ITEM 1. BUSINESS
Redwood Empire Bancorp ("Redwood," and with its subsidiaries, the "Company") is a financial institution holding company headquartered in Santa Rosa, California, and operating in Northern California through one principal subsidiary, National Bank of the Redwoods, a national bank ("NBR" or the "Bank"). A previously owned subsidiary of the Company, Allied Bank, F.S.B., a federal savings bank ("Allied") merged with its sister subsidiary, NBR, in March 1997.
(a) GENERAL DEVELOPMENT OF BUSINESS.
Redwood is a California corporation, headquartered in Santa Rosa, California. Its wholly-owned subsidiary is NBR, a national bank which was chartered in 1985. In addition, NBR has three wholly-owned California chartered subsidiaries, Valley Mortgage Corporation and Allied Diversified Credit, and Redwood Merchant Services, Inc., which are currently inactive. Redwood was created by NBR in August 1988, in order to become a bank holding company through the acquisition of all of NBR's outstanding shares. That transaction was consummated in January 1989. Redwood acquired Allied in September 1990, through a tax-free reorganization in which Redwood exchanged shares of its stock for all of the outstanding shares of Allied. The acquisition of Allied was accounted for as a pooling of interests for financial reporting purposes.
On October 31, 1992, Lake Savings and Loan Association, a one-branch California chartered savings and loan based in Lakeport, California ("Lake"), was purchased for approximately $2,300,000 in cash, and merged into Allied. At the time of its acquisition Lake had total assets of approximately $41 million. The acquisition was accounted for as a purchase.
On November 4, 1994, Codding Bank, a multiple-branch California chartered bank based in Rohnert Park, California ("Codding"), was purchased for $7,028,000 in cash, including merger related expenses,
and merged into NBR. At the merger date, the fair value of the assets acquired totaled approximately $42 million.
In November 1996, the Board of Directors of the Company voted to merge Allied into NBR. On February 3, 1997, NBR received approval from the Office of the Comptroller of the Currency to merge Allied into NBR. The merger was consummated March 24, 1997. The combination of the two wholly-owned subsidiaries of Redwood was structured as a merger transaction wherein Allied has merged into NBR with NBR as the survivor. As a result of the merger NBR assumed all of Allied's rights and obligations. Allied ceased to exist as a federally chartered savings institution upon the merger.
In September 1999, the Company divested itself of its subprime mortgage brokerage and mortgage banking units, Valley Financial and Allied Diversified Credit. The divestiture took the form of an asset sale and employee transfer to Valley Financial Funding, Inc., whose shareholders include senior management of Valley Financial and Allied Diversified Credit. The Company has disclosed the operations of these units as well as the after tax loss on disposition as discontinued operations. Accordingly, historical financial information has been recast to present the operating results of Valley Financial and Allied Diversified Credit as discontinued operations.
(b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS.
Through September 10, 1999, the Company operated in four principal industry segments: core community banking, merchant card services, sub prime lending, and residential mortgage banking and brokerage. The Company's core community banking industry segment includes commercial, commercial real estate, construction, and permanent residential lending along with all depository activities. The Company's merchant card services industry group provides credit card settlement services for 67,000 merchants throughout the United States. The Company's sub prime lending unit, known as Allied Diversified Credit and the Company's residential mortgage banking and brokerage arm, known as Valley Financial were divested on September 10, 1999. The divestiture took the form of an asset sale and employee transfer. The Company has disclosed the operations of these units as well as the after tax loss on disposition as discontinued operations. Accordingly, historical financial information regarding segments has been restated. For further discussion see "Management Discussion and Analysis of Financial Condition and Results of Operations" in Item 7.
(c) NARRATIVE DESCRIPTION OF BUSINESS.
The Company's business strategy involves two principal business activities which are conducted through NBR: community banking and merchant card services.
NBR provides its core community banking services through five retail branches located in Sonoma County, California, one retail branch located in Mendocino County, California, and one retail branch located in Lake County, California. NBR generally extends commercial loans to professionals and to businesses with annual revenues of less than $10 million. Commercial loans are primarily for working capital, asset acquisition and commercial real estate. NBR's targeted commercial banking market area includes the California counties north of San Francisco. NBR is a Preferred Lender under the Small Business Administration ("SBA") Loan Guarantee Program. NBR also originates commercial and residential construction loans for its portfolio.
The primary sources of funds for the Company's commercial and residential lending programs are local deposits, proceeds from loan sales, loan payments, and other borrowings. The Company attracts deposits primarily from local businesses, professionals and retail customers. The Company's primary deposit market areas include the counties of Sonoma, Mendocino and Lake. Sonoma, Mendocino and Lake Counties have benefited from the migration of population and businesses into the area, as well as growth in established firms and industries. These counties have generally exceeded the growth in population and economic activity of California as a whole. The Company generally does not purchase deposits through deposit brokers and had no brokered deposits at December 31, 1999. In addition to deposits, the Company may obtain other borrowed funds through its membership in the Federal Home
Loan Bank of San Francisco (the "FHLB") and its retention of treasury, tax and loan funds at the Federal Reserve Bank of San Francisco.
The Company provides Visa and Mastercard credit card processing and settlement services for roughly 67,000 merchants located throughout the United States. Yearly processing volume is in excess of $1.6 billion. The Company's merchant card services customer base is made up of merchants located in its primary market area and merchants who have been acquired by the Company through the use of independent sales organizations, or ISO's.
The Company is regulated by various government agencies, with the primary regulators being the Board of Governors of the Federal Reserve System (the "FRB"), the Office of the Comptroller of the Currency (the "OCC") and the Federal Deposit Insurance Corporation (the "FDIC").
The Company and its subsidiaries had 162 full-time-equivalent employees at December 31, 1999. Redwood's headquarters are located at 111 Santa Rosa Avenue, Santa Rosa, California 95404-4905, and its telephone number is (707) 573-4800.
REGULATION AND SUPERVISION
THE EFFECT OF GOVERNMENT POLICY ON BANKING
The earnings and growth of the Company are affected not only by local market area factors and general economic conditions, but also by government monetary and fiscal policies. For example, the FRB influences the supply of money through its open market operations in U.S. Government securities and adjustments to the discount rates applicable to borrowings by depository institutions and others. Such actions influence the growth of loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and impact of future changes in such policies on the business and earnings of the Company cannot be predicted. Additionally, state and federal tax policies can impact banking organizations.
As a consequence of the extensive regulation of commercial banking activities in the United States, the business of the Company is particularly susceptible to being affected by the enactment of federal and state legislation which may have the effect of increasing or decreasing the cost of doing business, modifying permissible activities or enhancing the competitive position of other financial institutions. Any change in applicable laws or regulations may have a material adverse effect on the business and prospects of the Company.
REGULATION AND SUPERVISION OF BANK HOLDING COMPANIES
The Company is a bank holding company subject to the Bank Holding Company Act of 1956, as amended ("BHCA"). The Company reports to, registers with, and may be examined by, the FRB. The FRB also has the authority to examine the Company's subsidiaries. The costs of any examination by the FRB are payable by the Company.
The FRB has significant supervisory and regulatory authority over the Company and its affiliates. The FRB requires the Company to maintain certain levels of capital. See "Capital Standards." The FRB also has the authority to take enforcement action against any bank holding company that commits any unsafe or unsound practice, or violates certain laws, regulations or conditions imposed in writing by the FRB.
Under the BHCA, a company generally must obtain the prior approval of the FRB before it exercises a controlling influence over a bank, or acquires directly or indirectly, more than 5% of the voting shares or substantially all of the assets of any bank or bank holding company. Thus, the Company is required to obtain the prior approval of the FRB before it acquires, merges or consolidates with any bank or bank holding company; any company seeking to acquire, merge or consolidate with the Company also would be required to obtain the prior approval of the FRB.
The Company is generally prohibited under the BHCA from acquiring ownership or control of more than 5% of the voting shares of any company that is not a bank or bank holding company and from
engaging directly or indirectly in activities other than banking, managing banks or providing services to affiliates of the holding company. However, a bank holding company, with the approval of the FRB, may engage, or acquire the voting shares of companies engaged in activities that the FRB has determined to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. A bank holding company must demonstrate that the benefits to the public of the proposed activity will outweigh the possible adverse effects associated with such activity.
A bank holding company may acquire banks in states other than its home state without regard to the permissibility of such acquisitions under state law, but subject to any state requirement that the acquired bank has been organized and operating for the minimum period of time and providing that the bank holding company, prior to or following the proposed acquisition, controls no more than 10% of the total amount of deposits of insured depository institutions in the United States and no more than 30% of such deposits in that state (or such lesser or greater amount set by state law). Banks may also merge across state lines, creating interstate branches. Furthermore, a bank may open new branches in a state in which it does not already have banking operations, if the laws of such state permit such DE NOVO branching.
Under California law, (a) out-of-state banks that wish to establish a California branch office to conduct core banking business must first acquire an existing five year old California bank or industrial loan company by merger or purchase; (b) California state-chartered banks are empowered to conduct various authorized branch-like activities on an agency basis through affiliated and unaffiliated insured depository institutions in California and other states and (c) the Commissioner is authorized to approve an interstate acquisition or merger which would result in a deposit concentration exceeding 30% if the Commissioner finds that the transaction is consistent with public convenience and advantage. However, a state bank chartered in a state other than California may not enter California by purchasing a California branch office of a California bank or industrial loan company without purchasing the entire entity or by establishing a de novo California bank.
The FRB generally prohibits a bank holding company from declaring or paying a cash dividend which would impose undue pressure on the capital of subsidiary banks or would be funded only through borrowing or other arrangements that might adversely affect a bank holding company's financial position. The FRB's policy is that a bank holding company should not continue its existing rate of cash dividends on its common stock unless its net income is sufficient to fully fund each dividend and its prospective rate of earnings retention appears consistent with its capital needs, asset quality and overall financial condition. See the section entitled "Restrictions on Dividends and Other Distributions" for additional restrictions on the ability on the Company and the Bank to pay dividends.
Transactions between the Company and the Bank are subject to a number of other restrictions. FRB policies forbid the payment by bank subsidiaries of management fees which are unreasonable in amount or exceed the fair market value of the services rendered (or, if no market exists, actual costs plus a reasonable profit). Subject to certain limitations, depository institution subsidiaries of bank holding companies may extend credit to, invest in the securities of, purchase assets from, or issue a guarantee, acceptance, or letter of credit on behalf of, an affiliate, provided that the aggregate of such transactions with affiliates may not exceed 10% of the capital stock and surplus of the institution, and the aggregate of such transactions with all affiliates may not exceed 20% of the capital stock and surplus of such institution. The Company may only borrow from depository institution subsidiaries if the loan is secured by marketable obligations with a value of a designated amount in excess of the loan. Further, the Company may not sell a low-quality asset to a depository institution subsidiary.
Comprehensive amendments to Regulation Y became effective in 1997, and are intended to improve the competitiveness of bank holding companies by, among other things: (i) expanding the list of permissible nonbanking activities in which well-run bank holding companies may engage without prior FRB approval, (ii) streamlining the procedures for well-run bank holding companies to obtain approval to engage in other nonbanking activities and (iii) eliminating most of the anti-tying restrictions imposed upon bank holding companies and their nonbank subsidiaries. Amended Regulation Y also provides for a streamlined and expedited review process for bank acquisition proposals submitted by well-run bank
holding companies and eliminates certain duplicative reporting requirements when there has been a further change in bank control or in bank directors or officers after an earlier approved change. These changes to Regulation Y are subject to numerous qualifications, limitations and restrictions. In order for a bank holding company to qualify as "well-run," both it and the insured depository institutions that it controls must meet the "well-capitalized" and "well-managed" criteria set forth in Regulation Y.
To qualify as "well-capitalized," the bank holding company must, on a consolidated basis: (i) maintain a total risk-based capital ratio of 10% or greater; (ii) maintain a Tier 1 risk-based capital ratio of 6% or greater; and (iii) not be subject to any order by the FRB to meet a specified capital level. Its lead insured depository institution must be well-capitalized as that term is defined in the capital adequacy regulations of the applicable bank regulator, 80% of the total risk-weighted assets held by its insured depository institutions must be held by institutions that are well-capitalized, and none of its insured depository institutions may be undercapitalized.
To qualify as "well-managed": (i) each of the bank holding company, its lead depository institution and its depository institutions holding 80% of the total risk-weighted assets of all its depository institutions at their most recent examination or review must have received a composite rating, rating for management and rating for compliance which were at least satisfactory; (ii) none of the bank holding company's depository institutions may have received one of the two lowest composite ratings; and (iii) neither the bank holding company nor any of its depository institutions during the previous 12 months may have been subject to a formal enforcement order or action.
BANK REGULATION AND SUPERVISION
As a national bank, the Bank is regulated, supervised and regularly examined by the OCC. Deposit accounts at the Bank are insured by the Bank Insurance Fund ("BIF") and the Savings Institution Insurance Fund ("SAIF"), as administered by the FDIC, to the maximum amount permitted by law. The Bank is also subject to applicable provisions of California law, insofar as such provisions are not in conflict with or preempted by federal banking law. The Bank is a member of the Federal Reserve System, and is also subject to certain regulations of the FRB dealing primarily with check clearing activities, establishment of banking reserves, Truth-in-Lending (Regulation Z), Truth-in-Savings (Regulation DD), and Equal Credit Opportunity (Regulation B).
The OCC may approve, on a case-by-case basis, the entry of bank operating subsidiaries into a business incidental to banking, including activities in which the parent bank is not permitted to engage. A national bank is permitted to engage in activities approved for a bank holding company through a bank operating subsidiary, such as acting as an investment or financial advisor, leasing personal property and providing financial advice to customers. In general, these activities are permitted only for well-capitalized or adequately capitalized national banks.
CAPITAL STANDARDS
The federal banking agencies have risk-based capital adequacy guidelines intended to provide a measure of capital adequacy that reflects the degree of risk associated with a banking organization's operations for both transactions reported on the balance sheet as assets and transactions, such as letters of credit and recourse arrangements, which are recorded as off balance sheet items. Under these guidelines, 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. government securities, to 100% for assets with relatively higher credit risk, such as certain loans.
In determining the capital level the Company and the Bank are required to maintain, the federal banking agencies do not, in all respects, follow generally accepted accounting principles ("GAAP") and have special rules which have the effect of reducing the amount of capital they will recognize for purposes of determining the capital adequacy of the Bank.
A banking organization's risk-based capital ratios are obtained by dividing its qualifying capital by its total risk-adjusted assets and off balance sheet items. The regulators measure risk-adjusted assets and off balance sheet items against both total qualifying capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and Tier 1 capital. Tier 1 capital consists of common stock, retained earnings, noncumulative perpetual preferred stock, other types of qualifying preferred stock and minority interests in certain subsidiaries, less most other intangible assets and other adjustments. Net unrealized losses on available-for-sale equity securities with readily determinable fair value must be deducted in determining Tier 1 capital. For Tier 1 capital purposes, deferred tax assets that can only be realized if an institution earns sufficient taxable income in the future are limited to the amount that the institution is expected to realize within one year, or ten percent of Tier 1 capital, whichever is less. Tier 2 capital may consist of a limited amount of the allowance for possible loan and lease losses, term preferred stock and other types of preferred stock not qualifying as Tier 1 capital, term subordinated debt and certain other instruments with some characteristics of equity. The inclusion of elements of Tier 2 capital are subject to certain other requirements and limitations of the federal banking agencies. The federal banking agencies require a minimum ratio of qualifying total capital to risk-adjusted assets and off balance sheet items of 8%, and a minimum ratio of Tier 1 capital to adjusted average risk-adjusted assets and off balance sheet items of 4%.
On October 1, 1998, the OCC adopted two rules governing minimum capital levels that OCC-supervised banks must maintain against the risks to which they are exposed. The first rule makes risk-based capital standards consistent for two types of credit enhancements (i.e., recourse arrangements and direct credit substitutes) and requires different amounts of capital for different risk positions in asset securitization transactions. The second rule permits limited amounts of unrealized gains on debt and equity securities to be recognized for risk-based capital purposes as of September 1, 1998. The OCC rules also provide that a qualifying institution that sells small business loans and leases with recourse must hold capital only against the amount of recourse retained. In general, a qualifying institution is one that is well-capitalized under the FDIC's prompt corrective action rules. The amount of recourse that can receive the preferential capital treatment cannot exceed 15% of the institution's total risk-based capital.
In addition to the risked-based guidelines, the federal banking agencies require banking organizations to maintain a minimum amount of Tier 1 capital to adjusted average total assets, referred to as the leverage capital ratio. For a banking organization rated in the highest of the five categories used to rate banking organizations, the minimum leverage ratio of Tier 1 capital to total assets must be 3%. It is improbable, however, that an institution with a 3% leverage ratio would receive the highest rating since a strong capital position is a significant part of the regulators' rating. Bank holding companies not rated in the highest category must have a minimum leverage ratio of 4%. For all banks not rated in the highest category, the minimum leverage ratio must be at least 100 to 200 basis points above the 3% minimum. Thus, the effective minimum leverage ratio, for all practical purposes, must be at least 4% or 5% for banks. In addition to these uniform risk-based capital guidelines and leverage ratios that apply across the industry, the regulators have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios.
The federal banking agencies recently amended their guidelines to clarify the leverage ratio requirement for banks to conform to that of bank holding companies. As of April 1, 1999, banks not rated in the highest category must have a minimum leverage ratio of 4%. The ratio for banks in the highest category will remain at 3%.
As of December 31, 1999, the Bank's capital ratios exceeded applicable regulatory requirements. The following tables present the capital ratios for the Company and the Bank, compared to the standards for
well-capitalized bank holding companies and depository institutions, as of December 31, 1999 (amounts in thousands except percentage amounts).
The federal banking agencies must take into consideration concentrations of credit risk and risks from non-traditional activities, as well as an institution's ability to manage those risks, when determining the adequacy of an institution's capital. This evaluation will be made as a part of the institution's regular safety and soundness examination. The federal banking agencies must also consider interest rate risk (when the interest rate sensitivity of an institution's assets does not match the sensitivity of its liabilities or its off-balance-sheet position) in evaluation of a bank's capital adequacy.
PROMPT CORRECTIVE ACTION AND OTHER ENFORCEMENT MECHANISMS
The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") requires each federal banking agency to take prompt corrective action to resolve the problems of insured depository institutions, including but not limited to those that fall below one or more prescribed minimum capital ratios. The law required each federal banking agency to promulgate regulations defining the following five categories in which an insured depository institution will be placed, based on the level of its capital ratios: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized.
Under the prompt corrective action provisions of FDICIA, an insured depository institution generally will be classified in the following categories based on the capital measures indicated below:
An institution that, based upon its capital levels, is classified as "well capitalized," "adequately capitalized" or "undercapitalized" may be treated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, determines that an unsafe or
unsound condition or an unsafe or unsound practice warrants such treatment. At each successive lower capital category, an insured depository institution is subject to more restrictions.
In addition to measures taken under the prompt corrective action provisions, commercial banking organizations may be subject to potential enforcement actions by the federal banking agencies 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 imposition of a conservator or receiver, the issuance of a cease-and-desist order that can be judicially enforced, the termination of insurance of deposits (in the case of a depository institution), the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the issuance of removal and prohibition orders against institution-affiliated parties and the enforcement of such actions through injunctions or restraining orders based upon a judicial determination that the agency would be harmed if such equitable relief was not granted. Additionally, a holding company's inability to serve as a source of strength to its subsidiary banking organizations could serve as an additional basis for a regulatory action against the holding company.
SAFETY AND SOUNDNESS STANDARDS
FDICIA also implemented certain specific restrictions on transactions and required federal banking regulators to adopt overall safety and soundness standards for depository institutions related to internal control, loan underwriting and documentation and asset growth. Among other things, FDICIA limits the interest rates paid on deposits by undercapitalized institutions, restricts the use of brokered deposits, limits the aggregate extensions of credit by a depository institution to an executive officer, director, principal shareholder or related interest, and reduces deposit insurance coverage for deposits offered by undercapitalized institutions for deposits by certain employee benefits accounts.
The federal banking agencies may require an institution to submit to an acceptable compliance plan as well as the flexibility to pursue other more appropriate or effective courses of action given the specific circumstances and severity of an institution's noncompliance with one or more standards.
RESTRICTIONS ON DIVIDENDS AND OTHER DISTRIBUTIONS
The power of the board of directors of an insured depository institution to declare a cash dividend or other distribution with respect to capital is subject to statutory and regulatory restrictions which limit the amount available for such distribution depending upon the earnings, financial condition and cash needs of the institution, as well as general business conditions. FDICIA prohibits insured depository institutions from paying management fees to any controlling persons or, with certain limited exceptions, making capital distributions, including dividends, if, after such transaction, the institution would be undercapitalized.
The federal banking agencies also have authority to prohibit a depository institution from engaging in business practices that are considered to be unsafe or unsound, possibly including the payment of dividends or other payments under certain circumstances even if such payments are not expressly prohibited by statute.
The payment of dividends by a national bank is further restricted by additional provisions of federal law, which prohibit a national bank from declaring a dividend on its shares of common stock unless its surplus fund exceeds the amount of its common capital (total outstanding common shares times the par value per share). Additionally, if losses have at any time been sustained equal to or exceeding a bank's undivided profits then on hand, no dividend shall be paid. Moreover, even if a bank's surplus exceeded its common capital and its undivided profits exceed its losses, the approval of the OCC is required for the payment of dividends if the total of all dividends declared by a national bank in any calendar year would exceed the total of its net profits of that year combined with its retained net profits of the two preceding years, less any required transfers to surplus or a fund for the retirement of any preferred stock. A national bank must consider other business factors in determining the payment of dividends. The payment of dividends by the Bank is governed by the Bank's ability to maintain minimum required capital levels and an adequate allowance for loan losses. Regulators also have authority to prohibit a depository institution
from engaging in business practices which are considered to be unsafe or unsound, possibly including payment of dividends or other payments under certain circumstances even if such payment are not expressly prohibited by statute.
PREMIUMS FOR DEPOSIT INSURANCE AND ASSESSMENTS FOR EXAMINATIONS
FDICIA established several mechanisms to increase funds to protect deposits insured by the BIF and SAIF administered by the FDIC. The FDIC is authorized to borrow up to $30 billion from the United States Treasury; up to 90% of the fair market value of assets of institutions acquired by the FDIC as receiver from the Federal Financing Bank; and from depository institutions that are members of the BIF and SAIF. Any borrowings not repaid by asset sales are to be repaid through insurance premiums assessed to member institutions. Such premiums must be sufficient to repay any borrowed funds within 15 years and provide insurance fund reserves of $1.25 for each $100 of insured deposits. FDICIA also provides authority for special assessments against insured deposits. No assurance can be given at this time as to what the future level of premiums will be.
COMMUNITY REINVESTMENT ACT AND FAIR LENDING DEVELOPMENTS
The Bank is subject to certain fair lending requirements and reporting obligations involving home mortgage lending operations and 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 their local communities, including low and moderate income neighborhoods. In addition to substantive penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and CRA into account when regulating and supervising other activities.
RECENTLY ENACTED AND PROPOSED LEGISLATION
On November 12, 1999, the President signed the Gramm-Leach-Bliley Financial Modernization Act of 1999 into law. The Modernization Act will:
- allow bank holding companies meeting management, capital and Community Reinvestment Act standards to engage in a substantially broader range of nonbanking activities than currently is permissible, including insurance underwriting and making merchant banking investments in commercial and financial companies; if a bank holding company elects to become a financial holding company, it files a certification, effective in 30 days, and thereafter may engage in certain financial activities without further approvals;
- allow insurers and other financial services companies to acquire banks;
- remove various restrictions that currently apply to bank holding company ownership of securities firms and mutual fund advisory companies; and
- establish the overall regulatory structure applicable to bank holding companies that also engage in insurance and securities operations.
This part of the Modernization Act became effective on March 13, 2000.
On January 19, 2000, the FRB adopted an interim rule allowing bank holding companies to submit certifications by February 15 to become financial holding companies on March 13, 2000. The FRB also provided regulations on procedures which would be used against financial holding companies which have depository institutions which fall out of compliance with the management or capital criteria. Only financial holding companies can own insurance companies and engage in merchant banking.
On January 14, 2000, the OCC proposed rules to allow national banks to form subsidiaries to engage in financial activities allowed for financial holding companies. Electing national banks must meet the same management and capital standards as financial holding companies but may not engage in insurance
underwriting, real estate development or merchant banking. Sections 23A and 23B of the Federal Reserve Act will apply to financial subsidiaries and the capital invested by a bank in its financial subsidiaries will be eliminated from the bank's capital in measuring all capital ratios. These rules may be used by national banks effective March 13, 2000.
The Modernization Act also modifies other current financial laws, including laws related to financial privacy and community reinvestment.
Additional proposals to change the laws and regulations governing the banking and financial services industry are frequently introduced in Congress, in the state legislatures and before the various bank regulatory agencies. The likelihood and timing of any such changes and the impact such changes might have on Redwood cannot be determined at this time.
The Company intends to comply with all provisions of the Gramm-Leach-Bliley Act and all implementing regulations as they become effective, and National Bank of the Redwoods intends to develop appropriate policies and procedures to meet its responsibilities in connection with the privacy provisions of Title V of that Act.
OTHER LEGISLATION
California law provides that, subject to numerous exceptions, a lender acting in the capacity of a lender shall not be liable under any state or local statute, regulation or ordinance, other than the California Hazardous Waste Control Law, to undertake a cleanup, pay damages, penalties or fines, or forfeit property as a result of the release of hazardous materials at or from the property.
In 1997, California adopted the Environmental Responsibility Acceptance Act (Cal. Civil Code Section Section 850-855) to facilitate (i) the notification of government agencies and potentially responsible parties (e.g., for cleanup) of the existence of contamination and (ii) the cleanup or other remediation of contamination by the potentially responsible parties. The Act requires, among other things, that owners of sites who have actual awareness of a release of a hazardous material that exceeds a specified notification threshold to take all reasonable steps to identify the potentially responsible parties and to send a notice of potential liability to the parties and the appropriate oversight agency.
The Company cannot be certain of the effect of the foregoing recently enacted legislation on its business.
Certain other pending legislative proposals include bills to let banks pay interest on business checking accounts, to institute "know your customer" policies, to cap consumer liability for stolen debit cards and to give judges the authority to force high-income borrowers to repay their debts rather than cancel them through bankruptcy.
COMPETITION
In the past, an independent bank's principal competitors for deposits and loans have been other banks (particularly major banks), savings and loan associations and credit unions. To a lesser extent, competition was also provided by thrift and loans, mortgage brokerage companies and insurance companies. Other institutions, such as brokerage houses, mutual fund companies, credit card companies, and even retail establishments have offered new investment vehicles which also compete with banks for deposit business. The direction of federal legislation in recent years favors competition between different types of financial institutions and to foster new entrants into the financial services market, and it is anticipated that this trend will continue.
CERTAIN IMPORTANT CONSIDERATIONS FOR INVESTORS
MERCHANT CREDIT CARD PROCESSING. The Company's profitability can be negatively impacted should one of the Company's merchant credit card customers be unable to pay on charge-backs from cardholders. Due to a contractual obligation between the Company and Visa and Mastercard, NBR stands in the place of the
merchant in the event that a merchant is unable to pay on charge-backs from cardholders. The Company utilizes ISO's to acquire merchant credit card customers. The Company's ability to maintain and grow net revenue from its merchant credit card processing operation is dependent upon maintaining and adding to these ISO relationships.
CONCENTRATION OF LENDING ACTIVITIES. Concentration of the Company's lending activities in the real estate sector, including construction loans, could have the effect of intensifying the impact on the Company of adverse changes in the real estate market in the Company's lending areas. At December 31, 1999, approximately 80% of the Company's loans were secured by real estate, of which 32% were secured by commercial real estate, including small office buildings, owner-user office/warehouses, mixed use residential and commercial properties and retail properties. Substantially all of the properties that secure the Company's present loans are located within Northern and Central California. The ability of the Company to continue to originate mortgage or construction loans may be impaired by adverse changes in local or regional economic conditions, adverse changes in the real estate market, increasing interest rates, or acts of nature (including earthquakes, which may cause uninsured damage and other loss of value to real estate that secures the Company's loans). Due to the concentration of the Company's real estate collateral, such events could have a significant adverse impact on the value of such collateral or the Company's earnings.
GOVERNMENT REGULATION. Redwood and its subsidiaries are subject to extensive federal and state governmental supervision, regulation and control, and future legislation and government policy could adversely affect the financial industry. Although the full impact of such legislation and regulation cannot be predicted, future changes may alter the structure of and competitive relationship among financial institutions. See "Regulation and Supervision," above.
COMPETITION FROM OTHER FINANCIAL INSTITUTIONS. The Company competes for deposits and loans principally with major commercial banks, other independent banks, savings and loan associations, savings banks, thrift and loan associations, credit unions, mortgage companies, insurance companies and other lending institutions. With respect to deposits, additional significant competition arises from corporate and governmental debt securities, as well as money market mutual funds. Several of the nation's largest savings and loan associations and commercial banks have a significant number of branch offices in the areas in which the Company conducts operations. Among the advantages possessed by the larger of these institutions are their ability to make larger loans, finance extensive advertising campaigns, access international money markets and generally allocate their investment assets to regions of highest yield and demand.
ITEM 2.
ITEM 2. PROPERTIES
The Company owns two depository branches and leases 7 other locations used in the normal course of business. In addition, the Company leases certain equipment. There are no contingent rental payments and the Company has three sublease arrangements. Total rental expenses under all leases, including premises, totaled $1,449,000, $2,210,000 and $2,095,000, in 1999, 1998 and 1997. The expiration dates of the leases vary, with the first such lease expiring during 2001 and the last such lease expiring during 2009. The Company maintains insurance coverage on its premises, leaseholds and equipment, including business interruption and record reconstruction coverage.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Certain lawsuits and claims arising in the ordinary course of business have been filed or are pending against the Company or its subsidiaries. Based upon information available to the Company, its review of such lawsuits and claims and consultation with its counsel, the Company believes the liability relating to these actions, if any, would not have a material adverse effect on its consolidated financial statements.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
No matters were submitted to a vote of the Company's shareholders during the fourth quarter of 1999.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
As of November 2, 1998, Redwood's Common Stock has been publicly traded on the NASDAQ National Market under the symbol "REBC". Prior to November 2, 1998, the Company Common Stock traded on the American Stock Exchange under the symbol "REB". As of December 31, 1999, there were 428 shareholders of record of Redwood's Common Stock.
In June of 1998 Redwood began quarterly cash dividends of $0.04 per outstanding share. Such dividend increased to $0.06 per outstanding share in September 1999 then to $0.10 per outstanding share in January 2000. Redwood did not pay dividends during the two year period ended December 31, 1997. There are regulatory limitations on cash dividends that may be paid by Redwood as well as regulatory limitations on cash dividends that may be paid by NBR to Redwood which could limit Redwood's ability to pay dividends. Federal regulatory agencies have the authority to prohibit the payment of dividends by NBR if a finding is made that such payment would constitute an unsafe or unsound practice, or if NBR became critically undercapitalized. See "Regulation and Supervision".
REDWOOD EMPIRE BANCORP COMMON STOCK PRICES
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
SUMMARY OF CONSOLIDATED FINANCIAL DATA AND PERFORMANCE RATIOS
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
FORWARD-LOOKING INFORMATION
This Annual Report on Form 10-K includes forward-looking information which is subject to the "safe harbor" created by the Securities Act of 1933 and Securities Exchange Act of 1934. These forward-looking statements (which involve the Company's plans, beliefs and goals, refer to estimates or use similar terms) involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Such risks and uncertainties include, but are not limited to, the following factors:
- Competitive pressure in the banking industry and changes in the regulatory environment.
- Changes in the interest rate environment and volatility of rate sensitive deposits.
- Declines in the health of the economy nationally or regionally which could reduce the demand for loans or reduce the value of real estate collateral securing most of the Company's loans.
- Credit quality deterioration that could cause an increase in the provision for loan losses.
- Dividend restriction.
- Regulatory discretion.
- Losses in the Company's merchant credit card processing business.
- Asset/liability matching risks and liquidity risks.
- Changes in the securities markets.
The Company undertakes no obligation to revise or publicly release the results of any revision to these forward-looking statements. For additional information concerning risks and uncertainties related to the Company and its operations, please refer to Certain Important Considerations for Investors in Item 1, and other information in this Report.
GENERAL
On September 10, 1999 the Company divested itself of its mortgage brokerage and mortgage banking units, Valley Financial and Allied Diversified Credit. The divestiture took the form of an asset sale and employee transfer to Valley Financial Funding, Inc., whose shareholders include senior management of Valley Financial and Allied Diversified Credit. As a result of the divestiture, the Company lost ninety-five employees of which sixty-three were transferred to Valley Financial Funding, Inc., while thirty-two were terminated by the Company. The Company has disclosed the operations of these units as well as the after tax loss on disposition as discontinued operations. Accordingly, historical financial information has been recast to present the operating results of Valley Financial and Allied Diversified Credit as discontinued operations. Revenue from discontinued operations was $4,369,000 for the year ended December 31, 1999, as compared to $10,863,000 and $6,702,000 for 1998 and 1997.
The Company derives its income from two principal sources: (1) net interest income, which is the difference between the interest income it receives on interest-earning assets and the interest expense it pays on interest-bearing liabilities; (2) non interest income or fee income which includes, fees earned on deposit services, income from SBA lending, electronic-based cash management services and merchant credit card processing.
The following analysis of the Company's financial condition and results of operations should be read in conjunction with the Consolidated Financial Statements of Redwood Empire Bancorp and related notes thereto included in this Annual Report on Form 10-K. Average balances, including such balances used in calculating financial and performance ratios, are generally daily averages for NBR, which management believes are representative of the operations of the Company.
RESULTS OF CONTINUING OPERATIONS BEFORE EXTRAORDINARY ITEM
In 1999 the Company reported income from continuing operations before extraordinary item of $4,875,000, or $1.41 diluted per share as compared to 1998 and 1997 net income from continuing operations before extraordinary item of $2,904,000, or $0.84 diluted per share, and $2,377,000, or $0.70 diluted per share, respectively.
Return on average assets for the year ended December 31, 1999 was 1.20% as compared to .73% and .54% for the years ended December 31, 1998 and 1997. Return on average common equity was 12.40% for the year ended December 31, 1999, as compared to 8.09% and 7.58% for the years ended December 31, 1998 and 1997.
In the first quarter of 1999 the Company recorded an extraordinary charge of $276,000, net of tax. Such charge is comprised of the unamortized debt issuance costs associated with the Company's $12,000,000 subordinated debt, which was early redeemed in the first quarter of 1999. In the first quarter of 1999 Redwood obtained funding for the early redemption through an $8,000,000 dividend from NBR and the redemption of a $3,000,000 note from NBR.
The Company's results from continuing operations in 1999 improved significantly from 1998. Net interest income increased $1,629,000 in 1999. The provision for loan losses declined by $1,290,000 in 1999. Improvement was also shown in noninterest expense, which decreased $711,000 to $16,166,000 in 1999 as compared to $16,877,000 in 1998. These improvements more than offset a decline in noninterest income of $428,000.
Results from continuing operations in 1998 improved when compared to 1997. Net interest income decreased by $1,598,000 in 1998 which was offset by an increase of $1,321,000 in noninterest income and a decline of $1,027,000 in noninterest expense.
NET INTEREST INCOME. For 1999, the Company's net interest income from continuing operations amounted to $19,687,000 as compared to $18,058,000 in 1998 and $19,656,000 in 1997. This represents an increase of $1,629,000 or 9% in 1999 and a decrease of $1,598,000 or 8% in 1998. The increase in 1999 when compared to 1998 is due to an increase in earning assets from $353,314,000 in 1998 to $371,170,000 in 1999 and an improvement in net interest margin from 5.11% in 1998 to 5.30% in 1999. The decrease in 1998 when compared to 1997 is primarily attributable to a decline in earning assets from $398,856,000 in 1997 to $353,314,000 in 1998 offset by an increase in net interest margin from 4.93% in 1997 to 5.11% in 1998.
The following table presents for the years indicated the distribution of consolidated average assets, liabilities and shareholders' equity, as well as the total dollar amounts of interest income from average earning assets and the resultant yields, and the dollar amounts of interest expense and average interest-bearing liabilities, expressed both in dollars and in rates. Nonaccrual loans are included in the calculation
of the average balances of loans, and interest not accrued is excluded. Fee income included in loan income is $1,110,000, $687,000 and $928,000 in 1999, 1998 and 1997.
The Company's average earning assets for 1999 increased approximately 5%, or $17,856,000, to $371,170,000, as compared to $353,314,000 for 1998. Average earning assets decreased $45,542,000 or 11% in 1998 as compared to 1997. The increase in earning assets in 1999 is primarily attributable to a increase in average portfolio loans of $26,636,000 partially offset by a decrease in federal funds sold of $9,797,000. Components of the increase in portfolio loans include increases of $16,196,000 in average outstanding residential mortgage loans and $12,020,000 in average outstanding commercial real estate loans.
The decrease in average earning assets for 1998 was due to the Company's efforts to reduce its concentration in construction loans and the refinance-driven reduction of its residential loan portfolio. Average portfolio loans decreased $55,406,000 or 17% to $266,716,000 in 1998 from $322,122,000 in 1997.
With the increase in earning assets in 1999 discussed above, the Company's funding levels also increased. The average balance of higher cost time deposits increased $19,843,000 in 1999 compared to a decrease of $38,318,000 in 1998. The growth in time deposits in 1999 is a result of the Company's marketing efforts to fund earning asset growth. Additionally, average demand deposits grew $3,777,000 in 1999 and $4,692,000 in 1998 as the Company was successful in obtaining low cost transactional accounts. Average other borrowings decreased $10,617,000 in 1999 due to the Company's early redemption of its subordinated debt. Average other borrowings remained unchanged at $12,000,000 in 1998 compared to 1997.
The following table sets forth changes in interest income and interest expense for each major category of earning asset and interest-bearing liability, and the amount of change attributable to volume and rate
changes for the years indicated. Changes not solely attributable to rate or volume have been allocated to rate.
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(1) Does not include interest income which would have been earned on nonaccrual loans had such loans performed in accordance with their terms.
(2) Loan fees of $1,110,000, $687,000 and $928,000 are included in interest income for 1999, 1998 and 1997.
(3) The average balance of securities classified as available for sale are presented at historical amortized cost without the effects of the fair value adjustments.
The net interest margin increased to 5.30% for the year ended December 31, 1999, as compared to 5.11% and 4.93% for the years ended December 31, 1998 and 1997. The increase in net interest margin in 1999 was primarily due to decreased liability costs slightly offset by a decline in yield on earning assets. The yield on earning assets decreased to 8.25% in 1999 compared to 8.65% in 1998 and 8.89% in 1997. The decline in earning asset yields in 1999 is primarily due to the change in the mix of earning assets. Average commercial and residential real estate loans, which bear a yield lower than other portfolio loan types increased $34,786,000. The decline in earning asset yield in 1998 is primarily attributable to an overall decline in general interest rates as evidenced by a drop in the prime rate from 8.50% at December 1997 to 7.75% at December 1998.
The effective rates on interest-bearing liabilities decreased to 4.03% for 1999 as compared to 4.59% for 1998 and 4.94% for 1997. The decrease in 1999 and 1998 was primarily due to a substantial downward repricing of the Company's money market and certificate of deposit accounts in the third and fourth quarter of 1998.
PROVISION FOR LOAN LOSSES. Annual fluctuations in the provision for loan losses result from management's regular assessment of the adequacy of the allowance for loan losses. The provision for loan losses was $750,000 for the year ended December 31, 1999 which represents a decrease of $1,290,000 or 63% from 1998. In 1998, the provision for loan losses of $2,040,000 represented a 3% decrease from $2,100,000 in 1997. This decrease in the provision for loan losses in 1999 when compared to 1998 was due to a decline in loan charge-offs and a decrease in nonperforming loans.
NONINTEREST INCOME. Noninterest income from continuing operations decreased 8%, or $428,000, to $5,197,000 as compared to $5,625,000, for 1998. The Company's noninterest income from continuing operations for 1998 increased by $1,321,000 or 31% from the $4,304,000 it received during 1997. The following table sets forth the sources of noninterest income from continuing operations for the years ended December 31, 1999, 1998 and 1997.
Merchant draft processing net revenue increased in 1999 to $3,154,000 as compared to $2,609,000 in 1998 and $1,585,000 in 1997. The two primary reasons for the 1998 and 1999 increase are due to an increase in the number of merchants serviced due to an increase of independent sales organizations (ISO's) to market the Bank's services and growth in the number of merchants obtained directly from the Company's marketing efforts.
In December 1998, the Company renegotiated the terms of a processing contract with an independent sales organization who represented $1,736,000 or 66% of the Company's 1998 merchant draft net processing revenue. In summary, as a result of the renegotiation, the ISO bought down its processing rate in consideration for a payment of $2,600,000 to the Company. The term of the renegotiated contract is for two years and requires the Company to continue to process merchant card transaction volume from this ISO's customers. The Company has and will continue to amortize such payment over the life of the renegotiated contract into income. During 1999 and 1998, $910,000 and $250,000 of this payment was recognized as revenue. The amount of unearned processing revenue was $1,440,000 as of December 31, 1999. The Company expects to build its overall merchant card processing business in an effort to offset any potential decline in future revenues.
The Company bears certain risks associated with its merchant credit card processing business. Due to a contractual obligation between NBR and Visa and MasterCard, NBR stands in the place of the merchant in the event that a merchant is unable to pay charge-backs from cardholders. As a result of this obligation, NBR may incur losses associated with its merchant credit card processing business. Accordingly, NBR has established a reserve to provide for losses associated with charge-back losses. Such reserve, which totaled $908,000 and $459,000 as of December 31, 1999 and 1998, was estimated based upon industry loss data and management's assumptions regarding merchant risk borne by NBR. Factors that may effect NBR's merchant risk include the amount of merchant risk borne by an ISO through its marketing agreement with the Bank.
Loan servicing revenues decreased to $129,000 for the year ended December 31, 1999, compared to $562,000 and $831,000 in 1998 and 1997. The decline in 1999 and 1998 was due to normal prepayments occurring within the Company's loan servicing portfolio. Future loan servicing income will be dependent on prepayments of loans held in the Company's servicing portfolio. Future loan servicing income is not expected to be material to the Company's operations.
In 1999, $500,000 of callable bonds carried within the Company's investment securities portfolio were called by their issuers compared to $32,700,000 in 1998. As several of these bonds were purchased at a discount the Company recorded a gain on the redemption of $5,000 in 1999 and $199,000 in 1998.
Securities sale and call activity was minimal in 1997. See Note D of Notes to Consolidated Financial Statements.
NONINTEREST EXPENSE. Noninterest expense amounted to $16,166,000 in 1999, $16,877,000 in 1998 and $17,904,000 in 1997. This represents a decrease of $711,000 or 4% in 1999 and a decrease of 1,027,000 or 6% in 1998 when compared to 1997.
Salary and employee benefits expense for 1999 increased $164,000, or 2%, to $8,802,000, as compared to $8,638,000 for 1998. This compared with a 4% decrease during 1998 over the 1997 salary and employee benefits expense of $9,021,000. The increase in salary and benefit expense in 1999 is due to the emphasis placed on growing the Company's core banking operations. The decrease in 1998 was due to increased efficiencies as a result of cost savings associated with the merger of Allied and NBR. The Company's full-time equivalent staff levels, adjusted for discontinued operations, were 162, 174, and 155 at December 31, 1999, 1998, and 1997, respectively.
Occupancy and equipment expense was $2,242,000 in 1999, $2,743,000 in 1998, and $2,719,000 in 1997. In 1999 the decrease of $501,000 was attributable to the Company's decreased space requirements as a result of the relocation of operating personnel. In 1998 occupancy and equipment costs increased $24,000 over 1997.
The following table describes the components of other noninterest expense for the years ended December 31, 1999, 1998 and 1997.
Noninterest expenses were $5,122,000 during 1999, a decrease of $374,000, or 7%, when compared to 1998 expenses of $5,496,000. Noninterest expense decreased $954,000 or 15% in 1998 when compared to 1997. The decline in 1999 is primarily attributable to a decline of $761,000 in net OREO expenses. The decline in 1998 when compared to 1997 is a result of the Company's cost control efforts.
INCOME TAXES. The Company's effective tax rate varies with changes in the relative amounts of its non-taxable income and nondeductible expenses. The Company's effective tax rate on continuing operations was 38.8% in 1999, 39.1% in 1998 and 39.9% in 1997.
BUSINESS SEGMENTS
Through September 10, 1999 operated in four principal industry segments: core community banking, merchant card services, sub prime lending, and residential mortgage banking and brokerage. The Company's core community banking industry segment includes commercial, commercial real estate, construction, and permanent residential lending along with all depository activities. The Company's merchant card services industry group provides credit card settlement services for 67,000 merchants throughout the United States. The Company's sub prime lending unit, known as Allied Diversified Credit, and the Company's residential mortgage banking and brokerage arm, known as Valley Financial, were divested on
September 10, 1999. The divestiture took the form of an asset sale and employee transfer. The Company has disclosed the operations of these units, as well as the after tax loss on disposition, as discontinued operations. Accordingly, historical financial information regarding segments has been restated to reflect only those segments associated with continuing operations.
Information related to the internal allocation of interest expense and overhead to segments presented in previous periods has been restated to present such amounts consistent with standards for accounting for discontinued operations. These standards do not allow the allocation of general corporate overhead to discontinued operations and generally require that the allocation of interest to discontinued operations be based on the marginal interest expense that would not have been incurred were it not for the discontinued operations.
Summary financial data by industry segment follows:
COMMUNITY BANKING
The Community Banking segment revenues increased in 1999 as a result of an improvement in the net interest margin and growth in earning assets. In 1999 segment expenses have declined primarily due to a decrease in the provision for loan losses, reduced OREO disposition costs and administrative expenses. In 1998 segment revenue declined due to a drop in earning assets. 1998 segment expenses dropped due to cost control measures.
BANKCARD
The Merchant Card processing segment provides Visa and Mastercard credit card processing and settlement services for roughly 67,000 merchants located throughout the United States. Yearly processing volume is in excess of $1.6 billion. The Company's merchant card services customer base is made up of merchants located in its primary market area and merchants who have been acquired by the Company through the use of independent sales organizations, or ISO's.
The Merchant Card processing segment has experienced three successive years of revenue and earnings growth due to an increase in the number of merchants it services and an increase of independent sales organizations (ISO's) to market its services. In December 1998 the Company renegotiated the terms
of a processing contract with an ISO who represented $1,736,000 or 66% of the Company's 1998 merchant draft net processing revenue and $1,412,000 or 45% of such revenue in 1999. As a result of the renegotiation the ISO bought down its processing rate in consideration for a payment of $2,600,000 to the Company. The term of the renegotiated contract is for two years and requires the Company to continue to process merchant card transaction volume from this ISO's customers. The Company has amortized such payment over the life of the renegotiated contract into income. During 1999 and 1998, $910,000 and $250,000 of this payment was recognized as revenue. The amount of unearned processing revenue was $1,440,000 as of December 31, 1999. The balance of this amount will be amortized into income in 2000.
The Company expects to build its overall merchant card processing business through direct marketing efforts and new ISO's in an effort to offset any potential decline in future revenues that may result in periods following the term of the buydown.
The Company bears certain risks associated with its merchant credit card processing business. Due to a contractual obligation between NBR and Visa and MasterCard, NBR stands in the place of the merchant in the event that a merchant is unable to pay charge-backs from cardholders. As a result of this obligation, NBR may incur losses associated with its merchant credit card processing business. Accordingly, NBR has established a reserve to provide for losses associated with charge-back losses. Such reserve, which totaled $908,000 and $459,000 as of December 31, 1999 and 1998, was estimated based upon industry loss data as a percentage of transaction volume throughout each year, historical losses incurred by the Company, and management's assumptions regarding merchant and ISO risk. The provision for charge-back losses, which is included in the financial statements as a reduction in merchant draft processing income, was $449,000, $288,000 and $56,000 in 1999, 1998 and 1997, respectively. While charge-off levels were nominal from 1997 to 1999, the increase in the reserve reflects the growth in transaction volume, increased exposures to internet merchants, and a new ISO relationship in which the Company assumes fraud risk directly rather than looking first to the ISO.
DISCONTINUED OPERATIONS
On September 10, 1999 the Company divested itself of its mortgage brokerage and mortgage banking units, Valley Financial and Allied Diversified Credit. The divestiture took the form of an asset sale and employee transfer to Valley Financial Funding, Inc., whose shareholders include senior management of Valley Financial and Allied Diversified Credit. As a result of the divestiture, the Company lost ninety-five employees of whom sixty-three were transferred to Valley Financial Funding, Inc., while thirty-two were terminated by the Company. The Company has disclosed the operations of these units as well as the after tax loss on disposition as discontinued operations. Accordingly, historical financial information has been recast to present the operating results of Valley Financial and Allied Diversified Credit as discontinued operations. After tax income from discontinued operations at December 31, 1999, 1998 and 1997 was ($437,000), $2,187,000 and $1,064,000, respectively. Revenue from discontinued operations was $4,369,000 for the year ended December 31, 1999, as compared to $10,863,000 and $6,702,000 for 1998 and 1997. Due to the disposition, the Company is no longer required to carry or fund a mortgage loan held for sale position. This position was previously funded with other borrowings and time deposits.
INVESTMENT PORTFOLIO
The Company classifies its investment securities as held to maturity or available for sale. The Company's intent is to hold all securities held to maturity until maturity and management believes that the Company has the ability to do so. Securities available for sale may be sold to implement the Company's asset/liability management strategies and in response to changes in interest rates, prepayment rates and similar factors. The following table summarizes the maturities of the Company's debt securities at their
carrying value and their weighted average yields at December 31, 1999. Yields on tax-exempt securities have been computed on a tax-equivalent basis.
The following table summarizes the book value of the Company's investment securities held on the dates indicated:
LOAN PORTFOLIO
The Company concentrates its lending activities in three principal areas: real estate mortgage loans (residential and commercial loans), real estate construction loans and commercial loans. At December 31, 1999, these three categories accounted for approximately 67%, 13% and 19%, respectively, of the Company's loan portfolio. The interest rates charged for the loans made by the Company vary with the degree of risk, the size and maturity of the loans, the borrowers' depository relationships with the Company and prevailing money market rates indicative of the Company's cost of funds.
Concentration of the Company's lending activities in the real estate sector could have the effect of intensifying the impact on the Company of adverse changes in the real estate market in the Company's lending areas. The ability of the Company to continue to originate mortgage loans may be impaired by adverse changes in local or regional economic conditions, adverse changes in the real estate market, increasing interest rates, or acts of nature (including earthquakes or floods, which may cause uninsured
damage and other loss of value to real estate that secures the Company's loans). Due to the concentration of the Company's real estate collateral, such events could have a significant adverse impact on the value of such collateral or the Company's earnings.
The following table sets forth the amounts of loans outstanding by category as of the dates indicated. There were no concentrations of loans exceeding 10% of total loans which are not otherwise disclosed as a category of loans in the table below.
REAL ESTATE MORTGAGE LOANS. As of December 31, 1999, the Company's residential mortgage loans totaled $130,504,000, or 42%, of its total loans. These loans were predominantly originated in Sonoma and Mendocino Counties. Total residential loans increased $33,310,000 during 1999 and $3,678,000 in 1998 as a result of normal origination activity. As of December 31, 1998, residential mortgage loans totaled $97,194,000 or 36% of total loans. As of December 31, 1997 residential mortgage loans totaled $93,516,000 or 33% of the total portfolio. Such loans declined $22,115,000 during 1997 due to a curtailment of origination activity. As of December 31, 1996 residential mortgage loans totaled $115,631,000. Such loans declined $34,509,000 during 1996 due to prepayments and continuing restructuring of the Company's balance sheet. This 1996 restructuring was accomplished by a $34,000,000 loan sale in the second quarter of 1996. In 1995, total residential mortgage loans decreased $54,800,000. The decrease in residential real estate loans is due primarily to loan sales of $35.9 million during the second quarter of 1995. The sale was executed to restructure the Company's balance sheet and consequently improve the Company's capital ratios and reduce its interest rate risk. In addition, in the third quarter of 1995, the Company swapped $22.1 million of adjustable rate loans with Fannie Mae for a mortgage-backed security, which had a coupon rate of 7.295%, and was scheduled to mature in 2025. This security, which was classified as available for sale, was sold prior to December 31, 1995, with settlement due from broker in January 1996.
At December 31, 1999, $67,662,000, or 52%, of the Company's residential real estate mortgage loans were fixed-rate mortgage loans having original terms ranging from one to thirty years. Another $57,757,000, or 44%, were held as adjustable-rate mortgages. The balance of these loans, $5,085,000, or 4%, consisted of multifamily loans and loans on improved single-family lots. The majority of the Company's residential mortgage loans have been underwritten for the Company's portfolio and do not necessarily meet standard underwriting criteria for sale in the secondary market. Approximately 82% of the total amount outstanding had principal balances that were less than $300,000. The Company's residential real estate mortgage loans predominately have loan-to-value ratios of 80% or less, using current loan balances and appraised values as of the time of origination. The Company's general policy is not to exceed an 80% loan-to-value ratio on residential mortgage loans without mortgage insurance. The Company generally does not make portfolio loans on a negative amortization basis.
As of December 31, 1999, the Company had outstanding $79,476,000 in commercial mortgage loans, which constituted 25% of total loans. These loans were primarily secured by owner-occupied commercial properties and have 5- to 15-year maturities based upon 25- to 30-year amortization periods. The ratio of the loan principal amount to appraised values are generally 75% or less, using appraised values at the time of loan origination, and the loans are predominantly for owner-occupied small office buildings or office/ warehouses. The Company originates commercial mortgage loans that are guaranteed by the SBA up to
70% to 90% of the balance. The SBA guaranteed portion of such loans can be sold into the secondary market with the unguaranteed principal balance retained. The aggregate retained unguaranteed principal balance of such loans was $5 million at December 31, 1999. Approximately 47% of the total amount outstanding of commercial mortgage loans had principal balances that were less than $250,000.
REAL ESTATE CONSTRUCTION LOANS. The Company's primary market focus emphasizes individual borrowers and small residential and commercial projects. The economic viability of the project and the borrower's past development record and creditworthiness are primary considerations in the loan underwriting decision. The Company had $40,059,000 in construction loans outstanding at December 31, 1999, comprising 13% of its total loans. These loans were principally located in Northern California. This represents a decrease of $6,846,000 or 15% from 1998. In 1998 construction loans decreased $8,126,000 or 15% from 1997. As of December 31, 1999, approximately $24 million of these loans consisted of 76 single-family individual-borrower construction loans, and the remaining loans included 13 subdivision projects, 5 land development projects and 7 commercial projects. At December 31, 1999, the largest single-family construction loan commitment was $1,015,000, and the average commitment was less than $375,000. The largest commitment for a subdivision project was $2,538,000 and the average subdivision commitment was less than $979,000. The average commercial project involved a loan of approximately $1,383,000.
Construction loans are funded on a line-item, percentage of completion basis. As the builder completes various line items (foundation, framing, electrical, etc.) of the project, or portions of those line items, the work is reviewed by one of several independent inspectors hired by the Company. Upon approval from the inspector, the Company funds the draw request according to the percentage completion of the line items that have been approved. The Company rotates inspectors during construction to ensure independent review. Actual funding checks must be signed by an officer of the Company, and that officer must also initial the line-item worksheet used to support the draw request. In addition, Company personnel or agents routinely inspect the various construction projects, all of which are located in the Company's lending area.
Commercial real estate mortgage and construction lending contains potential risks which are not inherent in other types of portfolio loans. These potential risks include declines in market values of underlying real property collateral and, with respect to construction lending, delays or cost overruns which could expose the Company to loss. In addition, risks in commercial real estate lending include declines in commercial real estate values, general economic conditions surrounding the commercial real estate properties and vacancy rates. A decline in the general economic conditions or real estate values within the Company's market area could have a negative impact on the performance of the loan portfolio or value of the collateral. Because the Company lends primarily within its market area, the real property collateral for its loans is similarly concentrated, rather than diversified over a broader geographic area. The Company could therefore be adversely affected by a decline in real estate values in its primary market area even if real estate values elsewhere in California remained stable or increased.
COMMERCIAL LOANS. Commercial loans consist primarily of short-term financing for businesses and professionals located in Sonoma and Mendocino Counties. At December 31, 1999, these loans totaled $61,165,000, or 19%, of the Company's total loans. This represents a decrease of $2,095,000 or 3% from 1999 due to normal loan payoffs and the competitive banking environment. In 1998 commercial loans decreased $5,837,000 or 8% from 1997. The commercial loans are diversified as to industries and types of businesses, with no material industry concentrations. Commercial loan borrowers generally have deposit relationships with the Company. The commercial loans can be unsecured or secured by various assets, including equipment, receivables, deposits and other assets. Commercial loans may be secured by commercial or residential property; however, they are not classified as mortgage loans since these loans are not typically taken out for the purpose of acquiring real estate and the loans are short-term. In these cases, the mortgage collateral is often taken as additional collateral. As of December 31, 1999, the size of individual commercial loans varied widely, with 93% having principal balances less than $350,000. At December 31, 1999, the Company had 3 commercial borrowers whose aggregate individual liability exceeded $2,000,000.
LOAN COMMITMENTS. In the normal course of business, there are various commitments outstanding to extend credit that are not reflected in the financial statements. Annual review of the commercial credit lines and ongoing monitoring of outstanding balances reduces the risk of loss associated with these commitments. As of December 31, 1999, the Company had outstanding $41,000 in unfunded mortgage loan commitments, $38,244,000 in undisbursed loan commitments and $539,000 in standby letters of credit. The Company's undisbursed commercial loan commitments represent primarily business lines of credit. The undisbursed construction commitments represented undisbursed funding on construction projects in process. The mortgage loan commitments represented approved but unfunded mortgage loans with the Company's mortgage banking business.
MATURITY DISTRIBUTION. The following table shows the maturity distribution of the Company's commercial and real estate construction loans outstanding as of December 31, 1999, which, based on remaining scheduled repayments of principal, were due within the periods indicated.
DEPOSIT STRUCTURE
The Company primarily attracts deposits from local businesses and professionals, as well as through retail certificates of deposits, savings and checking accounts. In addition to the Company's local depository offices, it attracts certificates of deposit, primarily from financial institutions throughout the nation, by publishing rates in national publications. These certificates of deposit have often been attracted at interest rates at or above local market retail deposit rates. The national deposit market is utilized to supplement the Company's liquidity needs. There can be no assurance that this funding practice will continue to provide deposits at attractive rates, or that applicable federal regulations will not limit the Company's ability to attract deposits in this manner. The amount of such deposits was $793,000 and $993,000 as of December 31, 1999 and 1998. The Company generally does not purchase brokered deposits and had no brokered deposits at December 31, 1999.
The following chart sets forth the distribution of the Company's average daily deposits for the periods indicated.
The Company's time deposits of $100,000 or more had the following schedule of maturities at December 31, 1999:
Time deposits of $100,000 or more are generally from the Company's local business and professional customer base. The potential impact on the Company's liquidity from the withdrawal of these deposits is considered in the Company's asset and liability management policies, which attempt to anticipate adequate liquidity needs through its management of investments, federal funds sold, or by generating additional deposits.
OTHER BORROWINGS
NBR maintains a secured line of credit with the FHLB collateralized by approximately $111,832,000 in residential mortgage loans. Available credit under this line at December 31, 1999 was $91,000,000. Advances can be made on a long-term and short-term basis with a rolling maturity date. On occasion, a borrowing is made on a fixed maturity basis. In such instances, maturities do not extend beyond one year. Redwood also maintains a $3,000,000 unsecrued line of credit with a major financial institution. As of December 31, 1999, $825,000 was outstanding under this line and represents the highest amount outstanding during the year. In addition, the Company enters into various short-term borrowing agreements, which include Treasury, Tax and Loan borrowings. These borrowings have maturities of one day and are collateralized by investments or loans.
The following table summarizes the balances outstanding at year end, the highest amount of borrowings outstanding for a month-end during the year, the average balance of borrowings and the weighted average rate for the years ended December 31, 1999, 1998 and 1997.
ASSET QUALITY
The Company attempts to minimize credit risk through its underwriting and credit review policies. The Company conducts its own internal credit review processes and, in addition, contracts with an independent loan reviewer who performs monthly reviews of new loans and potential problem loans that meet predetermined parameters. The Board of Directors of NBR has an internal asset review committee which reviews the asset quality of new and problem loans on a monthly basis and reports the findings to the full Board. In management's opinion, this loan review system facilitates the early identification of potential problem loans.
The performance of the Company's loan portfolio is evaluated regularly by management. The Company places a loan on nonaccrual status when one of the following events occurs: any installment of principal or interest is 90 days or more past due (unless, in management's opinion, the loan is well secured
and in the process of collection); management determines the ultimate collection of principal of or interest on a loan to be unlikely; or the terms of a loan have been renegotiated to less than market rates due to a serious weakening of the borrower's financial condition.
With respect to the Company's policy of placing loans 90 days or more past due on nonaccrual status unless the loan is well secured and in the process of collection, a loan is considered to be in the process of collection if, based on a probable specific event, it is expected that the loan will be repaid or brought current. Generally, this collection period would not exceed 30 days. When a loan is placed on nonaccrual status, the Company's general policy is to reverse and charge against current income previously accrued but unpaid interest. Interest income on such loans is subsequently recognized only to the extent that cash is received and future collection of principal is deemed by management to be probable. Where the collectibility of the principal of or interest on a loan is considered to be doubtful by management, it is placed on nonaccrual status prior to becoming 90 days delinquent.
Interest income is recognized on impaired loans in a manner similar to that of all loans. It is the Company's policy to place loans that are delinquent 90 days or more as to principal or interest on nonaccrual status unless secured and in the process of collection, and to reverse from current income accrued but uncollected interest. Cash payments subsequently received on nonaccrual loans are recognized as income only where the future collection of principal is considered by management to be probable.
At December 31, 1999 and 1998 the Company's total recorded investment in impaired loans was $4,430,000 and $10,293,000 of which $4,119,000 and $8,573,000 relates to the recorded investment for which there is a related allowance for credit losses of $1,121,000 and $1,543,000. The amount of that recorded investment for which there is no related allowance for credit losses was $311,000 and $1,720,000 at December 31, 1999 and 1998. At December 31, 1999 substantially all of the impaired loan balance was measured based on the fair value of the collateral, with the remainder measured by estimated present value cash flow.
The average recorded investment in impaired loans during the years ended December 31, 1999, 1998 and 1997 was $4,420,000, $10,377,000 and $10,949,000. The related amount of interest income recognized during the period that such loans were impaired was $292,000, $578,000 and $558,000.
As of December 31, 1999 and 1998 there were $3,063,000 and $5,556,000 of loans on which the accrual of interest had been discontinued. Interest due but excluded from interest income on loans placed on nonaccrual status was $362,000, $341,000 and $469,000 for the years ended December 31, 1999, 1998 and 1997. Interest income received on nonaccrual loans was $205,000, $51,000 and $84,000 for the years ended December 31, 1999, 1998 and 1997.
The following table sets forth the amount of the Company's nonperforming assets as of the dates indicated.
Nonperforming loans totaled $4,081,000 at December 31, 1999, consisting of $1,363,000 that were secured by residential real estate with the remaining $2,718,000 either unsecured or collateralized by various business assets other than real estate.
Other real estate owned totaled $2,363,000 at December 31, 1999, consisting of $2,018,000 in construction, commercial buildings and land development and $345,000 in residential properties.
In addition to the above mentioned assets, as of December 31, 1999 management of the Company has identified two lending relationships which in aggregate amount to approximately $931,000 in potential nonperforming loans, as to which it has serious doubts as to the ability of the borrowers to comply with the present repayment terms and which may become nonperforming assets, based on known information about possible credit problems of the borrower.
The following table provides certain information for the years indicated with respect to the Company's allowance for loan losses as well as charge-off and recovery activity.
The allowance for loan losses is established through charges to earnings in the form of the provision for loan losses. Loan losses are charged to, and recoveries are credited to, the allowance for loan losses. The provision for loan losses is determined after considering various factors such as loan loss experience, current economic conditions, maturity of the portfolio, size of the portfolio, industry concentrations, borrower credit history, the existing allowance for loan losses, independent loan reviews, current charges and recoveries to the allowance for loan losses, and the overall quality of the portfolio, as determined by management, regulatory agencies, and independent credit review consultants retained by the Company.
The adequacy of the Company's allowance for loan losses is based on specific and formula allocations to the Company's loan portfolio. Specific allocations of the allowance for loan losses are made to identified
problem or potential problem loans. The specific allocations are increased or decreased through management's reevaluation of the status of the particular problem loans. Loans which do not receive a specific allocation receive an allowance allocation based on a formula, represented by a percentage factor based on underlying collateral, type of loan, historical charge-offs and general economic conditions, which is applied against the general portfolio segments.
It is the policy of management to make additions to the allowance for loan losses so that it remains adequate to cover anticipated charge-offs, and management believes that the allowance at December 31, 1999 is adequate. However, the determination of the amount of the allowance is judgmental and subject to economic conditions which cannot be predicted with certainty. Accordingly, the Company cannot predict whether charge-offs of loans in excess of the allowance may be required in future periods.
The provision for loan losses reflects an accrual sufficient to cover projected probable charge-offs and the maintenance of the allowance at a level deemed adequate to absorb potential future losses.
The table below sets forth the allocation of the allowance for loan losses by loan type as of the dates specified. The allocation of individual categories of loans includes amounts applicable to specifically identified as well as unidentified losses inherent in that segment of the loan portfolio and will necessarily change whenever management determines that the risk characteristics of the loan portfolio have changed.
Management believes that any breakdown or allocation of the allowance for loan losses into loan categories lends an appearance of exactness which does not exist, in that the allowance is utilized as a single unallocated allowance available for all loans and undisbursed commitments. The allocation below should not be interpreted as an indication of the specific amounts or loan categories in which future charge-offs may occur:
From time to time the Company may be required to repurchase mortgage loans from investors depending upon representations and warranties of the purchase agreement between the investor and the Company. Such representations and warranties include valid appraisal, status of borrower or fraud. The Company expects that it may be required to repurchase loans in the future. In 1999, 1998 and 1997 the Company was required by various mortgage loan investors to repurchase 4, 9 and 26 non performing residential mortgage loans totaling $943,000, $542,000 and $3,459,000, respectively. The Company maintains a reserve for its estimate of potential losses associated with the potential repurchase of previously sold mortgage loans. Such reserve amounts to $142,000 and $172,000 as of December 31, 1999 and 1998.
YEAR 2000
The Company's mission critical systems successfully responded to the century date change. Accordingly, the Company's core banking systems, including the applications software for its deposit, loan and merchant card processing computer systems, as well as the electronic funds transfers system with the Federal Reserve, are fully operational and accurately processing customer information and transactions. The Company will continue to monitor its systems and those of its vendors and suppliers over the coming months.
LIQUIDITY
Redwood's primary source of liquidity is dividends from NBR. Redwood's primary uses of liquidity are associated with dividend payments made to the stockholders and operating expenses. It is the Company's general policy to retain liquidity at the parent at a level which management believes to be consistent with the safety and soundness of the Company as a whole. As of December 31, 1999, Redwood held $119,000 in deposits at NBR. In addition, the Company has a $3,000,000 unsecured line of credit with a major financial institution, which bears an interest rate equal to the prime rate plus one percent. As of December 31, 1999 $825,000 was outstanding under this line of credit.
In 1998, Redwood reinstated a cash dividend to its common stock holders at a quarterly rate of $.04 per share. In 1999, Redwood increased this dividend 50% to $0.06 per share. In the fourth quarter of 1999, the dividend increased again to $0.10 per share. Payment of dividends by the Company is ultimately dependent on dividends from NBR to Redwood. Federal regulatory agencies have the authority to prohibit the payment of dividends by NBR to Redwood if a finding is made that such payment would constitute an unsafe or unsound practice, or if NBR became undercapitalized. If NBR is restricted from paying dividends, Redwood could be unable to pay the above obligations. No assurance can be given as to the ability of NBR to pay dividends to Redwood. In 1999, 1998 and 1997 NBR declared dividends of $10,900,000, $1,200,000 and $860,000.
Although each entity within the consolidated group manages its own liquidity, the Company's consolidated cash flows can be divided into three distinct areas; operating, investing and financing. For the year ended December 31, 1999 the Company received $35,331,000 in cash flows from operations while using $47,670,000 and $9,292,000 in investing and financing activities, respectively.
The principal sources of asset liquidity are federal funds sold. Secondary sources of liquidity are loan repayments, investments available for sale, maturing investments, and investments that can be used as collateral for other borrowings. At December 31, 1999, the Company had $1,497,000 in federal funds sold. Total investments were $76,705,000, of which $29,835,000 were pledged.
Time deposits from other financial institutions totaled $793,000 or .2% of total deposits, at December 31, 1999, a decrease of $200,000 from the $993,000 recorded at December 31, 1998, which amounted to .3% of total deposits at that time. These deposits are used to supplement liquidity when the Company determines that deposits from local sources would be more expensive. The Company is able to retain such deposits at favorable rates when desired.
Liability-based liquidity includes interest-bearing and noninterest bearing retail deposits, which are a relatively stable source of funds, time deposits from financial institutions throughout the United States, federal funds purchased, and other short-term and long-term borrowings, some of which are collateralized. The Company collateralized FHLB advances as NBR is a member of the FHLB. Management uses FHLB advances as part of its funding strategy because the rates paid for those advances are generally in line with the rates paid on time certificates of deposits. FHLB advances must be collateralized by the pledging of qualified mortgage loans of NBR. At December 31, 1999 approximately $111,832,000 of residential mortgage loans were pledged to secure any funds the Company may borrow. NBR's FHLB borrowing limitation at December 31, 1999 was $91,000,000. At December 31, 1999 and December 31, 1998, NBR had paid off all FHLB advances, as compared to advances outstanding of $1,800,000 at December 31, 1997. Management believes that at December 31, 1999 the Company's liquidity position was adequate for the operations of Redwood and its subsidiaries for the foreseeable future.
CAPITAL
A strong capital base is essential to the Company's continued ability to service the needs of its customers. Capital protects depositors and the deposit insurance fund from potential losses and is a source of funds for the substantial investments necessary for the Company to remain competitive. In addition, adequate capital and earnings enable the Company to gain access to the capital markets to supplement its internal growth of capital. Capital is generated internally primarily through earnings retention.
The Company and NBR are each required to maintain minimum capital ratios defined by various federal government regulatory agencies. The FRB and the OCC have each established capital guidelines, which include minimum capital requirements. The regulations impose two sets of standards: "risk-based" and "leverage".
Under the risk-based capital standard, assets reported on an institution's balance sheet and certain off-balance sheet items are assigned to risk categories, each of which is assigned a risk weight. This standard characterizes an institution's capital as being "Tier 1" capital (defined as principally comprising shareholders' equity and noncumulative preferred stock) and "Tier 2" capital (defined as principally comprising the allowance for loan losses and subordinated debt). At December 31, 1999, 1998 and 1997, the Company and its subsidiaries were required to maintain a total risk-based capital ratio of 8%, including a Tier 1 capital ratio of at least 4%.
Under the leverage capital standard, an institution must maintain a specified minimum ratio of Tier 1 capital to total assets, with the minimum ratio ranging from 4% to 6% for other than the highest rated institutions. The minimum leverage ratio for the Company and NBR is based on average assets for the quarter.
NBR maintains insurance on its customer deposits with the Federal Deposit Insurance Corporation ("FDIC"). The FDIC manages the Bank Insurance Fund ("BIF"), which insures deposits of commercial banks such as NBR, and the Savings Association Insurance Fund ("SAIF"), which insures deposits of savings associations such as Allied. FDICIA mandated that the two funds maintain reserves at 1.25% of their respective federally insured deposits.
The table below shows the capital ratios for the Company and NBR at December 31, 1999.
Under the most stringent capital requirement, the Company has approximately $19,854,000 in excess capital before it becomes under-capitalized. Similarly, NBR has $20,519,000 in excess capital.
COMMON STOCK REPURCHASE
In November 1998, the Board of Directors authorized the repurchase of up to 5% of the outstanding stock of the Company or 171,000 shares. This repurchase authorization was completed in November 1999. Upon completion of the initial 5% repurchase the Company's Board of Directors authorized an additional 5% share repurchase.
During 1999 and 1998 the Company repurchased 191,500 and 16,500 shares of its common stock for $4,181,938 and $282,750 respectively. The average price paid under the repurchase program was $21.84 in 1999 and $17.14 in 1998.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
As a financial institution, the Company's primary component of market risk is interest rate volatility. Fluctuation in interest rates will ultimately impact both the level of income and expense recorded on a large portion of the Bank's assets and liabilities, and the market value of all interest earning assets and interest bearing liabilities, other than those which possess a short term to maturity. Since virtually all of the Company's interest bearing liabilities and all of the Company's interest earning assets are located at the Bank, virtually all of the Company's interest rate risk exposure lies at the Bank level. As a result, all significant interest rate risk management procedures are performed at the Bank level. Based upon the nature of its operations, the Bank is not subject to foreign currency exchange or commodity price risk. The
Bank's real estate loan portfolio, concentrated primarily within northern California, is subject to risks associated with the local economy. The Company does not own any trading assets. See "Asset Quality".
The fundamental objective of the Company's management of its assets and liabilities is to maximize the economic value of the Company while maintaining adequate liquidity and an exposure to interest rate risk deemed by management to be acceptable. Management believes an acceptable degree of exposure to interest rate risk results from the management of assets and liabilities through maturities, pricing and mix to attempt to neutralize the potential impact of changes in market interest rates. The Bank's profitability is dependent to a large extent upon its net interest income, which is the difference between its interest income on interest-earning assets, such as loans and securities, and its interest expense on interest-bearing liabilities, such as deposits and borrowings. The Bank, like other financial institutions, is subject to interest rate risk to the degree that its interest-earning assets reprice differently than its interest-bearing liabilities. The Bank manages its mix of assets and liabilities with the goals of limiting its exposure to interest rate risk, ensuring adequate liquidity, and coordinating its sources and uses of funds.
The Bank seeks to control its interest rate risk exposure in a manner that will allow for adequate levels of earnings and capital over a range of possible interest rate environments. The Bank has adopted formal policies and practices to monitor and manage interest rate risk exposure. As part of this effort, the Bank measures risk in three ways: repricing of earning assets and interest bearing liabilities; changes in net interest income for interest rate shocks up and down 200 basis points; and changes in the market value of equity for interest rate shocks up and down 200 basis points.
The following table sets forth, as of December 31, 1999, the distribution of repricing opportunities for the Company's earning assets and interest-bearing liabilities, the interest rate sensitivity gap, the cumulative interest rate sensitivity gap, the interest rate sensitivity gap ratio (i.e., earning assets divided by interest-bearing liabilities) and the cumulative interest rate sensitivity gap ratio.
The Company's gap position is substantially dependent upon the volume of loans held in the portfolio. These loans generally have maturities greater than five years; however, these loans have a repricing frequency of at least quarterly and therefore are classified in the above table as repricing within three months. Additionally, interest-bearing transaction accounts, which consist of money market, demand and savings deposit accounts, are classified as repricing within three months. Some of these deposits may be
repriced at management's option, and therefore a decision not to reprice such deposits could significantly alter the Company's net interest margin.
Management expects that, in a declining rate environment, the Company's net interest margin would be expected to decline, and, in an increasing rate environment, the Company's net interest margin would tend to increase. The Company has experienced greater mortgage lending activity through mortgage refinancings and financing new home purchases as rates declined, and may increase its net interest margins in an increasing rate environment if more traditional commercial bank lending becomes a higher percentage of the overall earning assets mix. There can be no assurance, however, that under such circumstances the Company will experience the described relationships to declining or increasing interest rates.
On a monthly basis, NBR management prepares an analysis of interest rate risk exposure. Such analysis calculates the change in net interest income and the theoretical market value of the Bank's equity given a change in general interest rates of 200 basis points up and 200 basis points down. All changes are measured in dollars and are compared to projected net interest income and the current theoretical market value of the Bank's equity. This theoretical market value of the Bank's equity is calculated by discounting cash flows associated with the Company's assets and liabilities. The following is a December 31, 1999 and 1998 summary of interest rate risk exposure as measured on a net interest income basis and a market value of equity basis, given a change in general interest rates of 200 basis points up and 200 basis points down.
The Company's interest rate risk exposure to a rising rate environment increased in 1999. This increase was principally due to modest growth in fixed rate commercial and residential real estate loans.
The model utilized by management to create the report presented above makes various estimates at each level of interest rate change regarding cash flows from principal repayments on loans and mortgage-backed securities and/or call activity on investment securities. In addition, repricing these earning assets and matured liabilities can occur in one of three ways: (1) the rate of interest to be paid on an asset or liability may adjust periodically based on an index; (2) an asset, such as a mortgage loan, may amortize, permitting reinvestment of cash flows at the then-prevailing interest rates; or (3) an asset or liability may mature, at which time the proceeds can be reinvested at current market rate. Actual results could differ significantly from those estimates which would result in significant differences in the calculated projected change.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
FINANCIAL STATEMENTS
The following consolidated financial statements of Redwood and its subsidiaries, and independent auditors' report included in the Annual Report of Redwood to its shareholders for the years ended December 31, 1999, 1998 and 1997.
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders of Redwood Empire Bancorp Santa Rosa, California
We have audited the accompanying consolidated balance sheets of Redwood Empire Bancorp and subsidiaries (Company) as of December 31, 1999 and 1998 and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1999. 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 generally accepted auditing standards. 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, such consolidated financial statements present fairly, in all material respects, the financial position of Redwood Empire Bancorp and subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with generally accepted accounting principles.
Deloitte & Touche LLP San Francisco, California January 26, 2000
REDWOOD EMPIRE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
See Notes to Consolidated Financial Statements.
REDWOOD EMPIRE BANCORP AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)
See Notes to Consolidated Financial Statements.
REDWOOD EMPIRE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
(IN THOUSANDS)
See Notes to Consolidated Financial Statements.
REDWOOD EMPIRE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
See Notes to Consolidated Financial Statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE A--DESCRIPTION OF BUSINESS
Redwood Empire Bancorp ("Redwood," and with its subsidiaries, the "Company") is a financial institution holding company headquartered in Santa Rosa, California, and operating in Northern California. Its wholly-owned subsidiary is National Bank of the Redwoods ("NBR"), a national bank chartered in 1985. A previously wholly-owned subsidiary, Allied Bank, F.S.B., ("Allied"), a Federal Savings Bank, was merged with its sister subsidiary, NBR, in March, 1997. The Company's business strategy involves two principal business activities, core community banking services and merchant card services, which are conducted through NBR.
NBR provides its core community banking services through five retail branches located in Sonoma County, California, one retail branch located in Mendocino County, California, and one retail branch located in Lake County, California. Loan services at NBR are generally extended to professionals and to businesses with annual revenues of less than $10 million. Commercial loans are primarily for working capital, asset acquisition and commercial real estate. NBR's targeted commercial banking market area includes the California counties north of San Francisco. NBR generates noninterest income through merchant draft processing by virtue of its status as a Principal Member of Visa/MasterCard. NBR is a Preferred Lender under the Small Business Administration ("SBA") Loan Guarantee Program. In addition, NBR originates both commerical and residential construction loans for its portfolio.
In September 1999, the Company divested itself of its subprime mortgage brokerage and mortgage banking units, Valley Financial and Allied Diversified Credit. The divestiture took the form of an asset sale and employee transfer to Valley Financial Funding, Inc., whose shareholders include senior management of Valley Financial and Allied Diversified Credit. As of December 31, 1999, there are no assets and $142,000 in liabilities on the Company's consolidated balance sheet related to the divested operations. The liability balance is related to potential repurchases of previously sold mortgage loans. During the period from October 1999 to December 1999 the Company has recorded $128,000 of income related to the divested operations and has received proceeds of $13,324,000 from the sale of mortgage loans held for sale. The Company has disclosed the operations of these units as well as the after tax loss on disposition as discontinued operations. Accordingly, historical financial information has been recast to present the operating results of Valley Financial and Allied Diversified Credit as discontinued operations. Revenue from discontinued operations was $4,369,000 for the year ended December 31, 1999, as compared to $10,863,000 and $6,702,000 for 1998 and 1997.
NOTE B--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accounting and reporting policies of the Company conform with generally accepted accounting principles and general practice within the banking industry. The preparation of financial statements in conformity with generally accepted accounting principles 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 financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. A summary of the more significant policies follows:
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of Redwood Empire Bancorp and its wholly-owned subsidiary, National Bank of the Redwoods. All material intercompany transactions and accounts have been eliminated.
Certain reclassifications to the 1998 and 1997 financial statements were made to conform to the 1999 presentation.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE B--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) For the purpose of the statements of cash flows, cash and cash equivalents have been defined as cash on hand, demand deposits with correspondent banks, cash items in transit and federal funds sold.
INVESTMENT SECURITIES
Securities held to maturity are carried at cost adjusted by the accretion of discounts and amortization of premiums. The Company has the ability and intent to hold these investment securities to maturity. Securities available for sale may be sold to implement the Company's asset/liability management strategies and in response to changes in interest rates, prepayment rates and similar factors. Available for sale securities are recorded at market value and unrealized gains or losses, net of income taxes, are included in accumulated other comprehensive income, a separate component of shareholders' equity. Gain or loss on sale of investment securities is based on the specific identification method.
LOANS AND THE ALLOWANCE FOR LOAN LOSSES
Loans are stated at the principal balance outstanding net of allowance for loan losses and deferred loan fees. Loan fees net of certain related direct costs to originate loans are deferred and amortized over the contractual life of the loan using a method approximating the interest method. Loan fees and direct costs related to the origination of loans held for sale are recognized as a component of gain or loss on sale of mortgage loans when the related loans are sold.
The allowance for loan losses is maintained at a level considered adequate to provide for losses that can be reasonably anticipated and is based on management's quarterly evaluation of the economic climate and other factors related to the collectability of loan balances. The factors considered by management include growth and composition of the loan portfolio, overall portfolio quality, review of specific problem loans, historical loss rates, regulatory reviews, trends and concentrations in delinquencies and current economic conditions that may affect the borrower's ability to pay. The actual results could differ significantly from management's estimates. The allowance for loan losses is increased by provisions charged to operations and reduced by loan charge-offs net of recoveries. A loan charge-off is recorded when a loan has been determined by management to be uncollectable.
A loan is impaired when, based upon current information and events, it is probable that NBR will be unable to collect all amounts due according to the contractual terms of the loan agreement. This standard is applicable to all loans, uncollateralized as well as collateralized, except loans that are measured at the lower of cost or fair value. Impairment is measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's observable market price, or the fair value of the collateral if the loan is collateral dependent. Management measures all loans individually for impairment as part of the Company's normal internal asset review process.
Interest income is recognized on impaired loans in a manner similar to that of all loans. It is the Company's policy to place loans that are delinquent 90 days or more as to principal or interest on nonaccrual status unless secured and in the process of collection, and to reverse from current income accrued but uncollected interest. Cash payments subsequently received on nonaccrual loans are recognized as income only where the future collection of principal is considered by management to be probable.
The Company originates loans to customers under an SBA program that generally provides for SBA guarantees of 70% to 85% of each loan. The Company may sell and retain the guaranteed portion of each loan to a third party and retain the unguaranteed portion in its own portfolio. A gain is recognized on these loans through collection on sale of a premium over the adjusted carrying value, through retention of an ongoing rate differential less a normal service fee (excess servicing fee) between the rate paid by the borrower to the Company and the rate paid by the Company to the purchaser, or both.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE B--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) To calculate the gain or loss on the sale, the Company's investment in an SBA loan is allocated among the retained portion of the loan, excess servicing retained and the sold portion of the loan, based on the relative fair market value of each portion. The gain on the sold portion of the loan is recognized currently. The excess servicing fees are reflected as an asset which is amortized over an estimated life using a method approximating the interest method; in the event future prepayments are significant and future expected cash flows are inadequate to cover the unamortized excess servicing asset, additional amortization would be recognized.
OTHER REAL ESTATE OWNED
Property acquired by the Company through foreclosure is recorded at the lower of estimated fair value less estimated selling costs (fair value) or the carrying value of the related loan at the date of foreclosure. At the time the property is acquired, if the fair value is less than the loan amounts outstanding, any difference is charged against the allowance for loan losses. After acquisition, valuations are periodically performed and, if the carrying value of the property exceeds the fair value, a valuation allowance is established by a charge to operations. Subsequent increases in the fair value may reduce or eliminate the allowance.
Operating costs on foreclosed real estate are expensed as incurred. Costs incurred for physical improvements to foreclosed real estate are capitalized if the value is recoverable through future sale.
MORTGAGE BANKING AND HEDGING ACTIVITIES
Prior to divesting Valley Financial and Allied Diversified Credit, the Company sold residential mortgage loans to a variety of secondary market investors, including Freddie Mac and Fannie Mae. Gains or losses on the sale of mortgage loans are recognized based on the difference between the selling price and the carrying value of the related mortgage loans sold.
Mortgage loans held for sale are carried at the lower of cost or market value as determined by outstanding commitments from investors, indicators of value obtained by management from independent third parties, current investor yield requirements calculated on an aggregate loan basis and the market value of its hedging instruments. Valuation adjustments are charged against the gain or loss on sale of mortgage loans.
OFF BALANCE SHEET RISK
The Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the statement of financial position. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments.
Loan commitments are typically contingent upon the borrower meeting certain financial and other covenants, and such commitments typically have fixed expiration dates and require payment of a fee. As many of these commitments are expected to expire without being drawn upon, the total commitments do
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE B--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) not necessarily represent future cash requirements. The Company evaluates each potential borrower and the necessary collateral on an individual basis. Collateral varies, but may include real property, bank deposits, debt securities, equity securities, or business assets.
Standby letters of credit are conditional commitments written by the Company to guarantee the performance of a customer to a third party. These guarantees relate primarily to inventory purchases by the Company's commercial customers, and such guarantees are typically short-term. Credit risk is similar to that involved in extending loan commitments to customers and the Company accordingly uses evaluation and collateral requirements similar to those of loan commitments. Virtually all such commitments are collateralized.
PREMISES AND EQUIPMENT
Premises and equipment consist of building, leasehold improvements, furniture and equipment and are stated at cost, less accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives for financial reporting purposes and an accelerated method for income tax reporting. Leasehold improvements are amortized over the terms of the lease or their estimated useful lives whichever is shorter.
INCOME TAXES
The Company accounts for income taxes using an asset and liability approach, which requires the recognition of deferred tax assets and liabilities at tax rates in effect when these balances are utilized. Future tax benefits attributable to temporary differences are recognized currently to the extent that realization of such benefits is more likely than not. These future tax benefits are measured by applying currently enacted tax rates.
EARNINGS PER COMMON SHARE
Basic earnings per share excludes dilution and is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE B--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The following table reconciles the numerator and denominator used in computing both basic earnings (loss) per share and diluted earnings (loss) per share for the periods indicated:
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Notes to Earnings per Common Share table:
(1) The weighted average common shares outstanding include the dilutive effects of common stock options of 92.
(2) The weighted average common shares outstanding include the dilutive effects of common stock options of 128 and 104 and convertible perpetual preferred stock of 166 and 499 for the years ended 1998 and 1997. There is no effect of perpetual preferred stock in 1999.
(3) Amounts are shown net of $112 and $449 in dividends on preferred stock for 1998 and 1997. There were no preferred dividends paid in 1999.
STOCK-BASED COMPENSATION
The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (APB) No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES. Accordingly, no compensation cost has been recognized on stock options granted. The Company presents the required pro forma disclosures of the effect of stock-based compensation on net income and earnings per share using the fair value method in accordance with SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION.
BUSINESS SEGMENTS
On January 1, 1998, the Company adopted SFAS No. 131, DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION, which establishes annual and interim reporting standards for an enterprise's operating segments and related disclosures about its products, services, geographic areas, and major customers.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE B--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) COMPREHENSIVE INCOME
Comprehensive income includes net income and other comprehensive income. The Company's only source of other comprehensive income is derived from unrealized gains and losses on investment securities held-for-sale. Reclassification adjustments result from gains or losses on investment securities held-for-sale that were realized and included in net income of the current period that also had been included in other comprehensive income as unrealized holding gains or losses in the period in which they arose. They are excluded from comprehensive income of the current period to avoid double counting.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES. The statement establishes accounting and reporting standards for derivative instruments and hedging activities. As amended by SFAS No. 137, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES--DEFERRAL OF THE EFFECTIVE DATE OF FASB STATEMENTS NO. 133, the statement is effective for all fiscal quarters of fiscal years beginning after June 15, 2000. The Company is in the process of determining the impact of SFAS No. 133 on the Company's consolidated financial statements.
NOTE C--CASH AND DUE FROM BANKS
The Company's subsidiaries are required to maintain average reserve balances with the Federal Reserve Bank. The required reserve balance included in cash and due from banks was approximately $2,922,000 and $3,183,000 at December 31, 1999 and 1998.
NOTE D--INVESTMENT SECURITIES
An analysis of the investment securities portfolio follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE D--INVESTMENT SECURITIES (CONTINUED)
Debt securities by contractual maturity at December 31, 1999, were due as follows:
Proceeds from sales of available for sale investments in debt securities during 1999, 1998 and 1997 were $1,987,000, $1,995,000, and $7,031,000. These sales resulted in the realization of gross gains of $14,000 for 1999, gross gains of $40,000 for 1998, gross gains of $30,000 and gross losses of $12,000 for 1997. Gains on redemption by issuers of debt securities amounted to $5,000, $185,000 and $5,000 in 1999, 1998 and 1997.
During 1996 the Company transferred $17,193,000 in investment securities carried as available for sale into the held to maturity category. At the date of transfer the unrealized holding loss of $300,000 continued to be reported as a component of accumulated other comprehensive income, a separate component of equity. Amortization or reduction through redemption of the securities by the issuer of the unrealized loss and amortization of the equity component offset each other with no effect on the results of operation. The balance of the unrealized loss included in accumulated other comprehensive income was reduced to zero
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE D--INVESTMENT SECURITIES (CONTINUED) as of December 31, 1998 as all transferred securities were redeemed. The balance of such unrealized loss was $242,000 as of December 31, 1997.
Securities carried at approximately $29,835,000 and $19,545,000 at December 31, 1999 and 1998 were pledged to secure public deposits, bankruptcy deposits, and treasury tax and loan borrowings.
NOTE E--MORTGAGE LOAN SERVICING
The Company services mortgage loans and participating interests in mortgage loans owned by investors. The unpaid principal balances of mortgage loans serviced for others are as follows:
NOTE F--LOANS AND THE ALLOWANCE FOR LOAN LOSSES
The Company primarily makes permanent and construction residential real estate loans in California, and loans to individuals and small businesses primarily in Sonoma and Mendocino Counties, California. There are no major industry segments in the loan portfolio. Outstanding loans by type were:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE F--LOANS AND THE ALLOWANCE FOR LOAN LOSSES (CONTINUED)
A summary of the transactions in the allowance for loan losses follows:
At December 31, 1999 and 1998 the Company's total recorded investment in impaired loans was $4,430,000 and $10,293,000 of which $4,119,000 and $8,573,000 relates to the recorded investment for which there is a related allowance for loan losses of $1,121,000 and $1,543,000 determined in accordance with these statements and $311,000 and $1,720,000 relates to the amount of that recorded investment for which there is no related allowance for loan losses determined in accordance with these statements. At December 31, 1999, approximately 80% of the impaired loan balance was measured based on the fair value of the collateral, with the remainder measured by estimated cash flow.
The average recorded investment in impaired loans during the years ended December 31, 1999, 1998 and 1997 was $4,420,000, $10,377,000 and $10,949,000. The related amount of interest income recognized during the periods that such loans were impaired was $292,000, $578,000 and $558,000.
As of December 31, 1999 and 1998 there were $3,063,000 and $5,556,000 of loans on nonaccrual. Interest due but excluded from interest income on these nonaccrual loans was $362,000, $341,000, and $469,000 for the years ended December 31, 1999, 1998 and 1997. Interest income received on nonaccrual loans was $205,000, $51,000, and $84,000 for the years ended December 31, 1999, 1998 and 1997.
At December 31, 1999 and 1998, the Company did not have any loans past due 90 days or more in interest or principal and still accruing interest.
The Company originates SBA loans for sale to investors. A summary of the activity in SBA loans is as follows:
From time to time the Company extends credit to executive officers, directors and related parties. No preference is given to these individuals as these transactions are made in the ordinary course of business at the Company's normal credit terms, including interest rates and collateralization. There were no such balances outstanding at December 31, 1999 and 1998.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE G--PREMISES, EQUIPMENT AND LEASES
A summary of premises and equipment is as follows:
Depreciation expense for the years ended December 31, 1999, 1998, and 1997 was $1,347,000, $1,731,000, and $1,430,000.
The Company leases certain premises and equipment used in the normal course of business. There are no contingent rental payments and the Company has three subleased properties. Total rental expense under all leases, including premises, totaled $1,449,000, $2,210,000, and $2,095,000 in 1999, 1998 and 1997. Minimum future lease commitments are as follows: 2000--$1,591,000; 2001--$1,484,000; 2002--$1,499,000, 2003--$962,000, 2004--$686,000 and thereafter--$503,000. Minimum future sublease receivables are as follows: 2000--$195,000; 2001--$196,000; 2002--$187,000; 2003--$90,000; and 2004--$77,000. All subleases expire in 2004.
NBR leases 22,000 square feet of an office building for its main office. Prior to June 1997, a partnership, of which a director of the Company is a minority partner, owned the office building. Total lease payments made to the partnership for the year ended December 31, 1997 were $440,000. There were no payments made to the partnership in 1998 and 1999.
NOTE H--DEPOSITS
Interest expense on time certificates of deposit of $100,000 or more was $2,641,000, $3,246,000, and $2,520,000 during 1999, 1998 and 1997, respectively.
At December 31, 1999 the scheduled maturities for all time deposits are as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE I--INCOME TAXES
The provision (benefit) for income taxes attributable to continuing operations consists of the following:
A reconciliation of the statutory income tax rate to the effective income tax rate attributable to continuing operations of the Company is as follows:
Deferred income taxes reflect the tax effect of temporary differences existing between the financial statement basis and tax basis of the Company's assets and liabilities. Deferred tax benefits attributable to temporary differences are recognized to the extent that realization of such benefits is more likely than not. The Company believes it is more likely than not that the net deferred tax asset at December 31, 1999 will be utilized to reduce future taxable income. Accordingly, there is no valuation allowance associated with
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE I--INCOME TAXES (CONTINUED) deferred tax assets at December 31, 1999. The tax effect of the principal temporary items creating the Company's net deferred tax asset included in other assets and interest receivable are:
NOTE J--OTHER BORROWINGS
Other borrowings consist of the following:
ADVANCES FROM THE FHLB
The Company has a line of credit for short-term purposes with the Federal Home Loan Bank (FHLB). During the year ended December 31, 1999 the average balance of FHLB advances was $4,293,000, the highest month-end balance during the year was $15,000,000 at an average interest rate of 5.31%. During 1998, the average balance of FHLB advances was $1,318,000 at an average interest rate of 6.03%. The highest month-end balance during the year was $1,966,000. At December 31, 1999 and 1998, the line of credit had been fully paid off. All borrowings from the FHLB must be collateralized, and the
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE J--OTHER BORROWINGS (CONTINUED) Company has pledged approximately $111,832,000 of residential mortgage loans as of December 31, 1999, to the FHLB to secure any funds it may borrow.
TREASURY, TAX AND LOAN NOTE
The Company enters into various short-term borrowing agreements which include Treasury, Tax and Loan borrowings. These borrowings have maturities of one day and are collateralized by investments or loans.
ADVANCES FROM UBOC
During 1999, the Company entered into an agreement with Union Bank of California (UBOC) to obtain an unsecured line of credit for short-term borrowing purposes. At December 31, 1999 the line of credit had an outstanding balance of $825,000, an interest rate of 9.50% and a maturity date of December 31, 2000. The average balance of UBOC advances was $35,000 for 1999 at an average interest rate of 9.37%. The highest month-end balance during the year was $825,000.
NOTE K--OTHER NONINTEREST EXPENSES
The major components of other expense are as follows:
NOTE L--STOCK OPTIONS AND BENEFIT PLANS
The Company's 1991 stock option plan, which was amended in 1992, provides for the granting of both incentive stock options and nonqualified stock options to Directors and key employees. Generally, options outstanding under the stock option plan are granted at prices equal to the market value of the stock at the date of grant, vest ratably over a four year service period and expire ten years subsequent to the award.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE L--STOCK OPTIONS AND BENEFIT PLANS (CONTINUED) Outstanding common stock options at December 31, 1999, are exercisable at various dates through 2006. The following table summarizes option activity:
At December 31, 1999 23,600 shares were available for future grants under the plan.
Additional information regarding options outstanding as of December 31, 1999 is as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE L--STOCK OPTIONS AND BENEFIT PLANS (CONTINUED) Had compensation cost for the grants been determined based upon the fair value method, the Company's net income and earnings per share would have been adjusted to the pro forma amounts indicated below.
The fair value of the options granted during 1999, 1998, and 1997, is estimated as $60,000, $727,000, and $225,000, on the date of grant using the Black-Scholes option-pricing model with the following assumptions: dividend at the current rate, volatility of 32.36%, 30.32%, and 29.5%, risk-free interest rate of 6.41%, 5.53%, and 6.65%, assumed forfeiture rate of zero, and an expected life of 10 years. The weighted average per share fair value of the 1999, 1998, and 1997 awards was $7.45, $9.82, and $7.48, respectively.
In 1991 the Company established a 401(K) savings plan for employees who have at least one year of continuous service. The Company's contributions are based on a sliding scale where it matches 100% of the first $300 contributed by the employee, 75% of the next $400, 50% of the next $800 and 25% of the next $4,000 for a maximum contribution per employee of $2,000. Company contributions totaled $138,000, $212,000, and $179,000 in 1999, 1998 and 1997.
In December 1993 the Company established a supplemental benefit plan (Plan) to provide death benefits and supplemental income payments during retirement for selected officers. The Plan is a nonqualified defined benefit plan and is unsecured. Benefits under the Plan are fixed for each participant and are payable over a specific period following the participant's retirement or at such earlier date as termination or death occurs. Participants vest in the plan based on their years of service subsequent to being covered by the Plan. The Company has purchased insurance policies to provide for its obligations under the Plan in the event a participant dies prior to retirement. The cash surrender value of such policies was $3,187,000 at December 31, 1999. Under this plan, the Company recognized expense of $54,000, $110,000, and $142,000 in 1999, 1998 and 1997. The aggregate projected benefit obligation of the Plan was approximately $206,000 and $163,000 at December 31, 1999 and 1998. A discount rate of 8.5% was used to determine the aggregate projected benefit obligation for both years.
NOTE M--SUBORDINATED DEBT AND PREFERRED STOCK
On February 22, 1999, the Company redeemed the entire $12,000,000 of its 8.5% subordinated notes. As a result of the redemption the Company recorded an extraordinary charge of $288,000 net of tax related to previously deferred debt issuance costs. Such charge was recorded by the Company in the first quarter of 1999.
On April 30, 1998 the Company called all 575,000 shares of its outstanding 7.80% Noncumulative Convertible Preferred Stock at a redemption price of $10.39 per share. As a result of this action, the
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE M--SUBORDINATED DEBT AND PREFERRED STOCK (CONTINUED) Company issued 497,865 shares of the Company's common stock in exchange for 573,290 shares of preferred stock. The remaining shares were redeemed with cash.
NOTE N--REGULATORY MATTERS
One of the principal sources of cash for Redwood are dividends from NBR. Total dividends which may be declared by subsidiary financial institutions depend on the regulations which govern them. In addition, regulatory agencies can place dividend restrictions on the subsidiaries based on their evaluation of the financial condition of the subsidiaries. No restrictions are currently imposed by regulatory agencies on the subsidiaries other than the limitations found in the regulations which govern the respective subsidiaries. At December 31, 1999, NBR could pay additional dividends to Redwood of approximately $2,151,000 without prior regulatory approval.
NBR is subject to certain restrictions under the Federal Reserve Act, including restrictions on the extension of credit to affiliates. In particular, it is prohibited from lending to an affiliated company unless the loans are secured by specific types of collateral. Such secured loans and other advances from the subsidiaries are limited to 10 percent of the subsidiary's equity. No such loans or advances were outstanding during 1999 or 1998.
Redwood and NBR are subject to various regulatory capital requirements administered by the federal banking agencies. In addition to these capital guidelines, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) required each federal banking agency to implement a regulatory framework for prompt corrective actions for insured depository institutions that are not adequately capitalized. The Board of Governors of the Federal Reserve System, FDIC, OCC and OTS have adopted such a system which became effective on December 19, 1992. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. The regulations require the Company to meet specific capital adequacy guidelines that involve quantitative measures of the Company's assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. NBR's capital classification is also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain a minimum leverage ratio of Tier 1 capital (as defined in the regulations) to adjusted assets (as defined), and minimum ratios of Tier 1 and total capital (as defined) to risk-weighted assets (as defined). As of December 31, 1999 and 1998, the most recent notification from the Office of the Comptroller of the Currency categorized NBR as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, NBR must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed NBR's category.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE N--REGULATORY MATTERS (CONTINUED)
Management believes that as of December 31, 1999, the Company and NBR meet all capital requirements to which they are subject. Under the most stringent capital requirement, NBR has approximately $16,299,000 in excess capital before it becomes "undercapitalized" under the regulatory framework for prompt corrective action.
The prompt corrective action regulations impose restrictions upon all financial institutions to refrain from certain actions which would cause an institution to be classified as "undercapitalized", such as the declaration of dividends or other capital distributions or payment of management fees, if following the distribution or payment the institution would be classified as "undercapitalized". In addition, financial institutions which are classified as "undercapitalized" are subject to certain mandatory and discretionary supervisory actions.
NOTE O--BUSINESS SEGMENTS
From January 1, 1999 to September 10, 1999, the Company operated in four principal industry segments: core community banking, merchant card services, sub prime lending, and residential mortgage banking and brokerage. The Company's core community banking industry segment includes commercial, commercial real estate, construction, and permanent residential lending along with all depository activities. The Company's merchant card services industry group provides credit card settlement services for 67,000 merchants throughout the United States. The Company's sub prime lending unit, known as Allied Diversified Credit and the Company's residential mortgage banking and brokerage arm, known as Valley
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE O--BUSINESS SEGMENTS (CONTINUED) Financial were divested on September 10, 1999. The divestiture took the form of an asset sale and employee transfer. The Company has disclosed the operations of these units as well as the after tax loss on disposition as discontinued operations. Accordingly, historical financial information regarding changes due to overhead and interest allocation for all segments has been restated.
The condensed income statements and average assets of the individual segments are set forth in the table below. The information in this table is derived from the internal management reporting system used by management to measure the performance of the segments and the Company. The management reporting system assigns balance sheet and income statement items to each segment based on internal management accounting policies. Net interest income is determined by the Company's internal funds transfer pricing system, which assigns a cost of funds or credit for funds to assets or liabilities based on their type, maturity or repricing characteristics. Noninterest income and expense directly attributable to a segment are assigned to that business. Total other operating expense includes indirect costs, such as overhead, operations and technology expense, are allocated to the segments based on an evaluation of costs for product or data processing. All amounts other than allocations of interest and indirect costs are derived from third parties. The provision for credit losses is allocated based on the required reserves and the net charge-offs for each respective segment. The Company allocates depreciation expense without allocating the related depreciable asset to that segment.
Information related to the interest allocation and indirect costs presented for 1998 and 1997 has been restated to allow for the Company's revision to the internal funds transfer pricing methodology and overhead allocation.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE O--BUSINESS SEGMENTS (CONTINUED)
NOTE P--FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS No. 107, DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS, requires that the Company disclose the fair value of financial instruments for which it is practicable to estimate that value. Although management uses its best judgment in assessing fair value, there are inherent weaknesses in any estimating technique that may be reflected in the fair values disclosed. The fair value estimates are made at a discrete point in time based on relevant market data, information about the financial instruments, and other factors. Estimates of fair value of instruments without quoted market prices are subjective in nature and involve various assumptions and estimates that are matters of judgment. Changes in the assumptions used could significantly affect these estimates. Fair value has not been adjusted to reflect changes in market conditions for the period subsequent to the valuation dates of December 31, 1999 and 1998 and therefore
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE P--FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED) estimates presented herein are not necessarily indicative of amounts which could be realized in a current transaction.
The following estimates and assumptions were used on December 31, 1999 and 1998 to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value.
(A) CASH AND CASH EQUIVALENTS
For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value.
(B) INVESTMENTS
Fair value equals quoted market price, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. For investments in unregistered mortgage-backed securities with recourse, fair value was estimated based on the expected future cash flows to be received adjusted for prepayments, foreclosures, losses and other significant factors impacting fair value. U.S. Government agency stock has no trading market but is required as part of membership, and therefore it is carried at cost.
(C) LOANS HELD FOR SALE
For uncommitted residential mortgages held for sale, fair value is estimated using indications of value obtained by management from independent third parties or quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. Committed residential mortgage loans held for sale are valued based on actual commitment prices. Fair value of certain loans held for sale include the value of premiums associated with the sale of the related servicing rights in the instance that a commitment exists for the sale of such servicing at a predetermined rate.
(D) LOANS RECEIVABLE
To estimate fair value of loans held for investment, including commercial loans, mortgages and construction loans, each loan category is segmented by fixed and adjustable rate interest terms, by estimated credit risk, by maturity, and by performing and nonperforming categories.
The fair value of performing loans is estimated by discounting contractual cash flows using the current interest rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Assumptions regarding credit risk, cash flow, and discount rates are judgmentally determined using available market information.
The fair value of nonperforming loans and loans delinquent more than 30 days is estimated by discounting estimated future cash flows using current interest rates with an additional risk adjustment reflecting the individual characteristics of the loans.
(E) INTEREST RECEIVABLE
For interest receivable, the carrying amount is a reasonable estimate of fair value.
(F) MORTGAGE SERVICING RIGHTS
The fair value of mortgage servicing rights is estimated on a loan by loan basis using market prices under comparable servicing sale contracts, when available or, using a cash flow model with current assumptions with respect to prepayments, servicing costs and other significant factors.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE P--FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED) (G) DEPOSIT LIABILITIES
Under SFAS No. 107, the fair value of deposits with no stated maturity, such as noninterest bearing demand deposits, savings and money market accounts, is equal to the amount payable on demand on December 31, 1999 and 1998. The fair value of time deposits, is based on the discounted value of contractual cash flows. The discount rate is based on rates currently offered for deposits of similar size and remaining maturities.
(H) OTHER BORROWINGS AND SUBORDINATED NOTES
The discounted value of contractual cash flows at market interest rates for debt with similar terms and remaining maturities are used to estimate the fair value of existing debt.
(I) COMMITMENTS TO FUND MORTGAGE LOANS
The fair value of commitments to fund fixed-rate mortgage loans represents the estimated gain (loss) to the Company of fully funding its commitments at current interest rates and selling the underlying loans in the secondary market.
(J) COMMITMENTS TO FUND OTHER LOANS
The fair value of commitments to fund other loans represents fees currently charged to enter into similar agreements with similar remaining maturities.
(K) FORWARD CONTRACTS TO SELL MBS
The fair value of forward contracts to sell MBS represents the difference between current rates for similar quantities and delivery dates of mortgage-backed securities as compared to the contractual rates.
The estimated fair values of the Company's financial instruments are as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE Q--COMMITMENTS AND CONTINGENCIES
Certain lawsuits and claims arising in the ordinary course of business have been filed or are pending against the Company or its subsidiaries. Based upon information available to the Company, its review of such lawsuits and claims and consultation with its counsel, the Company believes the liability relating to these actions, if any, would not have a material adverse effect on its consolidated financial statements.
A listing of financial instruments whose contract amounts represent credit risk is as follows:
NOTE R-- CONDENSED FINANCIAL INFORMATION OF REDWOOD EMPIRE BANCORP (PARENT ONLY)
CONDENSED BALANCE SHEETS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
CONDENSED STATEMENTS OF OPERATIONS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
CONDENSED STATEMENTS OF CASH FLOWS
QUARTERLY RESULTS
UNAUDITED QUARTERLY STATEMENTS OF OPERATIONS DATA (dollars in thousands)
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item can be found in Redwood's Definitive Proxy Statement pursuant to Regulation 14A under the Securities Exchange Act of 1934, and is by this reference incorporated herein.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item can be found in Redwood's Definitive Proxy Statement pursuant to Regulation 14A under the Securities Exchange Act of 1934, and is by this reference incorporated herein.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item can be found in Redwood's Definitive Proxy Statement pursuant to Regulation 14A under the Securities Exchange Act of 1934, and is by this reference incorporated herein.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
(a) TRANSACTIONS WITH MANAGEMENT AND OTHERS.
During the year ended December 31, 1999, 1998, and 1997, the Company's operating subsidiary, National Bank of the Redwoods, paid $130,354, $174,577, and $496,557 pursuant to various construction contracts with Colombini Construction in which Colombini Construction acted as a general contractor. Richard Colombini, who is a director of the Company, is also the President and majority owner of Colombini Construction. The amounts paid to Colombini Construction included subcontractor costs. The construction contracts involved leasehold improvements for one of the Bank's branches and two operations centers. Substantially all of the contracts entered into with Colombini Construction were granted based upon competitive bids.
NBR leases 22,000 square feet of an office building for its main office. Prior to June 1997, a partnership of which Richard Colombini is a minority partner, owned the building. Total lease payments made to the partnership for the year ended December 31, 1997 was $440,000.
(b) CERTAIN BUSINESS RELATIONSHIPS.
Except as disclosed elsewhere in this Item, management is not aware of any business relationships required to be disclosed hereunder.
(c) INDEBTEDNESS OF MANAGEMENT.
Some of the Company's directors and executive officers and their immediate families, as well as the companies with which they are associated, are customers of or have had banking transactions with the Company in the ordinary course of the Company's business, and the Company expects to have banking transactions with such persons in the future. In management's opinion, all such loans and commitments to lend were made in the ordinary course of business, in compliance with applicable laws, on substantially the same terms, including interest rates and collateral, as those prevailing for comparable transactions with other persons of similar credit worthiness and, in the opinion of management, did not involve more than a normal risk of collectibility or present other unfavorable features. The Company has a strong policy regarding review of the adequacy and fairness to the Company of loans to its directors and officers. At December 31, 1999, there were no outstanding balances under extensions of credit to directors and executive officers of the Company and companies with which directors are associated.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K.
1. The following consolidated financial statements of Redwood and its subsidiaries, and independent auditors' report included for the years ended December 31, 1999, 1998 and 1997 are included in Item 8.
Independent Auditors' Report Consolidated Financial Statements of Redwood Empire Bancorp
Consolidated Statements of Operations Consolidated Balance Sheets Consolidated Statements of Shareholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements
2. FINANCIAL STATEMENT SCHEDULES.
All financial statement schedules have been omitted, as inapplicable.
3. EXHIBITS.
The following documents are included or incorporated by reference in this Annual Report on Form 10-K.
(b) REPORTS ON FORM 8-K.
On November 3, 1999 the Company filed a Form 8-K reporting third quarter 1999 financial results.
On December 2, 1999 the Company filed a Form 8-K in which it declared an increase of quarterly cash dividend on its Common stock and announced completion of an initial share repurchase and authorization of a new share repurchase.
(c) EXHIBITS.
See Item 14(a)3 and the Index to Exhibits.
(d) EXCLUDED FINANCIAL STATEMENTS
Not applicable.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated.