses of $1.0 million as compared to total fair value of $33.3 million and unrealized losses of $0.7 million at December 31, 2008. At December 31, 2009, the market value of securities which have been in a continuous loss position for 12 months or more totaled $3.3 million with an unrealized loss of $323,000 compared to $7.6 million with an unrealized loss of $276,000, respectively, at December 31, 2008.
For investment securities in an unrealized loss position at December 31, 2009, the Company has the intent and ability to hold these investment securities until the full recovery of their carrying value.
All individual securities that have been in a continuous unrealized loss position for twelve months or longer at December 31, 2009 had investment grade ratings upon purchase. The issuers of these securities, except as noted below, have not, to the Company’s knowledge, established any cause for default on these securities and the various rating agencies have reaffirmed these securities’ long-term investment grade status at December 31, 2009.
The Company owns one collateralized debt obligation (“CDO”) security that is backed by trust preferred securities issued by banks and thrifts. The market for this security at December 31, 2009 is not active and markets for similar securities are also not active. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which these CDO’s trade and then by a significant decrease in the volume of trades relative to historical level. There are currently very few market participants who are willing and able to transact for these securities.
Moody’s downgraded the security to non-investment grade for credit impairment on November 13, 2008. As a result of the Company’s periodic reviews for impairment, the corporate trust preferred security was written down by $9.9 million and charged to other-than-temporary-impairment (“OTTI”) during 2008 and the book value of the security held in the available-for-sale investment portfolio was adjusted to $1.1 million as of December 31, 2008. As of April 1, 2009, the noncredit related portion of the previous OTTI of $1.6 million was reinstated to the amortized cost of the security. At December 31, 2009, the fair value of the security was $2.4 million due to the decline in the fair value which is considered temporary. The methodologies for measuring fair value of this security are discussed in Note 18 to the consolidated financial statements.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
4. LOANS AND ALLOWANCE FOR LOAN LOSSES
Loans consist of the following at December 31, 2009 and 2008:
This includes SBA loans held for sale of $23.3 million and $9.9 million at the lower of cost or fair value at December 31, 2009 and 2008, respectively.
As of December 31, 2009, the Company has pledged, under a blanket lien, all qualifying commercial and residential loans as collateral under the borrowing agreement with FHLB with a total carrying value of $812.9 million.
At December 31, 2009 and 2008, the Company serviced loans sold to unaffiliated parties in the amounts of $113.0 million and $131.2 million, respectively. The Company recorded an addition to servicing assets of $0 and $434,000 and net amortization of servicing assets of $255,000 and $390,000 during the years ended December 31, 2009, and 2008, respectively. There was no valuation allowance for the servicing assets at December 31, 2009 and 2008. The servicing assets, net of servicing liabilities, are included in other assets in the accompanying consolidated statements of financial condition. The net servicing assets balance as of December 31, 2009 and 2008 was $656,000 and $911,000, respectively.
Loan servicing assets and servicing liabilities represent the value associated with servicing loans sold. The value is determined through a discounted cash flow analysis which uses interest rates, prepayments speed and adequate compensation assumptions as inputs.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The following is a summary of activity in the allowance for loan losses for the years ended December 31, 2009, 2008 and 2007:
Although the Company has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent upon the real estate market in California. Should the real estate market experience an overall decline in property values, the ability of borrowers to make timely scheduled principal and interest payments on the Company’s loans may be adversely affected and, in turn, may result in increased delinquencies and foreclosures. In the event of foreclosures, the value of the property acquired may be less than the appraised value when the loan was originated and may, in some instances, result in insufficient proceeds upon disposition to recover the Company’s investment in the foreclosed property. Furthermore, although most of the Company’s trade finance activities are related to trade with Asia, these loans are generally made to companies domiciled or with collateral in the United States of America.
The following table provides information on impaired loans:
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The following is an analysis of all loans to officers and directors of the Company and its affiliates as of December 31, 2009 and 2008. All such loans were made under terms that are consistent with the Company’s normal lending policies.
Directors of the Company guaranteed loan balances of $0.3 million and $9.6 million at December 31, 2009 and 2008, respectively.
5. PREMISES AND EQUIPMENT
The following is a summary of the major components of premises and equipment as of December 31, 2009 and 2008:
Depreciation and amortization expense for the years ended December 31, 2009, 2008, and 2007 amounted to $2.2 million, $2.1 million, and $1.9 million, respectively.
6. OTHER REAL ESTATE OWNED
As of December 31, 2009, the Company had five other real estate owned (“OREO”) properties comprised of four commercial properties totaling $4.2 million and one residential property in the amount of $55,000. The Company disposed of four properties for $6.3 million during 2009.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
7. INVESTMENTS IN AFFORDABLE HOUSING PARTNERSHIPS
The Company has invested in certain limited partnerships that were formed to develop and operate several apartment complexes designed as high-quality affordable housing for lower income tenants throughout the State of California and other states. The Company’s ownership in each limited partnership varies from under 2% to 22%. At December 31, 2009 and 2008, the investments in these limited partnerships amounted to $11.5 million and $12.9 million, respectively. Two of the nine limited partnerships invested in by the Company are accounted for using the equity method of accounting, since the Company has significant influence over the partnership. For those investments in limited partnerships for which the Company does not have a significant influence, such investments are accounted for using the cost method of accounting and the annual amortization is based on the proportion of tax credits received in the current year to total estimated tax credits to be allocated to the Company. Each of the partnerships must meet the regulatory minimum requirements for affordable housing for a minimum 15-year compliance period to fully utilize the tax credits. If the partnerships cease to qualify during the compliance period, the credit may be denied for any period in which the project is not in compliance and a portion of the credit previously taken is subject to recapture with interest.
The approximate remaining federal and state tax credits to be utilized over a multiple-year period are $10.0 million and $11.4 million at December 31, 2009 and 2008, respectively. The Company’s usage of tax credits was $0, $1.2 million, and $628,000 for the years ended December 31, 2009, 2008 and 2007, respectively. Investment amortization amounted to $1.4 million, $1.0 million, and $696,000 for the years ended December 31, 2009, 2008 and 2007, respectively.
8. DEPOSITS
Deposits consist of the following at December 31, 2009 and 2008:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Time deposits by maturity dates are as follows at December 31, 2009:
A summary of interest expense on deposits for the years ended December 31 is as follows:
The Company accepts deposits from the State of California. These deposits totaled $115.0 million and $115.5 million at December 31, 2009 and 2008, respectively. The Company has pledged U.S. government agencies and U.S. government sponsored enterprise securities and mortgage-backed securities with a total carrying value of $131.6 million (available-for-sale at fair market value of $135.4 million) as of December 31, 2009 and $138.4 million (available-for-sale at fair market value of $136.3 million and held-to-maturity at amortized cost of $2.1 million) as of December 31, 2008, respectively, to secure such public deposits. Interest expense for the years ended December 31, 2009, 2008 and 2007 was $454,000, $2.3 million, $3.7 million, respectively.
In the ordinary course of business, the Company has received deposits from certain directors, executive officers and businesses with which they are associated. At December 31, 2009 and 2008, the total of these deposits amounted to $1.8 million.
9. OTHER BORROWED FUNDS
The Company borrows funds from the FHLB and the Treasury, Tax, and Loan Investment Program. Other borrowed funds totaled $148.4 million and $193.0 million at December 31, 2009 and 2008, respectively. Interest expense on total borrowed funds was $7.0 million in 2009, $9.3 million in 2008, and $11.3 million in 2007, reflecting weighted average interest rates of 4.28%, 3.61% and 5.01%, respectively.
As of December 31, 2009, the Company borrowed $146.8 million as compared to $192.2 million at December 31, 2008 from the FHLB with note terms from less than 1 year to 15 years. Notes of 10-year and 15-year terms are amortizing at the predetermined schedules over the life of the notes. Of the $146.8 million outstanding, $145.0 million is composed of six fixed rate term advances, each with an option to be called by the FHLB after the lockout dates varying from 6 months to 2 years. If market interest rates are higher than the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
advances’ stated rates at that time, the advances will be called by the FHLB and the Company will be required to repay the FHLB. If market interest rates are lower after the lockout period, then the advances will not be called by the FHLB. If the advances are not called by the FHLB, then they will mature on the maturity dates ranging from 4 years to 10 years. The Company may repay the advances with a prepayment penalty at any time. If the advances are called by the FHLB, there is no prepayment penalty.
The Company has pledged, under a blanket lien (all qualifying commercial and residential loans) as collateral under the borrowing agreement with Federal Home Loan Bank, with a total carrying value of $812.9 million and $1.0 billion at December 31, 2009 and 2008, respectively. Total interest expense on the notes was $6.9 million, $9.3 million and $11.2 million for the years ended December 31, 2009, 2008 and 2007, respectively, reflecting average interest rates of 4.30%, 3.62% and 5.01%, respectively.
Federal Home Loan Bank advances outstanding as of December 31, 2009, with an average interest rate of 4.36%, mature as follows:
Borrowings obtained from the Treasury Tax and Loan Investment Program mature within a month from the transaction date. Under the program, the Company receives funds from the U.S. Treasury Department in the form of open-ended notes, up to a total of $2.2 million. The Company has pledged U.S. government agencies and/or mortgage-backed securities with a total carrying value of $2.2 million at December 31, 2009, as collateral to participate in the program. The total borrowed amount under the program, outstanding at December 31, 2009 and 2008, was $1.5 million and $0.8 million, respectively. Interest expense on notes was $0, $9,000, and $25,000 for the years ended December 31, 2009, 2008 and 2007, respectively, reflecting average interest rates of 0.00%, 1.21% and 3.25%, respectively.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
10. INCOME TAXES
The following is a summary of income tax (benefit) expense for the years ended December 31, 2009, 2008 and 2007:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
As of December 31, 2009 and 2008, the cumulative temporary differences, as tax affected, are as follows:
In assessing the future realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not 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, the projected future taxable income, and tax-planning strategies in making this assessment.
The Company’s net deferred tax asset increased significantly during 2009 and 2008 due primarily to increases in the allowance for loan losses. To the extent that the allowance for loan losses is not allocable to specific loans, it represents future tax benefits which would be realized when actual charge-offs are made against the allowance. As a result of the loss incurred during 2009, management has assessed, by year, the future reversal of all temporary differences to determine which deductions would be available to carry back to tax years with taxable income or could be utilized by projected future taxable income. As a result of this analysis, management has determined that a portion of the Company’s net deferred tax asset does not meet the more likely than not
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
criteria for realization. Accordingly, the Company has recorded a valuation allowance of $16.3 million. The net deferred tax asset valuation allowance includes a valuation allowance for capital losses, established in 2008, due to the uncertainty surrounding the realization of the benefits of these losses that may result from future capital gain.
Applicable income tax provisions (benefits), in 2009, 2008, and 2007 resulted in effective tax rates of (12.1)%, (115.4)%, and 38.3%, respectively. The primary reasons for the differences from the federal statutory tax rate of 35.0% are as follows for the years ended December 31, 2009, 2008 and 2007:
Income taxes receivable of $16.1 million at December 31, 2009 consist of refunds of estimated tax payments of $3.5 million and refunds of $12.6 million due to the Federal carryback of net operating losses. Additionally, the Company had available federal tax credits of $1.2 million available to reduce future tax liabilities, state tax credits of $167,000 available to reduce future tax liabilities and state net operating losses of $43.2 million available to reduce future taxable income (expiring in 2029).
The Company is required to determine whether it is more likely than not that a tax position will be sustained upon examination based on the technical merits of the position. A tax position that meets the more likely than not recognition threshold is measured to determine the amount of benefit to be recognized in the consolidated financial statements. The Company has concluded that neither it, nor the Bank and its subsidiary, has any uncertain tax positions that require recognition in the consolidated financial statements. Therefore, no reserve related to uncertainty is necessary as of December 31, 2009. This determination was based on tax years that remain subject to examination by the relevant tax authorities. The Internal Revenue Service (the “IRS”) and the Franchise Tax Board (the “FTB”) have examined the Company’s consolidated federal income tax returns for tax years up to and including 2004. Therefore, years 2005 through 2008 remain open for examination. As of December 31, 2009, the Company was under examination by the IRS for the tax years 2005 through 2008 and the tax years 2005 through 2007 by the FTB.
The Company’s policy is to record any interest or penalties paid in connection with income taxes on the appropriate line of the Statement of Operations.
11. LONG-TERM SUBORDINATED DEBENTURES
Center Capital Trust I is a Delaware business trust formed by the Company for the sole purpose of issuing trust preferred securities fully and unconditionally guaranteed by the Company. During the fourth quarter of
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
2004, Center Capital Trust I issued 18,000 Capital Trust Preferred Securities (“TP Securities”), with liquidation value of $1,000 per security, for gross proceeds of $18,000,000. The entire proceeds of the issuance were invested by Center Capital Trust I in $18,000,000 of Junior Long-term Subordinated Debentures (the “Subordinated Debentures”) issued by the Company, with identical maturity, repricing and payment terms as the TP Securities. The Subordinated Debentures represent the sole assets of Center Capital Trust I. The Subordinated Debentures mature on January 7, 2034 and bear a current interest rate of 3.13% (based on 3-month LIBOR plus 2.85%), with repricing and payments due quarterly in arrears on January 7, April 7, July 7, and October 7 of each year commencing April 7, 2004. The Subordinated Debentures are redeemable by the Company, subject to receipt by the Company of prior approval from the Federal Reserve Bank to the extent then required, on any January 7th, April 7th, July 7th, and October 7th on or after April 7, 2009 at the Redemption Price. Redemption Price means 100% of the principal amount of Subordinated Debentures being redeemed plus accrued and unpaid interest on such Subordinated Debentures to the Redemption Date, or in case of redemption due to the occurrence of a Special Event, to the Special Redemption Date if such Redemption Date is on or after April 7, 2009. The TP Securities are subject to mandatory redemption to the extent of any early redemption of the Subordinated Debentures and upon maturity of the Subordinated Debentures on January 7, 2034.
Holders of the TP Securities are entitled to a cumulative cash distribution on the liquidation amount of $1,000 per security at a current rate per annum of 3.13%. The distribution rate is a per annum rate which resets quarterly, equal to LIBOR (as in effect) immediately preceding each interest payment date (January 7, April 7, July 7, and October 7 of each year) plus 2.85%. The distributions on the TP Securities are treated as interest expense in the consolidated statements of operations. The Company has the option to defer payment of the distributions for a period of up to five years, as long as the Company is not in default on the payment of interest on the Subordinated Debentures. The TP Securities issued in the offering were sold in private transactions pursuant to an exemption from registration under the Securities Act of 1933, as amended. The Company has guaranteed, on a subordinated basis, distributions and other payments due on the TP Securities.
On March 1, 2005, the Federal Reserve Board adopted a final rule that allows the continued inclusion of trust-preferred securities in the Tier I capital of bank holding companies. However, under the final rule, after a five-year transition period, the aggregate amount of trust preferred securities and certain other capital elements that could be included in Tier I capital would be limited to 25 percent of Tier I capital elements, net of goodwill. Trust preferred securities currently make up 6.7% of the Company’s Tier I capital.
As of December 31, 2009 and 2008, Center Capital Trust I is not reported on a consolidated basis. Therefore, the capital securities of $18,000,000 are not presented on the consolidated statements of financial condition. Instead, the long-term subordinated debentures of $18,557,000 issued by Center Financial to Center Capital Trust I and the investment in Center Capital Trust I’s common stock of $557,000 (included in other assets) are separately reported.
12. GOODWILL AND INTANGIBLES
In April 2004, the Company purchased the Chicago branch of Korea Exchange Bank and recorded goodwill of $1.3 million and a core deposit intangible of $462,000. The Company amortizes premiums on acquired deposits using the straight-line method over 5 to 9 years. Amortization expense for core deposit intangible was $53,000 for years ended December 31, 2009, 2008 and 2007, respectively. Core deposit intangible net of amortization was $0 and $213,000 at December 31, 2009 and 2008, respectively.
Based on the annual impairment analysis of such goodwill and core deposit intangible at December 31, 2009, the Company determined that the goodwill and core deposit intangible are impaired in their entirety and, as a result, the entire amounts were written off.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
13. COMMITMENTS AND CONTINGENCIES
The Company leases its premises under noncancelable operating leases. At December 31, 2009, future minimum rental commitments under these leases are as follows:
Rental expense recorded under such leases amounted to approximately $3.0 million, $2.5 million, and $2.5 million in 2009, 2008 and 2007, respectively.
Litigation
From time to time, the Company is a party to claims and legal proceedings arising in the ordinary course of business. It is the management’s opinion that the resolution of any such claims or legal proceedings would not have a material adverse effect on the Company’s financial condition or results of operations.
On August 6, 2008 the Bank entered into a Settlement Agreement with KEIC (the “KEIC Settlement Agreement”). Pursuant to the KEIC Settlement Agreement, KEIC dismissed with prejudice its complaints against the Bank in both the Superior Court of the State of California and in federal court and assigned to Center Bank its rights and claims as against certain other defendants. In consideration of its dismissal of such claims and assignment of such rights, the Bank agreed to pay consideration of $10.5 million to KEIC, consisting of cash consideration of $6.5 million in scheduled installments over a three-year period and the issuance of 415,369 shares of the common stock of the Company valued at $4.0 million.
Pursuant to separate agreement, KEIC and nine Korean banks mutually dismissed all claims against one another arising out of or related to the KEIC Action. The Bank also entered into a settlement agreement with Korea Data Systems (USA), Inc (“KDS-USA”) and Lap Shun (John) Hui, pursuant to which KDS-USA agreed to pay the Bank a total of $2.5 million in cash payable in scheduled installments over a two-year period in consideration for Center Bank dismissing with prejudice all claims against KDS-USA.
The Company recognized net expense of $7.5 million based on the present value of long-term receivables and payables during 2008. In December 2009, the Company paid KEIC $3.2 million for the remaining balance of the cash consideration. At December 31, 2009, the Company had a long-term receivable of $0.5 million and no long-term payable, respectively. At December 31, 2008, the Company had a long-term receivable of $1.4 million and a long-term payable of $4.0 million.
Employment Agreement
Effective January 16, 2010, the Company and Center Bank entered into an employment agreement with Mr. Jae Whan Yoo, President and Chief Executive Officer of the Company, (the “Agreement”) for a term of three years, at an annual base salary of $300,000 for the first year of the term, with annual increases thereafter based on increases in the applicable Consumer Price Index, not to exceed 7% per year. Mr. Yoo will also receive
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
restricted stock awards of 28,301 shares of the Company’s common stock, 14,151 shares of which will vest on January 15, 2012 and 14,150 shares on January 15, 2013.
Pursuant to the Securities Purchase Agreement with the U.S. Treasury Department, the Company agreed that, until such time as the U.S. Treasury Department ceases to own any securities acquired from the Company pursuant to the Securities Purchase Agreement, the Company will take all necessary action to ensure that the benefit plans with respect to the Company’s senior executive officers comply with Section 111(b) of the Emergency Economic Stabilization Act of 2008 (“EESA”) as implemented by any guidance or regulation under Section 111(b) of EESA that has been issued and is in effect as of the date of issuance of the Series A Preferred Stock and the Warrants and not adopt any benefit plans with respect to, or which cover, our senior executive officers that do not comply with EESA. The Company’s five senior executive officers have consented to the foregoing, and the three applicable executives have executed either amendments to their employment agreement or agreements concerning their compensation arrangements in order to comply with EESA.
14. SHAREHOLDERS’ EQUITY
On March 25, 2009, the Company’s board of directors suspended its quarterly cash dividends based on adverse economic conditions and a reduction in the Company’s earnings. No quarterly cash dividends have been declared since the suspension. (see “Quarterly Dividends” below).
As a bank holding company, the Company’s ability to pay dividends primarily depends upon the dividends received from the Bank. The dividend practice of the Bank, like the Company’s dividend practice, will depend upon its earnings, financial position, current and anticipated cash requirements and other factors deemed relevant by Center Bank’s board of directors at that time. The dividend practices of both the Bank and Center Financial are restricted by state and federal law as well as by regulatory requirements and potentially by contractual requirements, in each case as more fully described below.
Quarterly Dividends-Center Financial paid cash dividends of 4 cents (adjusted for two-for-one stock split paid in March 2004) per share from the fourth quarter of 2003 through the first quarter of 2007, and 5 cents per share from the second quarter of 2007 through the fourth quarter of 2008. On March 25, 2009, the Company’s board of directors suspended its quarterly cash dividends based on adverse economic conditions and a reduction in the Company’s earnings. The board of directors determined that this is a prudent, safe and sound practice to preserve capital, and does not expect to resume the payment of cash dividends in the foreseeable future. Unless the preferred stock issued to the U.S. Treasury Department in the TARP Capital Purchase Program has been redeemed, the Company will not be permitted to resume paying cash dividends without the consent of the U.S. Treasury Department until December 2011. In addition, the Bank and the Company have each entered into MOUs with the respective regulatory agency or agencies, pursuant to which both the Bank and the Company must obtain prior regulatory approval to pay dividends. See Note 20-Regulatory Matters. Once the Company is no longer restricted in its ability to pay cash dividends by any specific regulatory requirements, the amount of any such dividend will be determined each quarter by the Company’s board of directors in its discretion, based on the factors described in the previous paragraph. No assurance can be given that the Bank’s and the Company’s future performance will justify the payment of dividends in any particular quarter and any such dividend will be at the sole discretion of Center Financial’s board of directors.
The Bank’s ability to pay cash dividends to Center Financial is also subject to certain legal limitations. Under California law, banks may declare a cash dividend out of their net profits up to the lesser of retained earnings or the net income for the last three fiscal years (less any distributions made to shareholders during such period), or with the prior written approval of the Commissioner of Financial Institutions, in an amount not exceeding the greatest of (i) the retained earnings of the bank, (ii) the net income of the bank for its last fiscal
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
year, or (iii) the net income of the bank for its current fiscal year. Since the Bank’s net loss for 2009 exceeded its combined earnings for 2008 and 2007, in addition to the regulatory approval requirements of the MOU, the Bank will need to obtain the prior written approval of the Commissioner to pay any dividends until the Bank’s net income for the previous three fiscal years is again greater than the amount of any such dividend. In addition, under federal law, banks are prohibited from paying any dividends if after making such payment they would fail to meet any of the minimum regulatory capital requirements. The federal regulators also have the authority to prohibit banks from engaging in any business practices which are considered to be unsafe or unsound, and in some circumstances the regulators might prohibit the payment of dividends on that basis even though such payments would otherwise be permissible.
The Company’s ability to pay dividends is also limited by state corporation law. The California General Corporation Law allows dividends to the company’s shareholders if the company’s retained earnings equal at least the amount of the proposed dividend. If a California corporation does not have sufficient retained earnings available for the proposed dividend, it may still pay a dividend to its shareholders if immediately after giving effect to the dividend the sum of the company’s assets (exclusive of goodwill and deferred charges) would be at least equal to 125% of its liabilities (not including deferred taxes, deferred income and other deferred liabilities) and the current assets of the company would be at least equal to its current liabilities, or, if the average of its earnings before taxes on income and before interest expense for the two preceding fiscal years was less than the average of its interest expense for the two preceding fiscal years, at least equal to 125% of its current liabilities. In addition, during any period in which the Company has deferred payment of interest otherwise due and payable on its subordinated debt securities, or any unpaid dividends on the preferred stock issued to the U.S. Treasury Department, it may not make any dividends or distributions with respect to its capital stock.
Stock-Based Compensation-The Company has a Stock Incentive Plan which was adopted by the Board of Directors in April 2006, approved by the shareholders in May 2006, and amended by the Board in June 2007 (the “2006 Plan”). The 2006 Plan provides for the granting of incentive stock options to officers and employees, and non-qualified stock options and restricted stock awards to employees (including officers) and non-employee directors. The 2006 Plan replaced the Company’s former stock option plan (the “1996 Plan”) which expired in February 2006, and all options under the 1996 Plan which were outstanding on April 12, 2006 were transferred to and made part of the 2006 Plan. The option prices of all options granted under the 2006 Plan (including options transferred from the 1996 Plan) must be not less than 100% of the fair market value at the date of grant. All options granted generally vest at the rate of 20% per year except that the options granted to the CEO and to the non-employee directors vest at the rate of 33 1/3% per year. All options not exercised generally expire ten years after the date of grant. Vesting of restricted stock awards (“RSAs”) is discretionary with the Board of Directors or the Compensation Committee, but awards granted to date generally vest at the rate of 50% on the third anniversary of the grant date and 25% per year for the next two years. However, the RSA granted to the CEO, and the Chief Credit Officer vests 50% on the second anniversary of the grant date and the remaining 50% the following year. RSAs granted to senior executive officers are also subject to restrictions on transfer even after vesting for as long as the Company has preferred stock outstanding to the U.S. Treasury Department pursuant to the TARP Capital Purchase Program.
The Company’s pre-tax compensation expense for stock-based employees and directors’ compensation was $1.0 million, $1.2 million, and $1.2 million ($640,000, $876,000, and $959,000 after tax effect of non-qualified stock options) for the years ended December 31, 2009, 2008 and 2007, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Stock Option Awards
The fair value of the stock options granted was estimated on the date of grant using the Black-Scholes option valuation model that uses the assumptions noted in the following table. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant. Beginning in 2006, the expected life (estimated period of time outstanding) of options granted with a 10-year term was determined using the average of the vesting period and term. Expected volatility was based on historical volatility for a period equal to the stock option’s expected life, ending on the day of grant, and calculated on a weekly basis.
A summary of the Company’s stock option activity and related information for the years ended December 31, 2009 and 2008 is set forth in the following table:
Information pertaining to stock options outstanding at December 31, 2009 and 2008 is as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The aggregate intrinsic value of options outstanding and options exercisable at December 31, 2009 was $2,000 and $0, respectively. The aggregate intrinsic value of options outstanding and options exercisable at December 31, 2008 was $78,000. Aggregate intrinsic value represents the difference between the Company’s closing stock price on the last trading day of the period, which was $4.60 and $6.17 as of December 31, 2009 and 2008, respectively, and the exercise price multiplied by the number of options outstanding. Total intrinsic value of options exercised was $7,000, $36,000 and $557,000 for the years ended December 31, 2009, 2008 and 2007, respectively. Total fair value of shares vested was $1.3 million, $1.4 million and $562,000 for the years ended December 31, 2009, 2008 and 2007, respectively.
A summary of the Company’s non-vested option shares as of December 31, 2009 is as follows:
As of December 31, 2009 and 2008, the Company had approximately $1.0 million and $1.9 million of unrecognized compensation costs related to unvested options, respectively. The Company expects to recognize these costs over a weighted average period of 2.17 years and 2.67 years at December 31, 2009 and 2008, respectively.
Restricted Stock Awards
The market price of the Company’s common stock at the date of grant is used to estimate the fair value of restricted stock awards. Restricted stock activity under the 2006 Plan as of December 31, 2009, and changes during the years ended December 31, 2009 and 2008, respectively, are as follows:
The Company recorded compensation cost of $18,000 and $30,000 related to the restricted stock granted under the 2006 Plan for the years ended December 31, 2009 and 2008, respectively. At December 31, 2009 and 2008, the Company had approximately $44,000 and $110,000 of unrecognized compensation costs related to unvested restricted stocks, respectively. The costs are expected to be recognized over a weighted-average period of 1.54 years and 2.40 years as of December 31, 2009 and 2008, respectively. There were no shares vested during the year ended December 31, 2009 and 2008.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Preferred Stock, Common Stock and Common Stock Warrants-The Company entered into Securities Purchase Agreements with a limited number of institutional and other accredited investors, including insiders, to sell a total of 73,500 shares of mandatorily convertible non-cumulative non-voting perpetual preferred stock, series B, without par value (the “Series B Preferred Stock”) at a price of $1,000 per share, for an aggregate gross purchase price of $73.5 million. This private placement closed on December 31, 2009, and the Company issued an aggregate of 73,500 shares of Series B Preferred Stock upon its receipt of consideration in cash.
The Series B Preferred Stock will automatically convert into a number of shares of Center Financial’s common stock after the Company has received shareholder approval of such conversion at a Special Meeting of Shareholders to be held on March 24, 2010. The conversion ratio for each share of Series B Preferred Stock will be equal to the quotient obtained by dividing the Series B Share Price by the conversion price. The initial conversion price of $3.75 per share is subject to certain possible adjustments in the future under certain circumstances, including failure to obtain shareholder approval for the conversion by May 17, 2010, which will decrease the conversion price by 10%. The Series B Preferred Stock will carry a non-cumulative cash dividend at a per annum rate equal to 12%, payable on June 30 and December 31 of each year, which dividend will not be paid as long as shareholder approval is obtained on or before May 17, 2010. The Series B Preferred Stock is redeemable at the option of the Company after five years on specified terms, and carries a liquidation preference of $1,000 per share, subject to certain adjustments. The Series B Preferred Stock may not be redeemed at the option of the holder. In the event the Company chooses to redeem the Series B Preferred Stock, the holders would be entitled instead to convert their shares into common stock under specified guidelines.
The Company also issued 3,360,000 shares of common stock in the previous private placement which closed on November 30, 2009 (the “November Private Placement”), which shares will also be eligible for resale as described below. In addition, the Company may issue 85,045 additional shares to investors in the November Private Placement upon shareholder approval thereof. The shares of common stock in the November Private Placement were sold at a price per share of $3.71 to non-affiliated investors and $4.69 to certain directors and officers of the Company. The difference in the purchase price was necessary to comply with NASDAQ Listing Rule 5635(c). The Company intends to seek shareholder approval of the November Private Placement at a special meeting to be held on March 24, 2010, so that all investors in the November Private Placement may be treated equally. If such approval is obtained, 85,045 additional shares would be issued to the directors and officers who invested in the November Private Placement, in order to effectuate this result.
The Company entered into a purchase agreement with the U.S. Treasury Department on December 12, 2008, pursuant to which the Company issued and sold 55,000 shares of the Company’s fixed-rate cumulative perpetual preferred stock for a total purchase price of $55.0 million, and a 10-year warrant to purchase 864,780 shares of the Company’s common stock at an exercise price of $9.54 per share. The Company will pay the U.S. Treasury Department a five percent dividend annually for each of the first five years of the investment and a nine percent dividend thereafter until the shares are redeemed. The cumulative dividend for the preferred stock is accrued for and payable on February 15, May 15, August 15 and November 15 of each year.
As a result of “qualified equity offerings” (as defined in the Securities Purchase Agreement with the U.S. Treasury Department) in the fourth quarter of 2009 aggregating in excess of $55 million (specifically $86.3 million) in gross proceeds, the number of common shares underlying the warrant was reduced to 432,290.
The Company allocated total proceeds of $55.0 million, based on the relative fair value of preferred stock and common stock warrants, to preferred stock for $52.9 million and common stock warrants for $2.1 million, respectively, on December 12, 2008. The preferred stock discount will be accreted, on an effective yield method, to preferred stock over the 10 years.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
In determination of the fair value of preferred stock and common stock warrants, certain assumptions were made. The Binomial Lattice model was used with the following assumptions for common stock warrants:
•
Risk-free interest rate: The constant maturities par yield curve based on Treasury yields provided by Federal Reserve, after interpolating the yield curve beyond the maturities provided in the release data, was used to derive a risk-free interest rate curve.
•
Stock price volatility: The volatility assumption utilized in the valuation should represent the “expected” volatility, which may or may not be the same as historical volatility. Since market events of the second half of 2008 are not likely to repeat given the current government ownership of major banks, the high market volatility during the second half of the year should be assigned a lower weighting in the 10-year term of the historical volatility. As a result of this adjustment, expected volatility of 32.0% was used in the valuation as compared to 36.5% of historical volatility.
•
Dividend rate: The Company utilized a constant dividend payment assumption in the model. The $0.05 per share per quarter constant payment is consistent with the Company’s then current policy and Management’s intention.
For preferred stock, the Company used a discount cash flow model to calculate the fair value with the following assumptions:
•
Dividend rate of 5% from year 1 to year 5 and 9% thereafter was used in accordance with the terms and conditions of the preferred stock. Expected life was assumed 10 years, considering the contractual term of 10 years. Risk-free interest rate was assumed at 3.66%, which is the 10-year U.S. Treasury Constant Maturity Rate for 2008. The assumed discount rate was 12% based on review of certain references. Certain actual preferred equity offerings rates in 2008 ranged from 7% to 12%. TARP is considered cheaper financing for capital and one of the objectives of the TARP is providing cheaper financing to help the capital situation in the banking sector. In this regard, the assumed discount rate should be higher than the coupon rate of 9%.
Using these assumptions, the fair value of common stock warrants amounted to $1.4 million and the fair value of the preferred stock amounted to $37.2 million. The relative fair values of preferred stock and common stock warrants were 96.3% and 3.7%, respectively. The total proceeds of $55 million were allocated, based on the relative fair value, to preferred stock in the amount of $52.9 million for preferred stock and $2.1 million for common stock warrants on December 12, 2008, respectively.
Postretirement Split-dollar Arrangement-As of January 1, 2008, the Company recorded the cumulative effect of a change in accounting principle for recognizing a liability for the postretirement cost of insurance for endorsement split-dollar life insurance coverage with split-dollar arrangement for employees and non-employee directors in the amount of $1.4 million as a reduction of equity. On a monthly basis, the Company records the benefit expense of such insurance coverage. Benefit expense during the year ended December 31, 2009 and 2008 amounted to $98,000 and $98,000, respectively.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
15. EARNINGS (LOSS) PER COMMON SHARE
The following is a reconciliation of the numerators and denominators of the basic and diluted earnings (loss) per share computations for the years ended December 31, 2009, 2008, and 2007.
Options not included in the computation of diluted earnings (loss) per share because they would have had an anti-dilutive effect amounted to 760,000 shares, 840,000 shares and 766,000 shares for the years ended December 31, 2009, 2008 and 2007, respectively.
16. EMPLOYEE BENEFIT PLAN
The Company has an Employees’ Profit Sharing and Savings Plan (the “Plan”), for the benefit of substantially all of its employees who have reached a minimum age of 21 years. Each employee is allowed to contribute to the Plan up to the maximum percentage allowable, not to exceed the limits of IRS Code Sections 401(k), 404 and 415. As of May 1, 2009, the Company has suspended its matching contribution. The Company may make a discretionary contribution, which is not limited to the current or accumulated net profit, as well as a
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
qualified non-elective contribution, with both amounts determined by the Company. For the years ended December 31, 2009, 2008, and 2007, the Company made matching contributions of $98,000, $369,000, and $275,000, respectively, and no discretionary contributions.
17. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, commercial letters of credit, standby letters of credit and performance bonds. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets.
The Company’s exposure to credit loss is represented by the contractual notional amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
Commitments to extend credit are agreements to lend to a customer provided there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since certain of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of the collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the borrower.
Commercial letters of credit, standby letters of credit, and performance bonds are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in making loans to customers. The Company generally holds collateral supporting those commitments if deemed necessary.
The following is a summary of the notional amounts of the Company’s financial instruments relating to extension of credit with off-balance-sheet risk at December 31, 2009 and 2008:
Liabilities for losses on outstanding commitments of $246,000 and $263,000 were separately reported in other liabilities at December 31, 2009 and 2008.
The Company’s exposure to credit loss in the event of non-performance by the customer is represented by the contractual amount of those instruments. Consistent credit policies are used by the Company for both on- and off- balance sheet items. The Company evaluates credit risk associated with the loan portfolio at the same time as it evaluates credit risk associated with commitments to extend credit and letters of credits.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
18. FAIR VALUE MEASUREMENTS
Fair value is measured in accordance with a three-level valuation hierarchy for disclosure of fair value measurement. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:
• Level 1 -
inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.
• Level 2 -
inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.
• Level 3 -
inputs to the valuation methodology are unobservable and significant to the fair value measurement.
Following is a description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy:
Assets
Securities.
U.S. Government Agencies-The Company measures fair value of U.S. Government agency securities by using quoted market prices for similar securities or dealer quotes, a level 2 measurement.
Municipal securities-The Company measures fair value of state and municipal securities by using quoted market prices for similar securities or dealer quotes, a level 2 measurement.
Residential mortgage-backed securities-The Company measures fair value of residential mortgage-backed securities by using quoted market prices for similar securities or dealer quotes, a level 2 measurement.
Collateralized mortgage obligations-The Company measures fair value of collateralized mortgage obligations by using quoted market prices for similar securities or dealer quotes, a level 2 measurement.
The Company owns one collateralized debt obligation (“CDO”) security that is backed by trust preferred securities (“TRUPS”) issued by banks and thrifts. The Company recognized an OTTI impairment during 2008 of $9.9 million to reduce the CDO TRUPS to fair value of $1.1 million at December 31, 2008. As of April 1, 2009, the noncredit related portion of the previous OTTI of $1.6 million was reinstated to the amortized cost of the security. At December 31, 2009, the fair value of the security was $2.4 million due to the decline in the fair value which is considered temporary. The CDO TRUPS securities market for the past several quarters has been severely impacted by the liquidity crunch and concern over the banking industry. If the weight of the evidence indicates the market is not orderly, a reporting entity shall place little, if any, weight compared with other indications of fair value on that transaction price when estimating fair value or market risk premiums. Factors that were considered to determine whether there has been a significant decrease in the volume and level of activity for the CDO TRUPS securities market when compared with normal activity include:
•
There are few recent transactions.
•
Price quotations are not based on current information.
•
Price quotations vary substantially either over time or among market makers.
•
Indexes that were previously highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
•
There is a significant increase in implied liquidity risk premiums. Yields or performance indicators (such as delinquency rates or loss severities) for observed transactions or quoted prices when compared with the reporting entity’s estimate of expected cash flows, considering all available market data about credit and other nonperformance risk for the asset or liability.
•
There is a wide bid-ask spread or significant increase in the bid-ask spread.
•
There is a significant decline or absence of new market issuances for the asset or liability.
•
Little information is publicly available.
The fair values of securities available for sale are generally determined by reference to the average of at least two quoted market prices obtained from independent external brokers or prices obtained from independent external pricing service providers who have experience in valuing these securities. In obtaining such valuation information from third parties, the Company has reviewed the methodologies used to develop the resulting fair values.
The Company’s Level 3 securities available for sale include one CDO TRUPS security. The fair value of the CDO TRUPS security has traditionally been based on the average of at least two quoted market prices obtained from independent brokers. However, as a result of the global financial crisis and illiquidity in the U.S. markets, the market for these securities has become increasingly inactive since mid-2007. The current broker price for the CDO TRUPS securities is based on forced liquidation or distressed sale values in very inactive markets that may not be representative of the economic value of these securities. As such, the fair value of the CDO TRUPS security has been below cost since the advent of the financial crisis. Additionally, most, if not all, of these broker quotes are nonbinding.
The Company considered whether to place little, if any, weight on transactions that are not orderly when estimating fair value. Although length of time and severity of impairment are among the factors to consider when determining whether a security that is other than temporarily impaired, the CDO TRUPS securities have only exhibited deep declines in value since the credit crisis began. The Company therefore believes that this is an indicator that the decline in price is primarily the result of the lack of liquidity in the market for these securities.
The Company regularly reviews the composition of the investment portfolio, taking into account market risks, the current and expected interest rate environment, liquidity needs, and overall interest rate risk profile and strategic goals. On a quarterly basis, the Company evaluates each security in the portfolio with an individual unrealized loss to determine if that loss represents an other-than-temporary impairment.
The Company considers the following factors in evaluating the securities: whether the securities were guaranteed by the U.S. government or its agencies and the securities’ public ratings, if available, and how those two factors affect credit quality and recovery of the full principal balance, the relationship of the unrealized losses to increases in market interest rates, the length of time the securities have had temporary impairment, and the Company’s intent and ability to hold the securities for the time necessary to recover the amortized cost. The Company also considers the payment performance, delinquency history and credit support of the underlying collateral for certain securities in the portfolio.
The Company continues to utilize Moody’s Analytics to compute the fair value of the CDO TRUPS security. Moody’s continues to update their valuation process. During the third quarter, Moody’s made changes to refine and improve the estimate of default probabilities to better align the valuation methodology with industry practices.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
In order to determine the appropriate discount rate used in calculating fair values derived from the income method for the CDO TRUPS security, certain assumptions were made using an exit pricing approach related to the implied rate of return which have been adjusted for general change in market rates, estimated changes in credit quality and liquidity risk premium, specific nonperformance and default experience in the collateral underlying the securities.
The Moody’s Analytics Discounted Cash flow Valuation analysis uses 3-month London Inter-Bank Offered Rate (“LIBOR”) + 300 basis points as a discount rate (to reflect illiquidity-the credit component of the discount rate is embedded in the credit analysis). Approximating the appropriate yield premium for the illiquidity of a CDO TRUPS security has proved to be difficult and management found it more useful to measure the price impact for this illiquidity discount. The table below illustrates this.
There are three maturity assumptions since the final maturity on the CDO TRUPS securities can be no longer than thirty years but may be less than that as well. From the percentage impact in the 300 basis points column, an illiquidity discount of 300 basis points seems to be sufficient and reasonable based on management’s opinion in consideration of current market conditions. The maturity date on the Company’s CDO TRUPS security is October 3, 2032 and that would put the price impact for illiquidity at a 45% to 59% discount as of December 31, 2009.
The spread over LIBOR does not include a credit spread as the probable credit outlook is included in the underlying cash flows. The spread over LIBOR only reflects a liquidity discount. The discount rate that reflects expectations about future defaults is appropriate if using contractual cash flows of a loan. That same rate is not used if using expected (probability-weighted) cash flows because the expected cash flows already reflect assumptions about future defaults; instead, a discount rate that is commensurate with the risk inherent in the expected cash flows is used.
Loans held for sale.
Loans held for sale are measured at the lower of cost or fair value. As of December 31, 2009 and 2008, the Company had $23.3 million and $9.9 million of loans held for sale, respectively. Management obtains quotes, bids or pricing indication sheets on all or part of these loans directly from the purchasing financial institutions. Premiums received or to be received on the quotes, bids or pricing indication sheets are indicative of the fact that cost is lower than fair value. At December 31, 2009 and 2008, the entire balance of loans held for sale was recorded at its cost. The Company records loans held for sale as nonrecurring with Level 2 inputs.
Impaired loans.
A loan is considered impaired when it is probable that all of the principal and interest due may not be collected according to the original underwriting terms of the loan. Impaired loans are measured at the lower of its carrying value or at an observable market price if available or at the fair value of the loan’s collateral if the loan is collateral dependent. Fair value of the loan’s collateral when the loan is dependent on collateral, is determined by appraisals or independent valuation, which is then adjusted for the cost associated with liquidating the collateral. The Company records impaired loans as nonrecurring with Level 2 inputs.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Other Real Estate Owned (OREO).
OREO is recorded at the lower of its carrying value or its fair value less anticipated disposal cost. Fair value of the OREO is determined by appraisals or independent valuation, which is then adjusted for the cost associated with liquidating the property. The Company records OREO as nonrecurring with Level 2 inputs.
Assets measured at fair value at December 31, 2009 are as follows:
The following table presents the Company’s reconciliation and statement of operations classification of gains and losses for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2009.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Liabilities
The Company did not identify any liabilities that are required to be presented at fair value.
19. FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company, using available market information and appropriate valuation methodologies available to management at December 31, 2009 and 2008, has determined the estimated fair value of financial instruments. However, considerable judgment is required to interpret market data in order to develop estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. Furthermore, fair values disclosed hereinafter do not reflect any premium or discount that could result from offering the instruments for sale. Potential taxes and other expenses that would be incurred in an actual sale or settlement are not reflected in the disclosed amounts.
The estimated fair values and related carrying amounts of the Company’s financial instruments are as follows:
The methods and assumptions used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value are explained below:
Cash and Cash Equivalents-The carrying amounts approximate fair value due to the short-term nature of these instruments.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Securities-The fair value of securities is generally determined by the valuation techniques available under the market approach, income approach and/or cost approach are used. The Company’s evaluations are based on market data and combinations of these approaches for its valuation methods are used depending on the asset class.
Loans-Fair values are estimated for portfolios of loans with similar financial characteristics, primarily fixed and adjustable rate interest terms. The fair values of fixed rate loans are based on discounted cash flows utilizing applicable risk-adjusted spreads relative to the current pricing of similar fixed rate loans, as well as anticipated repayment schedules. The fair value of adjustable rate loans is based on the estimated discounted cash flows utilizing the discount rates that approximate the pricing of loans collateralized by similar properties or assets. The fair value of nonperforming loans at December 31, 2009 and December 31, 2008 was not estimated because it is not practicable to reasonably assess the credit adjustment that would be applied in the marketplace for such loans. The estimated fair value is net of allowance for loan losses, deferred loan fees, and deferred gain on SBA loans.
Federal Home Loan Bank and Other Equity Stock-The carrying amounts approximate fair value, as the stocks may be sold back to the Federal Home Loan Bank and other bank at carrying value.
Accrued Interest Receivable and Accrued Interest Payable-The carrying amounts approximate fair value due to the short-term nature of these assets and liabilities.
Customer’s Liability on Acceptances and Acceptances Outstanding-The carrying amounts approximate fair value due to the short-term nature of these assets.
Deposits-The fair value of nonmaturity deposits is the amount payable on demand at the reporting date. Nonmaturity deposits include non-interest-bearing demand deposits, savings accounts, NOW accounts, and money market accounts. Discounted cash flows have been used to value term deposits such as certificates of deposit. The discount rate used is based on interest rates currently being offered by the Company on comparable deposits as to amount and term.
Other Borrowed Funds-These funds mostly consist of FHLB advances. The fair values of FHLB advances are estimated based on the discounted value of contractual cash flows, using rates currently offered by the Federal Home Loan Bank of San Francisco for fixed-rate credit advances with similar remaining maturities at each reporting date.
Long-term Subordinated Debentures-The fair value of long-term subordinated debentures are estimated by discounting the cash flows through maturity based on prevailing rates offered on the 30-year Treasury bond at each reporting date.
Loan Commitments, Letters of Credit, and Performance Bond-The fair value of loan commitments, standby letters of credit, commercial letters of credit and performance bonds is estimated using the fees currently charged to enter into similar agreements.
20. REGULATORY MATTERS
Risk-Based Capital-The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies, including the FDIC. Failure to meet minimum capital requirements can initiate certain mandatory actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines, the Company and the Bank must meet
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
specific capital guidelines that involve quantitative measures of the assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Effective December 18, 2009, the Bank entered into a memorandum of understanding (“MOU”) with the FDIC and the Department of Financial Institutions (the “DFI”). The MOU is an informal administrative agreement pursuant to which the Bank has agreed to take various actions and comply with certain requirements to facilitate improvement in its financial condition. In accordance with the MOU, the Bank agreed among other things to (a) develop and implement strategic plans to restore profitability; (b) develop a capital plan containing specified elements including achieving by December 31, 2009 and thereafter maintaining a Leverage Capital Ratio of not less than 9% and a Total Risk-Based Capital Ratio of not less than 13%; (c) refrain from paying cash dividends without prior regulatory approval; (d) reduce the amounts of its assets adversely classified or criticized in its most recent FDIC examination or internally graded Special Mention within certain specified time parameters; (e) increase the allowance for loan and lease losses (“ALLL”) by $18.7 million (which was completed in the second quarter of 2009) and thereafter maintain an appropriate ALLL balance; (f) develop and implement certain specified policies and procedures relating to the ALLL, troubled debt restructurings, and non-accrual and impaired loans; (g) develop and implement a plan for reducing concentrations of commercial real estate loans; (h) make certain revisions to the Bank’s liquidity policy concerning “high-rate” deposits and reduce the Net Non-Core Funding Dependency Ratio to less than 40% by December 31, 2010; (i) conduct a complete review of management and staffing and submit written findings to the FDIC and the DFI concerning the same; (j) notify the FDIC and the DFI prior to appointing any new director or senior executive officer; (k) refrain from establishing any new offices without prior regulatory approval; and (l) submit written quarterly progress reports to the FDIC and the DFI detailing the form and manner of any actions taken to secure compliance with the MOU and the results thereof.
On December 9, 2009, the Company entered into an MOU with the Federal Reserve Bank of San Francisco (the “FRB”) pursuant to which the Company agreed, among other things, to (i) take steps to ensure that the Bank complies with the Bank’s MOU; (ii) implement a capital plan addressing specified items and submit the plan to the FRB for approval; (iii) submit annual cash flow projections to the FRB; (iv) refrain from paying cash dividends, receiving cash dividends from the Bank, increasing or guaranteeing debt, redeeming or repurchasing its stock, or issuing any additional trust preferred securities, without prior FRB approval; and (v) submit written quarterly progress reports to the FRB detailing compliance with the MOU.
The MOUs will remain in effect until modified or terminated by the FRB, the FDIC and the DFI. The Company does not expect the actions called for by the MOUs to change its business strategy in any material respect, although they may have the effect of limiting or delaying the Bank’s or the Company’s ability or plans to expand. The board of directors and management of the Bank and the Company have taken various actions to comply with the MOUs, and will diligently endeavor to take all actions necessary for compliance. Management believes that the Bank and the Company are currently in substantial compliance with the terms of the MOUs, although formal determinations of compliance with the MOUs can only be made by the regulatory authorities. In that regard, the Bank’s Leverage Capital Ratio and Total Risk-Based Capital ratios as of December 31, 2009 were 12.0% and 17.2%, considerably in excess of the required ratios for the Bank. Management will continue to work closely with the FRB, the FDIC and the DFI in order to continue to comply with the terms of the MOUs.
On March 1, 2005, the Federal Reserve Board (“FRB”) adopted a final rule that allows the continued inclusion of trust preferred securities in the Tier I capital of bank holding companies. However, under the final rule, after a five-year transition period, the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25% of Tier I capital elements, net of goodwill. Trust preferred securities currently make up 6.7% of the Company’s Tier I capital.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
To be categorized as “well capitalized”, the Company must maintain specific total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table below. The actual and required capital amounts and ratios at December 31, 2009 and 2008 are as follows:
As of December 31, 2009, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action.
21. BUSINESS SEGMENT INFORMATION
The Company manages its activities as a single operating segment, and accordingly, the Company’s operations consist of a single reportable business segment.
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
22. QUARTERLY FINANCIAL DATA (UNAUDITED)
Summarized quarterly financial data follows:
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
23. PARENT ONLY CONDENSED FINANCIAL STATEMENTS
The information below is presented as of December 31, 2009 and 2008 and for the years ended December 31, 2009, 2008 and 2007.
CONDENSED STATEMENTS OF FINANCIAL CONDITION
CONDENSED STATEMENTS OF OPERATIONS
CENTER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
CONDENSED STATEMENTS OF CASH FLOWS
24. SUBSEQUENT EVENTS
The Company has evaluated subsequent events for recognition or disclosure and determined there were no significant events that required disclosure in its consolidated financial statements.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
The Company’s Chief Executive Officer and its Chief Financial Officer, after evaluating the effectiveness of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13(a)-15(e) as of the end of the period covered by this report (the “Evaluation Date”) have concluded that as of the Evaluation Date, the Company’s disclosure controls and procedures were adequate and effective to ensure that material information relating to the Company and its consolidated subsidiaries would be made known to them by others within those entities, particularly during the period in which this annual report was being prepared.
Disclosure controls and procedures are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Management’s Annual Report on Internal Control over Financial Reporting
Management is responsible for the preparation, integrity and reliability of the consolidated financial statements and related financial information contained in this annual report. The financial statements were prepared in accordance with generally accepted accounting principles and prevailing practices of the banking industry. Where amounts must be based on estimates and judgments, they represent the best estimates and judgments of management.
Management has established and is responsible for maintaining an adequate internal control structure designed to provide reasonable, but not absolute, assurance as to the integrity and reliability of the financial statements, safeguarding of assets against loss from unauthorized use or disposition and the prevention and detection of fraudulent financial reporting. The internal control structure includes: a financial accounting environment; a comprehensive internal audit function; an independent audit committee of the board of directors; and extensive financial and operating policies and procedures. Management also recognizes its responsibility for fostering a strong ethical climate which is supported by a code of conduct, appropriate levels of management authority and responsibility, an effective corporate organizational structure and appropriate selection and training of personnel.
The board of directors, primarily through its audit committee, oversees the adequacy of the Company’s internal control structure. The audit committee, whose members are neither officers nor employees of the Company, meets periodically with management, internal auditors and internal credit examiners to review the functioning of each and to ensure that each is properly discharging its responsibilities. In addition, Grant Thornton LLP, an independent registered public accounting firm, was engaged to audit the Company’s consolidated financial statements and express an opinion as to the fairness of presentation of such financial statements. Grant Thornton LLP has issued an audit report on the effectiveness of the Company’s internal control over financial reporting based on criteria established in “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”).
Management recognizes that there are inherent limitations in the effectiveness of any internal control structure. 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.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2009 based upon the criteria for effective internal control over financial reporting described in “Internal Control-Integrated Framework” issued by COSO. Based upon this assessment, management believes that, as of December 31, 2009, the Company maintained effective control over financial reporting.
Changes in Internal Controls
There were no significant changes in the Company’s internal controls or in other factors that could significantly affect the Company’s internal controls over financial reporting during the quarter ended December 31, 2009, except for the remediation of the material weakness described below.
Management previously disclosed a material weakness in internal control over financial reporting in its annual report on Form 10-K for the year ended December 31, 2008 and each of the quarterly reports on Form 10-Q during 2009, relating to our internal controls over the preparation and review of allowance for loan losses. To remediate this material weakness, management implemented an additional review process by establishing interdepartmental committee and performing more frequent loan loss provision analysis. As a result of these actions, management of the Company believes this material weakness has been satisfactorily remediated as of December 31, 2009.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
Center Financial Corporation
We have audited Center Financial Corporation’s (a California Corporation) internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Center Financial Corporation’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, included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on Center Financial Corporation’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, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, 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, Center Financial Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by COSO.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statements of financial condition of Center Financial Corporation as of December 31, 2009 and 2008 and the related consolidated statements of operations, shareholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended December 31, 2009 and our report dated March 12, 2010 expressed an unqualified opinion.
/s/ GRANT THORNTON LLP
Los Angeles, California
March 12, 2010
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE
The information required to be furnished pursuant to this item with respect to Directors and Executive Officers of the Company will be set forth under the caption “Election of Directors” in the Company’s proxy statement for the 2010 Annual Meeting of Shareholders (the “Proxy Statement”), which the Company will file with the SEC within 120 days after the close of the Company’s 2009 fiscal year in accordance with SEC Regulation 14A under the Securities Exchange Act of 1934. Such information is hereby incorporated by reference.
The information required to be furnished pursuant to this item with respect to compliance with Section 16(a) of the Exchange Act will be set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement, and is incorporated herein by reference.
The information required to be furnished pursuant to this item with respect to the Company’s Code of Ethics and corporate governance matters will be set forth under the caption “Corporate Governance” in the Proxy Statement, and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required to be furnished pursuant to this item will be set forth under the caption “Executive Officer and Director Compensation” and “Compensation Discussion and Analysis” in the Proxy Statement, and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Securities Authorized for Issuance Under Equity Compensation Plans
The information required by Item 12 with respect to securities authorized for issuance under equity compensation plans is set forth under “Item 5 - Market for Registrant’s Common Equity and Issuer Repurchases of Equity Securities” above.
Other Information Concerning Security Ownership of Certain Beneficial Owners and Management
The remainder of the information required by Item 12 will be set forth under the captions “Security Ownership of Certain Beneficial Owners and management” and “Election of Directors” in the Proxy Statement, and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE
The information required to be furnished pursuant to this item will be set forth under the caption “Related Party Transactions” and “Corporate Governance-Director Independence” in the Proxy Statement, and is incorporated herein by reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
The information required to be furnished pursuant to this item will be set forth under the caption “Ratification of Appointment of Independent Registered Public Accounting Firm-Fees” in the Proxy Statement, and is incorporated herein by reference
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES
(a) Exhibits
Filed as an Exhibit of the same number to the Form 10-Q for the quarterly period ended June 30, 2008 and incorporated herein by reference
Filed as an Exhibit to the Form 8-K filed with the Commission on May 12, 2006 and incorporated herein by reference
Filed as an Exhibit to the Form 8-K filed with the SEC on December 16, 2008 and incorporated herein by reference
Filed as an Exhibit to the Form 8-K filed with the SEC on December 31, 2009 and incorporated herein by reference
Filed as an Exhibit to the Form 8-K filed with the Commission on February 1, 2007 and incorporated herein by reference
Filed as an Exhibit of the same number to the Form 10-Q for the quarterly period ended June 30, 2007 and incorporated herein by reference
Filed as an Exhibit of the same number to the Company’s Registration Statement on Form S-4 filed with the Securities and Exchange Commission (the “Commission”) on June 14, 2002 and incorporated herein by reference
Filed as an Exhibit of the same number to the Form 10-K for the fiscal year ended December 31, 2003 and incorporated herein by reference
Filed as an Exhibit of the same number to the Form 10-Q for the quarterly period ended March 31, 2006 and incorporated herein by reference
Filed as an Exhibit to the Form 8-K filed with the SEC on December 1, 2009 and incorporated herein by reference
Filed as an Exhibit of the same number to the Form 10-K for the fiscal year ended December 31, 2007 and incorporated herein by reference
(b) Financial Statement Schedules
Schedules to the financial statements are omitted because the required information is not applicable or because the required information is presented in the Company’s Consolidated Financial Statements or related notes.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized:
Date: March 12, 2010
/S/ JAE WHAN YOO
Jae Whan Yoo
President & Chief Executive 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 capacity and the dates indicated.