Item 1. Business.
General
We are Harrington West Financial Group, Inc., a Delaware corporation and a diversified, community-based, financial institution holding company headquartered in Solvang, California, with executive offices in Scottsdale, Arizona. We conduct our operations primarily through our wholly-owned subsidiary, Los Padres Bank, FSB, a federally chartered savings bank, located in central California and Scottsdale, Arizona, and its division in the Kansas City metropolitan area, Harrington Bank. Los Padres Bank provides an array of financial products and services for businesses and retail customers through its sixteen full-service offices. At December 31, 2007, we had consolidated total assets of $1.2 billion, total deposits of $836.3 million and stockholders’ equity of $55.0 million.
We are focused on providing our diversified products and personalized service approach in three distinct markets: (i) the central coast of California, (ii) the Kansas City metropolitan area and (iii) the Phoenix/Scottsdale metropolitan area. Los Padres Bank operates eleven offices on the central coast of California, three offices in the Kansas City metropolitan area under the Harrington Bank brand name, and two banking offices in the Phoenix/Scottsdale, Arizona metropolitan area. In 2006, we opened our third Harrington Bank office in Johnson County, Kansas in the Kansas City metro. HWFG’s controlled banking center development plan remains on track. The Surprise, Arizona banking center is scheduled to open in the Spring of 2008, the Gilbert, Arizona banking center near the end of 2008, and the Dear Valley Airpark, Arizona banking center in the Fall of 2009. This development will bring HWFG’s total banking centers to 5 in metro Phoenix, 11 on the central coast of California and 19 throughout all of HWFG’s markets. HWFG is exploring augmenting these banking centers with the use of existing, shared ATM networks and its existing desktop deposit applications. Each of our markets has its own local independent management team operating under the Los Padres or Harrington names. Our loan underwriting, corporate administration and treasury functions are centralized in Solvang, California to create operating efficiencies. Our commercial lending operations are centralized in Mission, Kansas.
Los Padres Bank is primarily engaged in attracting deposits from individuals and businesses and using these deposits, together with borrowed funds, to originate commercial real estate, commercial business, single-family and multi-family residential and consumer loans. We also generate fee income from the brokering of mortgage loans, deposit services, early prepayments of some loans, and loan originations. We maintain a portfolio of highly liquid mortgage-backed and related securities as a means of managing our excess liquidity and enhancing our profitability. We utilize various interest rate contracts as a means of managing our interest rate risk. We also operate Harrington Wealth Management Company, which provides trust and investment management services to individuals and small institutional clients on a fee basis, by employing a customized
asset allocation approach and investing predominantly in low fee, indexed mutual funds and exchange traded funds.
Lending Activities
General. At December 31, 2007, Los Padres Bank’s net loan portfolio totaled $782.6 million, representing approximately 64.0% of our $1.2 billion of total assets at that date. Los Padres Bank’s primary focus with respect to its lending operations has historically been the direct origination of single-family residential, multi-family residential, consumer and commercial real estate as well as commercial and industrial loans. While we continue to emphasize single-family residential loan products that meet our customer’s needs, we now generally broker such loans on behalf of third party investors in order to generate fee income and have been increasing our emphasis on loans secured by commercial real estate, consumer loans, construction and land acquisition and commercial and industrial loans. We also offer multi-family residential loans. The following table sets forth the composition of our loan portfolio by type of loan at the dates indicated.
(1)
Includes loans secured by residential and commercial properties. At December 31, 2007, we had $49.0 million of construction loans secured by residential properties, $41.1 million of land and development (loans for the initial acquisition of land and off-site improvements) and $36.3 million of construction loans secured by commercial properties.
(2)
Includes loans collateralized by deposit accounts and consumer line of credit loans.
The following table sets forth certain information at December 31, 2007, regarding the dollar amount of loans maturing in our loan portfolio based on the contractual terms to maturity or scheduled amortization, but does not include potential prepayments. Loans having no stated schedule of repayments and no stated maturity are reported as due in one year or less.
(1)
Includes loans secured by residential and commercial properties.
(2)
Includes loans collateralized by deposit accounts and consumer line of credit loans.
Scheduled contractual amortization of loans does not reflect the expected term of our loan portfolio. The average life of loans is substantially less than their contractual terms because of prepayments and due-on-sale clauses, which gives us the right to declare a conventional loan immediately due and payable in the event that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase when current mortgage loan rates are higher than rates on existing mortgage loans and, conversely, decrease when rates on existing mortgage loans are lower than current mortgage loan rates. Under the latter circumstance, the weighted average yield on loans decreases as higher-yielding loans are repaid or refinanced at lower rates.
The following table sets forth the dollar amount of total loans due after one year from December 31, 2007, as shown in the preceding table, which have fixed interest rates or which have floating or adjustable interest rates.
(1)
Includes loans secured by residential and commercial properties.
(2)
Includes loans collateralized by deposit accounts and consumer line of credit loans.
Origination, Purchase and Sale of Loans. The lending activities of Los Padres Bank are subject to the written, non-discriminatory underwriting standards and loan origination procedures established by Los Padres Bank’s board of directors and management. Loan originations are obtained by a variety of sources, including referrals from real estate brokers, builders, existing customers, walk-in customers and advertising. In its present marketing efforts, Los Padres Bank emphasizes its community ties, customized personal service, competitive rates and terms, and its efficient underwriting and approval process. Loan applications are taken by lending personnel, and the loan department supervises the obtainment of credit reports, appraisals and other documentation involved with a loan. Property valuations are performed by independent outside appraisers approved by Los Padres Bank’s board of directors. Los Padres Bank requires title, hazard and, to the extent applicable, flood insurance on all security property.
Mortgage loan applications are initially processed by loan officers who do not have approval authority. All real estate loans which are either at or below the Federal Home Loan Mortgage Corporation’s (“Freddie Mac”), lending limit and which meet all of the bank’s underwriting guidelines can be approved by designated senior management of Los Padres Bank. All consumer loans up to $250 thousand may be approved by designated senior management of Los Padres Bank. All loans in excess of these amounts up to $1.0 million ($500 thousand for commercial and industrial loans) require the approval of two members of Los Padres Bank’s Executive Loan Committee, which consists of designated senior management of Los Padres Bank. Loans in excess of $1.0 million ($500 thousand for commercial and industrial loans), but not exceeding $5.0 million, require the approval of a majority of Los Padres Bank’s Loan Committee, consisting of designated senior management of Los Padres Bank. All loans in excess of $5.0 million, up to Los Padres Bank’s legal lending limit, must be approved by either Los Padres Bank’s Loan Oversight Committee, comprised of both designated senior management and certain members of the Board of Directors, or the Board of Directors of Los Padres Bank.
A savings institution generally may not make loans to any one borrower and related entities in an amount which exceeds 15% of its unimpaired capital and surplus, although loans in an amount equal to an additional 10% of unimpaired capital and surplus may be made to a borrower if the loans are fully secured by
readily marketable securities. At December 31, 2007, Los Padres Bank’s regulatory limit on loans-to-one borrower was $13.8 million.
The risks associated with lending are well defined. Credit risk is managed through the adherence, with few exceptions, to specific underwriting guidelines. We rely on our internal credit approval and administrative process to originate loans as well as our internal asset review process, which oversees our loan quality in order to ensure that our underwriting standards are maintained. We believe that the low level of our non-performing assets is evidence of our adherence to our underwriting guidelines.
As a federally chartered savings bank, Los Padres Bank has general authority to originate and purchase loans secured by real estate located throughout the United States. Despite this nationwide lending authority, we estimate that at December 31, 2007, the majority of the loans in Los Padres Bank’s portfolio are secured by properties located or made to customers residing in each of our primary market areas located in the California central coast, the Kansas City metropolitan area, and the Phoenix/Scottsdale metropolitan area.
Single-Family Residential Real Estate Loans. Los Padres Bank has historically concentrated its lending activities on the origination of loans secured by first mortgage liens on existing single-family residences. The single-family residential loans originated by Los Padres Bank are generally made on terms, conditions and documentation, which permit the sale of such loans to Freddie Mac, the Federal National Mortgage Association (“Fannie Mae”), and other institutional investors in the secondary market. Since January 2001, as a means of generating additional fee income and in order to reflect management’s decision to emphasize holding higher spread earning loans in its portfolio, Los Padres Bank has been brokering conforming permanent single-family residential loans on behalf of third parties in order to generate fee income. During the years ended December 31, 2007 and 2006, Los Padres Bank brokered $27.1 million and $48.5 million, respectively, of such single-family residential loans on behalf of third parties.
Los Padres Bank still holds a portfolio of single-family residential loans. Los Padres Bank will retain in its portfolio single-family residential loans that, due to the nature of the collateral, carry higher risk adjusted spreads. Examples of these types of loans include construction loans that have converted into permanent loans and non-conforming single-family loans, whether as a result of a non-owner occupied or rural property, balloon payment or other exception from agency guidelines. At December 31, 2007, Los Padres Bank had $125.5 million of single-family residential loans in its portfolio, which amounted to 15.9% of total loans receivable as of such date. At December 31, 2007, total loans due after one year had $95.9 million or 76.3% of Los Padres Bank’s single-family residential loans with fixed interest rates and $28.4 million or 23.7% with interest rates which adjust in accordance with a designated index. Single-family residential loans have terms of up to 30 years and generally have loan-to-value ratios of 80% or less, or 90% or less to the extent the borrower carries private mortgage insurance for the balance in excess of the 80% loan-to-value ratio.
Multi-Family Residential and Commercial Real Estate Loans. At December 31, 2007, Los Padres Bank had an aggregate of $82.7 million and $266.3 million invested in multi-family residential and commercial real estate loans, respectively, or 10.5% and 33.6% of total loans receivable, respectively.
Los Padres Bank’s multi-family residential loans are secured by multi-family properties of five units or more, while Los Padres Bank’s commercial real estate loans are secured by industrial, warehouse and self-storage properties, office buildings, office and industrial condominiums, retail space and strip shopping centers, mixed-use commercial properties, mobile home parks, nursing homes, hotels and motels. Substantially all of these properties are located in Los Padres Bank’s primary market areas. Los Padres Bank typically originates commercial real estate and multi-family loans for terms of up to 20 years based upon a 30-year loan amortization period. Los Padres Bank will originate these loans on both a fixed-rate or adjustable-rate basis, with the latter adjusting on a periodic basis of up to one year based on the London Interbank Offered Rate (“LIBOR”), the one-year U.S. Treasury index of constant comparable maturities, a designated prime rate, or the 11th District Cost of Funds Index. Adjustable-rate loans may have an established ceiling and floor, and the maximum loan-to-value for these loan products is generally 75%. As part of the criteria for underwriting
commercial real estate loans, Los Padres Bank generally requires a debt coverage ratio (the ratio of net cash from operations before payment of debt service to debt service) of 1.3:1 or more. It is also Los Padres Bank’s general policy to seek additional protection to mitigate any weaknesses identified in the underwriting process. Additional coverage may be provided through secondary collateral and personal guarantees from the principals of the borrowers.
Commercial real estate lending entails different and significant risks when compared to single-family residential lending because such loans typically involve large loan balances to single borrowers and because the payment experience on such loans is typically dependent on the successful operation of the project or the borrower’s business. In addition, the balloon payment features of these loans may require the borrower to either sell or refinance the underlying property in order to make the payment. These risks can also be significantly affected by supply and demand conditions in the local market for apartments, offices, warehouses or other commercial space. Los Padres Bank attempts to minimize its risk exposure by requiring that the loan does not exceed established loan-to-value and debt coverage ratios, and by monitoring the operation and physical condition of the collateral.
Construction Loans. Los Padres Bank originates loans to finance the construction of single-family and multi-family residences and commercial properties located in its primary market area. At December 31, 2007, Los Padres Bank’s construction loans amounted to $126.4 million or 16.0% of total loans receivable, $49.0 million of which were for the construction of residential properties, $41.1 million of which were for land acquisition and the development of residential properties, and $36.3 million of which were for the construction of commercial properties.
Los Padres Bank primarily provides construction loans to individuals building their primary or secondary residence as well as to local developers with whom Los Padres Bank is familiar and who have a record of successfully completing projects. Residential construction loans to developers generally are made with terms not exceeding two years, have interest rates which are fixed or adjust, with the latter adjusting on a periodic basis of up to one year based upon a designated prime rate or LIBOR, and are generally made with loan-to-value ratios of 80% or less. Residential construction loans to individuals are interest only loans for the term of the construction and then generally convert to a permanent loan. Los Padres Bank’s construction/permanent loans have been successful due to its ability to offer borrowers a single closing and, consequently, reduced costs. Los Padres Bank also offers adjustable-rate loans based on a designated prime rate or other indices with terms of up to two years for the construction of commercial properties. Such loans are generally made at a maximum loan-to-value ratio of 85% of discounted appraised value or less.
Construction lending and acquisition and development lending are generally considered to involve a higher degree of risk of loss than long-term financing on improved, owner-occupied real estate. Risk of loss on construction loans and acquisition and development loans is dependent largely upon the accuracy of the initial appraisal of the property’s projected value at completion of construction as well as the estimated cost, including interest, of construction. During the construction phase, a number of factors could result in delays and cost overruns. If either estimate proves to be inaccurate or the borrower is unable to provide additional funds, the lender may be required to advance funds beyond the amount originally committed to permit completion of the project and/or be confronted at the maturity of the construction loan with a project whose value is insufficient to assure full payment. Los Padres Bank attempts to minimize the foregoing risks primarily by limiting its construction lending to experienced developers and by limiting the total amount of loans to builders for speculative construction projects. It is also Los Padres Bank’s general policy to obtain regular financial statements and tax returns from builders so that it can monitor their financial strength and ability to repay.
Land acquisition and development. Los Padres Bank has decreased its loans for land acquisition and development (loans for the initial acquisition of land and off-site improvements) from $54.7 million at December 31, 2006 to $45.3 million at December 31, 2007. Land acquisition and development loans are typically issued with short terms, bearing adjustable-rates of interest based on a designated prime rate or
LIBOR and are generally made with loan-to-value ratios of 70% or less with secondary credit support in the form of borrower and investor guarantees.
Commercial and Industrial Loans. Los Padres Bank is placing increased emphasis on the origination of commercial business loans because of the higher risk-adjusted spreads generally associated with these types of loans. At December 31, 2007, Los Padres Bank’s commercial and industrial loans amounted to $117.8 million or 14.9% of total loans receivable.
The commercial and industrial loans that Los Padres Bank is originating include lines of credit, term loans and letters of credit. These loans are typically secured by collateral and are used for general business purposes, including working capital financing, equipment financing, capital investment and general investment. Depending on the collateral pledged to secure the extension of credit, maximum loan-to-value ratios are 80% or less. Loan terms generally vary from one to seven years. The interest rates on such loans are generally variable and are indexed to the Wall Street Journal Prime Rate, plus a margin. Commercial and industrial loans typically have shorter maturity terms and higher interest spreads than mortgage loans, but generally involve more credit risk than mortgage loans because of the type and nature of the collateral. Los Padres Bank’s business customers are typically small to medium sized, privately-held companies with local or regional businesses that operate in Los Padres Bank’s primary markets.
Consumer and Other Loans. Los Padres Bank is authorized to make loans for a wide variety of personal or consumer purposes. Los Padres Bank has been originating consumer loans in recent years in order to provide a wider range of financial services to its customers and because such loans generally carry higher interest rates than mortgage loans. The consumer and other loans offered by Los Padres Bank include home equity lines of credit, home improvement loans, vehicle loans, secured and unsecured personal lines of credit and deposit account secured loans. At December 31, 2007, $27.2 million or 3.4% of Los Padres Bank’s total loans receivable consisted of consumer loans.
Home equity lines of credit are originated by Los Padres Bank for up to 90% of the appraised value, less the amount of any existing prior liens on the property. Los Padres Bank also offers home improvement loans in amounts up to 80% of the appraised value, less the amount of any existing prior liens on the property. Home improvement loans have a maximum term of 15 years and carry fixed or adjustable interest rates. Home equity lines of credit have a maximum repayment term of 15 years and carry interest rates that adjust monthly in accordance with a designated prime rate. Los Padres Bank will secure each of these types of loans with a mortgage on the property, generally a second mortgage, and may originate the loan even if another institution holds the first mortgage. At December 31, 2007, home equity lines of credit and home improvement loans totaled $23.7 million or 88.0% of Los Padres Bank’s total consumer loan portfolio and an aggregate of $46.0 million were committed and un-drawn under these loans and lines of credit.
Los Padres Bank currently offers loans secured by deposit accounts, which amounted to $992.6 thousand or 3.7% of Los Padres Bank’s total consumer and other loan portfolio at December 31, 2007. Such loans are originated for up to 90% of the deposit account balance, with a hold placed on the account restricting the withdrawal of the account balance.
At December 31, 2007, vehicle loans, secured and unsecured personal line of credit loans amounted to $1.1 million or 4.0% of Los Padres Bank’s total consumer and other loan portfolio.
Consumer loans generally have shorter terms and higher interest rates than mortgage loans but generally involve more credit risk than mortgage loans because of the type and nature of the collateral. In addition, consumer lending collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness and personal bankruptcy. Los Padres Bank believes that the generally higher yields earned on consumer loans compensate for the increased credit risk associated with such loans and Los Padres Bank intends to continue to offer consumer loans in order to provide a full range of services to its customers.
Asset Quality
General. Los Padres Bank’s Internal Asset Review Committee and the Internal Asset Oversight Committee, consisting of Los Padres Bank’s senior executive officers and certain members of the Board of Directors, monitors the credit quality of Los Padres Bank’s assets, reviews classified and other identified loans and determines the proper level of reserves to allocate against Los Padres Bank’s loan portfolio, in each case subject to guidelines approved by Los Padres Bank’s board of directors.
Loan Delinquencies. When a borrower fails to make a required payment on a loan, Los Padres Bank attempts to cure the deficiency by contacting the borrower and seeking payment. Contacts are generally made following the sixteenth day after a payment is due, at which time a late payment is assessed. In most cases, deficiencies are cured promptly. If a delinquency extends beyond 16 days, the loan and payment history is reviewed and efforts are made to collect the payment. While Los Padres Bank generally prefers to work with borrowers to resolve such problems, when the account becomes 45 days delinquent, Los Padres Bank will institute foreclosure by issuing a Notice of Intent to Foreclose or other proceedings, as necessary, to minimize any potential loss. After 75 days and the loan is not brought current or no workout agreement has been initiated, a Notice of Default is recorded.
Non-Performing Assets. Los Padres Bank will place loans on non-accrual status when, in the judgment of management, the probability of collection of interest is deemed to be insufficient to warrant further accrual. When such a loan is placed on non-accrual status, previously accrued but unpaid interest is deducted from interest income. Los Padres Bank generally does not accrue interest on loans past due 60 days or more.
Non-performing loans are defined as non-accrual loans 90 days past due. Non-performing assets are defined as non-performing loans and real estate acquired by foreclosure or deed-in-lieu thereof. Troubled debt restructurings are defined as loans which Los Padres Bank has agreed to modify by accepting below market terms either by granting interest rate concessions or by deferring principal and/or interest payments. The following table sets forth the amounts and categories of our non-performing assets and troubled debt restructurings at the dates indicated.
At December 31, 2007, and 2006, we had one, and two non-performing loans, respectively. At December 31, 2007, we had non-performing loans representing an increase of $1.7 million from December 31, 2006. Refer to “Changes in Financial Condition”, pg 62 for additional information.
The interest income that would have been recorded during the years ended December 31, 2007, and 2006 if Los Padres Bank’s non-accruing loans at the end of such periods had been current in accordance with their terms during such periods is $178.2 thousand, and $6.8 thousand, respectively. The interest income that was recorded during the years ended December 31, 2007, and 2006 with respect to Los Padres Bank’s non-accruing loans was $140.6 thousand and $4.0 thousand, respectively.
Classified Assets. Federal regulations require that each insured savings institution classify its assets on a regular basis. In addition, in connection with examinations of insured institutions, federal examiners have authority to identify problem assets and, if appropriate, classify them. Los Padres Bank has established three classifications for potential problem assets: “substandard,” “doubtful” and “loss.” Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified as loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. Los Padres Bank has established another category, designated “special mention,” for assets that do not currently expose Los Padres Bank to a sufficient degree of risk to warrant classification as substandard, doubtful or loss. Assets classified as substandard or doubtful require Los Padres
Bank to establish allowances for loan losses based on the methodology described below. If an asset or portion thereof is classified as loss, the insured institution must either establish specific allowances for loan losses in the amount of 100% of the portion of the asset classified loss, or charge-off such amount. At December 31, 2007, Los Padres Bank had $6.8 million of classified loans, $6.4 million of which was classified as substandard and $467 thousand was classified as doubtful or loss. As of December 31, 2007, Los Padres Bank had $35.0 million of loans that were designated special mention. At December 31, 2006, Los Padres Bank had $1.4 million of classified loans, $1.3 million of which was classified as substandard and $98 thousand were classified as doubtful or loss. As of December 31, 2006, Los Padres Bank had $12.1 million of loans that were designated special mention. Our classified and special mention loans, in addition to the non-performing loans discussed above, are the extent of the loans in our portfolio that give us some repayment concern at this time.
Allowance for Loan Losses. The allowance for loan losses reflects management’s judgment of the level of allowance adequate to provide for probable incurred losses inherent in the loan portfolio as of the balance sheet date. On a quarterly basis, Los Padres Bank assesses the overall adequacy of the allowance for loan losses, utilizing a consistent and systematic approach which includes the application of an allocated allowance for specifically identified problem loans, a formula allowance for non-homogeneous loans, a formula allowance for large groups of smaller balance homogeneous loans and an unallocated allowance.
Allocated allowance for specifically identified problem loans. A specific reserve is established for impaired loans in accordance with SFAS No. 114, Accounting by Creditors for Impairment of a Loan as amended by SFAS No. 118. A loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. The specific reserve is determined based on the present value of expected future cash flows discounted at the loan’s effective interest rate, except that as a practical expedient, we may measure impairment based on a loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent.
Formula allowance for non-homogeneous loans. Los Padres Bank segments its non-homogeneous loan portfolio into pools with similar characteristics based on loan type (collateral driven) and risk factor (loan grade). Currently, these loans are segmented into four categories by collateral, further stratified by loan grade (pass, special mention, substandard, and doubtful). The general pool categories are multi-family residential, commercial real estate, land acquisition and development, and commercial and industrial. These non-homogeneous loans are reviewed individually.
The formula allowance is calculated by applying adjusted loss rates to these pools. Pool loss rates are established by examining historical charge-off data for groups of loans and adjusting them for a variety of qualitative factors deemed appropriate by management. The analysis of historical loss data in determining the initial loss rates is based on an average ten-year period. Where Los Padres Bank has no or nominal actual charge-off data for certain loan types, industry data and management’s judgment is utilized as representative starting loss rates.
Formula allowance for large groups of smaller balance homogeneous loans. The allocated loan loss allowance for large groups of smaller balance homogeneous loans is focused on loss experience for the pool rather than on an analysis of individual loans. Large groups of smaller balance homogeneous loans consist of consumer loans and single-family residential loans. The allowance for groups of performing loans is based on historical losses over a ten year period.
Unallocated Allowance. The unallocated allowance contains amounts that are based on management’s evaluation of conditions that are not directly measured in the determination of the formula and specific allowances. The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they are not identified with specific problem credits or portfolio segments. The
conditions evaluated in connection with the unallocated allowance include the following, which existed at the balance sheet date:
•
trends in criticized and non-accrual assets;
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the levels and trends in charge-offs, recovery history and loan restructuring;
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changes in volumes and terms of the loan portfolio;
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any credit concentrations or changes in the level of such concentrations;
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changes in the effectiveness of the internal asset review process;
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changes in lending policies, procedures and practices;
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changes in the experience, ability and depth of lending management;
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changes in the national, regional and local economic conditions;
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changes in value of underlying collateral for collateral-dependent loans; and
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the trend in local real estate values.
Management and the Internal Asset Review Committee review these conditions quarterly in discussion with our senior credit officers. To the extent that any of these conditions is evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management’s estimate of the effect of such condition may be reflected as a specific allowance, applicable to such credit or portfolio segment. Where any of these conditions is not evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management’s evaluation of the probable loss related to such condition is reflected in the unallocated allowance which varies from plus or minus 5% of the total allowance for loan losses.
The allowance for loan losses is based upon estimates of probable incurred losses inherent in the loan portfolio. The actual losses can vary from the estimated amounts. Our methodology includes several features that are intended to reduce the differences between estimated and actual losses. The loss migration model that is used to establish the loan loss factors is designed to be self-correcting by taking into account our loss experience over prescribed periods. Similarly, by basing the loan loss factors over a period reflective of two business cycles, the methodology is designed to take our recent loss experience for consumer and commercial and industrial loans into account. Furthermore, based on management’s judgment, our methodology permits adjustments to any loss factor used in the computation of the formula allowance for significant factors, which affect the collectibility of the portfolio as of the evaluation date, but are not reflected in the loss factors. By assessing the probable estimated losses inherent in the loan portfolio on a quarterly basis, we are able to adjust specific and inherent loss estimates based upon the most recent information that has become available.
Although our management believes it uses the best information available to establish the level of the allowance, there can be no assurance that additions to such allowance will not be necessary in future periods. Furthermore, various regulatory agencies, as an integral part of their examination process, periodically review our valuation allowance. These agencies may require us to increase the allowance, based on their judgments of the information available to them at the time of the examination.
The following table is an allocation of our allowance for loan losses as of the dates presented:
At December 31, 2007, the formula allowance for non-homogeneous loan allowance increased by $6 thousand from December 31, 2006, primarily due to an increase in total non-homogeneous loans and, offset to a lesser extent, by a decrease in criticized loans related to non-homogeneous loans.
The formula allowance for homogeneous loans increased by $144 thousand for the year ended 2007, as a result of increasing single-family construction loan balances. Los Padres Bank shifted its strategic focus away from originating single-family loans for its portfolio and has opted to originate such loans on a brokered basis due to high competition and the resulting low risk-adjusted spreads.
Specific reserves are established for impaired loans in accordance with SFAS No. 114. At December 31, 2007, we had $440 thousand in allocated reserves. In 2006, we had $16 thousand in allocated reserves.
The following table sets forth the activity in our allowance for loan losses for the periods indicated.
The following table sets forth information concerning the allocation of our allowance for loan losses by loan category at the dates indicated
(1)
Percent of loans in each category to total loans
Investment Activities
General. Our securities portfolio is managed under the direction of our Chief Executive Officer and Chief Investment Officer in accordance with a comprehensive written investment policy which addresses strategies, types and levels of allowable investments which are reviewed and approved by Los Padres Bank’s board of directors. The management of the securities portfolio is set in accordance with strategies developed by Los Padres Bank’s Asset and Liability Committee (“ALCO”) and approved by its Board of Directors. On February 27, 2007, we announced the hiring of John R. Mason as Chief Investment Officer. Mr. Mason has over twenty years experience in the investment and risk management fields. We have completed the process of bringing all of the risk and investment management operations in-house with a marginal cost savings versus our Portfolio and Rate Risk Analysis Agreement with Smith Breeden Associates, Inc., which terminated on April 30, 2007. Los Padres Bank’s Chief Executive Officer and Chief Investment Officer, have the primary responsibility for managing the investment portfolio in accordance with the policy and ALCO approved strategies. These responsibilities include informing ALCO of the types of investments available, the status and performance of the portfolio and current market conditions. Designated officers of Los Padres Bank are authorized to: purchase or sell eligible investments under repurchase or reverse repurchase agreements; execute hedging strategies approved by the ALCO; pledge securities owned as collateral for public agency deposits or repurchase accounts or agreements; and lend securities to approved dealers in government securities or approved commercial banks. The Chief Executive Officer, the Chief Investment Officer, the President, the Chief Financial Officer or the Controller of Los Padres Bank has the authority to purchase or sell designated instruments up to $5.0 million in any one transaction and, acting together, any two members of the ALCO have authority to purchase or sell securities of between $5.0 million and $30.0 million in any one transaction. For purchases or sales greater than $30.0 million, the prior approval of a majority of the ALCO is required. Designated officers are also authorized to invest excess liquidity in approved liquid investment vehicles. In addition, the Board of Directors of Los Padres Bank ratifies all securities purchased and sold by Los Padres Bank.
We invest in a portfolio of mortgage-backed and related securities, interest rate contracts, U.S. Government agency securities, government sponsored enterprises, asset-backed securities, corporate securities and, to a much lesser extent, equity securities. In selecting securities for our portfolio, we employ an option-adjusted pricing analysis and credit related analysis in order to ascertain the net risk-adjusted spread expected to be earned with respect to the various investment alternatives. The nature of this analysis is to quantify the costs embedded in the yield of an investment, such as the duration-matched funding cost, the costs of the options embedded in the investment’s cash flow (such as a borrower’s ability to prepay a mortgage) and servicing costs. The objective of our investment management process is to select investments with the greatest net spreads and actively manage the underlying risks of these investments.
We manage our securities portfolio in order to enhance net interest income and net market value on a risk-adjusted basis and deploy excess capital until we can reinvest such assets into loans or other community banking assets. As a result, we monitor the net risk-adjusted spread of our investments and compare them with the spreads available with respect to other securities in the market. Accordingly, as market conditions fluctuate (e.g., as risk-adjusted spreads narrow), we may sell individual securities prior to their maturity and reinvest the proceeds into new investments, which generally carry wider risk-adjusted spreads. We will utilize various interest rate contracts such as interest rate swaps, caps, floors, options and futures in order to mitigate our interest rate exposure in our securities portfolio, which allows us to respond to changing prepayment rates on our mortgage-backed and related securities. The investment portfolio, although hedged for interest rate risk, is still susceptible to adverse changes in the spreads between the yields on mortgage-backed and related securities and the related Treasury and LIBOR based hedges. Substantially all of our securities are classified as available for sale securities and, pursuant to SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, are reported at fair value with unrealized gains and losses included in stockholders’ equity.
Mortgage-Backed and Related Securities. At December 31, 2007, our mortgage-backed and related securities including pass-through mortgage-backed securities, collateral mortgage obligations and mortgage
related asset-backed securities classified as available for sale and held to maturity amounted to $349.8 million or 98.9% of our securities portfolio and 28.6% of our total assets. By investing in mortgage-backed and related securities, our management seeks to achieve a targeted option-adjusted spread over applicable funding costs.
We invest in mortgage-backed and related securities, including mortgage participation certificates, which are insured or guaranteed by U.S. Government agencies and government sponsored enterprises or by private issuers who are rated based on the underlying collateral and priority of cash flows, and investment grade collateralized mortgage obligations (“CMOs”) and real estate mortgage investment conduits (“REMICs”). Mortgage-backed securities, which also are known as mortgage participation certificates or pass-through certificates, represent a participation interest in a pool of single-family mortgages. The principal and interest payments on these securities are passed from the mortgage originators, through intermediaries, generally U.S. Government agencies and government sponsored enterprises, that pool and repackage the participation interests in the form of securities, to investors such as us. Such U.S. Government agencies and government-sponsored enterprises, which guarantee the payment of principal and interest to investors, primarily include Freddie Mac, Fannie Mae and the Government National Mortgage Association (“Ginnie Mae”).
Mortgage-backed securities typically are issued with stated principal amounts, and are backed by pools of mortgages that have loans with interest rates that are within a range and have varying maturities. The characteristics of the underlying pool of mortgages, i.e., fixed-rate or adjustable-rate, as well as prepayment risk, are passed on to the certificate holder. The term of a mortgage-backed pass-through security thus approximates the terms of the underlying mortgages.
Our mortgage-backed and related securities, including CMO’s, include securities issued by entities which have qualified under the Internal Revenue Code of 1986, as amended (the “Code”) as REMICs. CMOs and REMICs, referred to in this document as CMOs, were developed in response to investor concerns regarding the uncertainty of cash flows associated with the prepayment option of the underlying mortgagor and are typically issued by governmental agencies, government sponsored enterprises and special purpose entities, such as trusts, corporations or partnerships, established by financial institutions or other similar institutions. In contrast to pass-through mortgage-backed securities, in which cash flow is received pro rata by all security holders, the cash flow from the mortgages underlying a CMO is segmented and paid in accordance with a predetermined priority to investors holding various CMO classes. By allocating the principal and interest cash flows from the underlying collateral among the separate CMO classes, different classes of bonds are created, each with its own stated maturity, estimated average life, coupon rate and prepayment characteristics.
Asset Backed Securities. The U.S. residential mortgage market is estimated to be in excess of $10 trillion in outstanding principal amount. The sub-prime portion of this market is approximately 12% of the total or $1.2 trillion. Sub-prime mortgage loans are generally considered the lowest credit segment in the mortgage market as the borrowers have low credit scores (FICO scores under 660). HWFG is not a program originator of sub-prime loans but does invest in investment grade sub-prime securities, largely rated AAA or AA by one or more rating agency, in a portion of its investment portfolio when HWFG’s analysis indicates the spreads and return potential of these securities are high relative to the underlying risk.
Few sub-prime mortgages are held by the entities that originated them. Most of these mortgages are pooled and securitized into a trust structure. The trust will then issue bonds to finance the sub-prime mortgages, and these mortgages and related securities will be serviced by a third party. The securities issued typically consist of senior and subordinate bonds, or tranches, and a small equity piece referred to as over-collateralization (OC). OC is the amount by which the assets owned by the trust exceed the liabilities (the sub-prime securities) issued. Senior bonds are typically rated AAA and have payment priority over the subordinate tranches. The subordinate tranches are typically issued with ratings from AA
down to BB. A subordinate security with a higher credit rating has payment priority over those with lower ratings in the event of credit loss. The credit performance of these securities vary widely based on the year of origination, the underwriting standards, the servicer’s expertise and the loan to value of the underlying loans. The sub-prime market is therefore very fragmented, allowing for excess returns through favorable analysis and selection of securities.
In order for the securities, or tranches, issued by the mortgage trust to attain high ratings, the rating agencies require certain levels of protection in the form of OC and subordination. Collectively these are referred to as credit enhancement. The amount of credit enhancement required is based on the characteristics of the loans in the trust. These characteristics are used by rating agencies to project the likelihood of future defaults and losses on the collateral. For the lowest rated tranche, this support will generally be limited to the OC. To increase the rating of the security to AAA, however, further protection in the form of subordination covers expected losses by many times. For example, credit enhancement of 20% or greater in many AA and AAA securities is made up of 4% OC and 16% subordination from the tranches junior to these securities in payment priority in the event of loss.
Based on the extremely poor performance of sub-prime loans originated between late 2005 and early 2007, it appears that rating agencies’ models were inaccurate in their projections of delinquencies and defaults and perhaps relied too heavily on historical performance, which focused on a very low mortgage rate and very high home price appreciation environment. As a result, the “sizing” of the required credit enhancement for a given rating appears too small based on recent performance of sub-prime mortgages originated in this period. Over the course of 2007, rating agencies have revised downward their original ratings on hundreds of sub-prime mortgage securities which were issued during the 2005-2007 time period.
A significant portion of the sub-prime write-downs incurred by larger financial institutions and investment banks in 2007 have been on Collateralized Debt Obligations (CDO) with largely BBB and BBB- sub-prime securities as the collateral for these CDOs. These BBB securities were then tranched to provide the higher rated CDO securities priority on the cash flows of these BBB securities. However, with the large delinquencies of the underlying sub-prime loans issued in the 2005 to 2007 period and the very low subordination of the BBB securities, a leveraging of credit risk occurred and even some AAA rated CDO securities have incurred write-downs. HWFG has not invested in sub-prime CDO’s.
HWFG does not rely solely on the rating agencies’ analysis and ratings of sub-prime securities. Management performs its own independent analysis of the expected cash flows for more extreme delinquency, default, and estimates of losses incurred in the foreclosure and sale process to determine whether credit enhancement is sufficient for the spread to be earned relative to the risk of default. HWFG also reviews the nature of the issuers and their underwriting performance as well as the capabilities and performance of the servicers of the underlying loans and securities.
In 2007, as delinquency and loss factors increased significantly and ratings were adjusted by the agencies on the sub-prime securities, spreads on almost all mortgage loan and related securities widened precipitously as credit conditions deteriorated and a sharp re-pricing of credit risk developed on almost all fixed income credit classes. Historically, periods of extreme market stress present excellent opportunities for HWFG to add high quality securities at wide risk-adjusted spreads.
On an ongoing basis HWFG monitors and evaluates the credit ratings and performance of its entire portfolio of mortgage related securities. HWFG performs stress testing of the cash flows on lower rated securities by projecting higher levels of delinquency, default, and losses on underlying foreclosed loans. During the third quarter evaluation, it was determined that a small portion of the sub-prime portfolio (1.4% of book value) had become impaired, which relies on the spread between the sub-prime
loans and issued securities plus prepayment penalty fees rather than the principal and interest of the loans like almost all of HWFG’s other sub-prime securities. That is, all $2.4 million book value of non-insured, NIM sub-prime securities were deemed other than temporarily impaired, and these securities were written down by $2.1 million to market value through earnings in 2007. The NIM securities were purchased on average approximately 20 months ago, have paid down approximately 79% of the original principal amount, and were originally investment-grade rated. Several factors are evaluated in management’s stress-testing and conclusions. These factors include a dramatic increase in the level of delinquencies, losses on the liquidation of collateral, declines in over-collateralization amounts and ratings downgrades on some of the securities. Based on its ongoing monitoring, HWFG expects to earn all interest and principal on its other available for sale mortgage investment securities; however, a more severe deterioration of the housing and credit markets, beyond stress test levels, could lead to additional write-offs.
Like most fixed-income securities, mortgage-backed and related securities are subject to interest rate risk. Unlike most fixed-income securities, however, the mortgage loans underlying a mortgage-backed or related security generally may be prepaid at any time without penalty. The ability to prepay a mortgage loan generally results in significantly increased price and yield volatility, with respect to mortgage-backed and related securities, than is the case with non-callable fixed income securities. Furthermore, mortgage-backed securities often are more sensitive to changes in interest rates and prepayments than traditional mortgage-backed securities and are, therefore, even more volatile. Nevertheless, we attempt to guard against both interest rate and prepayment risk. No assurance can be made, however, that these instruments will be effective.
Although mortgage-backed and related securities often carry lower yields than traditional mortgage loans, these securities generally increase the quality of our assets by virtue of the securities’ underlying insurance or guarantees or collateral support. These securities also require less capital under risk-based regulatory capital requirements than non-insured or non-guaranteed mortgage loans, are more liquid than individual mortgage loans, which enhances our ability to actively manage our portfolio, and may be used to collateralize borrowings or other obligations. At December 31, 2007, $300.6 million or 85.6% of our mortgage-backed and related securities were pledged to secure various obligations (such as Federal Home Loan Bank (“FHLB”) advances, repurchase agreements and collateral for interest rate swaps). In addition, as a result of our maintaining a substantial portion of our assets in mortgage-backed and related securities, we have been able to maintain a relatively low level of operating expenses.
At December 31, 2007, the contractual maturity of substantially all of our mortgage-backed or related securities was in excess of 10 years. The actual maturity of a mortgage-backed or related security may be less than its stated maturity due to prepayments of the underlying mortgages. Prepayments that are faster than anticipated may shorten the life of the security and affect its yield to maturity. The yield to maturity is based upon the interest income and the amortization of any premium or discount related to the security. In accordance with generally accepted accounting principles, premiums and discounts are amortized over the contractual life of the loans, which decrease and increase interest income, respectively. The prepayment assumptions used to determine the amortization period of premiums and discounts can significantly affect the yield of the mortgage-backed or related security, and these assumptions are reviewed periodically to reflect actual prepayments. Although prepayments of underlying mortgages depends on many factors, including the type of mortgages, the coupon rate, the age of mortgages, the geographical location of the underlying real estate collateralizing the mortgages and general levels of market interest rates, the difference between the interest rates on the underlying mortgages and the prevailing mortgage interest rates generally is the most significant determinant of the rate of prepayments. During periods of falling mortgage interest rates, if the coupon rate of the underlying mortgages exceeds the prevailing market interest rates offered for mortgage loans, refinancing generally increases and accelerates the prepayment of the underlying mortgages and the related security.
In the past we also invested in investment grade commercial mortgage backed securities (“CMBS”), which are securities collateralized by mortgage loans secured by industrial, office, warehouse, retail space strip shopping centers, motels and other commercial related real estate. The cash flows from these mortgages are normally paid in a predetermined priority to investors holding the various classes of securities. The mortgage loans underlying these securities typically have a prepayment lockout for a period of five to ten years and, as such, have less prepayment risk than single-family mortgage securities. At December 31, 2007, we held no commercial mortgage-backed securities but held $31.1 million commercial mortgage-backed securities at December 31, 2006. We are invested in total rate of return swaps with the underlying securities being AAA rated CMBS at December 31, 2007.
At December 31, 2007, of the $351.5 million of the available for sale and held to maturity securities held by us, an aggregate of $54.7 million was secured by fixed-rate mortgage loans and an aggregate of $296.8 million was secured by adjustable-rate mortgage loans.
Corporate Debt Securities. We plan, from time to time, to invest in corporate investment grade notes and bonds that are general obligations of the issuing company or backed by specific equipment or other collateral of the issuing company. These securities are rated by the major rating agencies based on the financial strength of the issuing company, priority in the debt structure of the company, and the underlying security, if any. At December 31, 2006 and 2007, we held no corporate debt securities.
Trading Account Assets and Other Securities. At December 31, 2007, we held a variety of assets classified as trading securities pursuant to SFAS No. 115, including mortgage-backed securities that had a fair value of $194 thousand, and equity securities (consisting of mutual funds invested in a variety of corporate fixed income and equity securities) with a fair value of $656 thousand.
As of December 31, 2006 there were no outstanding total return swaps. We invested in total rate of return (TROR) swaps in our trading portfolio that during the year had a maximum notional amount of $80 million (which was the notional amount at year-end) to capitalize on the widening spreads in the latter half of 2007. With regard to the CMBS total return swaps, we receive the net spread between the yield on certain investment grade CMBS indexes, such as the Lehman Brothers AAA CMBS Index, and the duration matched LIBOR yield (less a spread) plus any market value changes due to the spread changing between the index and the duration matched LIBOR yield. As spreads tighten, gains are realized, and as they widen, losses are realized. The purpose of these total return swaps is to create incremental income for Los Padres Bank.
The total return for our CMBS TROR swaps in 2007 was a loss of $2.5 million, which consisted of $340 thousand of net interest income and a realized and unrealized mark-to-market loss of $2.8 million. In 2006, the total return for our CMBS TROR swaps was a gain of $1.2 million, which consisted of $301 thousand of net interest income and a realized and unrealized mark-to-market gain of $947 thousand. Also see “Note 22 to the Consolidated Financial Statement” or “Subsequent Events” for additional information.
All securities held do not have a single maturity date. The following table presents certain information regarding the composition and period to maturity of our securities classified as available for sale as of the dates indicated below.
The following table presents certain information regarding the composition and period to maturity of our securities classified as held to maturity as of the dates indicated below.
(1)
Consists entirely of Fannie Mae participation certificates.
The following table presents certain information regarding the composition of our trading account assets as of the dates indicated below.
The following table sets forth the fair value of our securities activities with respect to our securities classified as available for sale and held to maturity for the periods indicated.
Sources of Funds
General. We consider various sources of funds to fund our investing and lending activities and we evaluate the available sources of funds in order to reduce our overall funding costs. Retail commercial deposits, California State certificate of deposits, reverse repurchase agreements, advances from the FHLB of San Francisco, notes payable, and sales, maturities and principal repayments on loans and securities have been the major sources of funds for use in our lending and investing activities, and for other general business purposes. We closely monitor rates and terms of competing sources of funds on a daily basis and utilize the source that we believe to be cost effective.
Deposits. Los Padres Bank attempts to price its deposits in order to promote deposit growth and offers a wide array of deposit products in order to satisfy our business and retail customers’ needs. Los Padres Bank’s current deposit products include passbook accounts, negotiable order of withdrawal (“NOW”) and demand deposit accounts, money market deposit accounts, fixed-rate, fixed-maturity retail certificates of deposit ranging in terms from one month to five years and individual retirement accounts.
Los Padres Bank’s retail deposits are generally obtained from residents in each of its primary market areas. Los Padres Bank opened its third banking office in the Kansas City metro area in the third quarter of 2006, and plans to open an office in Surprise, Arizona in April of 2008 and in Gilbert, Arizona anticipated early in 2009. The principal methods currently used by Los Padres Bank to attract deposit accounts include offering a variety of products and services, and competitive interest rates. Los Padres Bank utilizes traditional marketing methods to attract new customers and savings deposits, including various forms of advertising.
The following table sets forth the maturities of Los Padres Bank’s certificates of deposit having principal amounts of $100,000 or more at December 31, 2007.
The following table sets forth by various interest rate categories the certificates of deposit with Los Padres Bank at the dates indicated.
The following table sets forth the amount and remaining maturities of Los Padres Bank’s certificates of deposit at December 31, 2007.
Borrowings. We obtain both long-term fixed-rate and short-term variable-rate advances from the FHLB of San Francisco upon the security of certain of our residential first mortgage loans and other assets, provided certain standards related to creditworthiness of Los Padres Bank have been met. FHLB of San Francisco advances are available for general business purposes to expand lending and investing activities. Borrowings have generally been used to fund the purchase of mortgage-backed and related securities and lending activities and have been collateralized with a pledge of loans, securities in our portfolio or any mortgage-backed or related securities purchased. Advances from the FHLB of San Francisco are made pursuant to several different credit programs, each of which has its own interest rate and range of maturities. At December 31, 2007, we had three advances from the FHLB of San Francisco, which mature between January 2008 and June 2010. At December 31, 2007, we had total FHLB of San Francisco advances of $247.0 million at a weighted average coupon of 4.50%. Our borrowings from the FHLB of San Francisco are limited to 35% of Los Padres Bank’s total assets, or $427.7 million at December 2007 and $403.5 million at December 31, 2006.
During 2007 and 2006, we obtained funds from the sales of securities to investment dealers under agreements to repurchase, known as reverse repurchase agreements. In a reverse repurchase agreement transaction, we will generally sell a mortgage-backed security agreeing to repurchase either the same or a
substantially identical security on a specific later date. The difference between the sale and the purchase price (referred to as the “drop”) together with the foregone coupon interest represents the cost of the financing transaction. The mortgage-backed securities underlying the agreements are delivered to the dealers who arrange the transaction. For agreements in which we have agreed to repurchase substantially identical securities, the dealers may sell, loan or otherwise dispose of our securities in the normal course of their operations; however, such dealers or third party custodians safe-keep the securities which are to be specifically repurchased by us. In this type of transaction, we are subject to the risk that the lender may default at maturity and not return the collateral. The amount at risk is the value of the collateral, which exceeds the balance of the borrowing. In order to minimize this potential risk, we only deal with large, established dealers when entering into these transactions. Reverse repurchase transactions are accounted for as financing arrangements rather than as sales of such securities, and the obligation to repurchase such securities is reflected as a liability in our consolidated financial statements. At December 31, 2007, we had three reverse repurchase agreements with Citigroup Financial Services totaling $45.0 million with a weighted average coupon of 3.11%, maturities ranging from May 2008 to July 2010 and secured by GNMA Arm’s with a fair value of $44.7 million. At December 31, 2006, we had four repurchase agreements with Citigroup Financial Services totaling $59.0 million with a weighted average coupon of 2.96% and maturities ranging from April 2007 to July 2010.
Through September 30, 2007 and December 31, 2006, the Company had a loan facility from two banks consisting of a revolving line of credit of $15.0 million. There were no draws on the line of credit during 2007 or 2006. The lines of credit matured on September 30, 2007 and were not renewed.
On September 27, 2004, we completed a $10.3 million capital trust offering with a newly formed trust, Harrington West Capital Trust II, in a private transaction. The capital trust securities bear an interest rate of three-month LIBOR plus 1.90% and will mature on October 7, 2034 and have a five-year call feature. We used a portion of the proceeds to downstream capital to Los Padres Bank for the continued expansion of its operations.
On September 25, 2003, we completed a $15.5 million capital trust offering. The capital securities were issued through a newly formed trust, Harrington West Capital Trust I, in a private transaction. The capital trust securities bear an interest rate of three-month LIBOR plus 2.85% and will mature on October 8, 2033 and have a five-year call feature. We used $11.3 million to pay off the secured line of credit with Harris Trust and Savings Bank and US Bank, N.A. The remaining proceeds were used to expand the Los Padres Bank operations in Overland Park, Kansas, Ventura, California and Scottsdale, Arizona.
The following table sets forth certain information regarding our short-term borrowings that mature in one year or less at or for the dates indicated.
Subsidiaries
Our primary subsidiary is Los Padres Bank. We were formed for the purpose of acquiring Los Padres Bank, and we completed the acquisition in 1996. Los Padres Bank is a wholly-owned subsidiary.
In February 1999, we purchased a 49% interest in Harrington Wealth Management Company, (“HWMC”) which provides trust and investment management services to individuals and small institutional clients for fee income. In November 2001, we purchased the remaining 51% interest in HWMC. HWMC performs management of investment portfolios through knowledge and analysis of the customer’s investment needs, risk tolerance, tax situation and investment horizon. At December 31, 2007, HWM administered approximately 493 accounts and had $184.4 million of assets under management that are not included on our balance sheet. For the years ended December 31, 2007, and 2006, HWM generated revenues of $964,000, and $848,000, respectively. HWM is a wholly owned subsidiary of Los Padres Bank.
Valley Oaks Financial Corporation was formed as a wholly owned service corporation of Los Padres Bank in 1983 and serves as the title-holder with respect to the mortgages we originate.
Harrington West Capital Trust I was formed as an unconsolidated subsidiary of Harrington West Financial Group in 2003 and was created in conjunction with the $15.5 million capital trust offering.
Harrington West Capital Trust II was formed as an unconsolidated subsidiary of Harrington West Financial Group in 2004 and was created in conjunction with the $10.3 million capital trust offering.
Employees
As of December 31, 2007, we had 198 full-time equivalent employees. Our employees are not subject to any collective bargaining agreements, and we believe that our relationship with our employees is satisfactory.
Regulation of Harrington West Financial Group, Inc.
General. Savings and loan holding companies and savings associations are extensively regulated under both federal and state law. This regulation is intended primarily for the protection of depositors and the Savings Association Insurance Fund (“SAIF”) and not for the benefit of our stockholders. The following information describes certain aspects of that regulation applicable to us, Los Padres Bank and Harrington Wealth Management Company, and does not purport to be complete. The discussion is qualified in its entirety by reference to all particular statutory or regulatory provisions. We are a unitary savings and loan holding company subject to regulatory oversight by the Office of Thrift Supervision (“OTS”). As such, we are required to register and file reports with the OTS and are subject to regulation and examination by the OTS. In addition, the OTS has enforcement authority over us and our subsidiaries, which also permits the OTS to restrict or prohibit activities that are determined to be a serious risk to Los Padres Bank.
Activities Restriction Test. As a unitary savings and loan holding company, we are generally not subject to activity restrictions, provided Los Padres Bank satisfies the Qualified Thrift Lender (“QTL”), test or meets the definition of a domestic building and loan association pursuant to the Code. We presently intend to
continue to operate as a unitary savings and loan holding company. Recent legislation terminated the “unitary thrift holding company exemption” for all companies that apply to acquire savings associations after May 4, 1999. However, since we are grandfathered, our unitary holding company powers and authorities were not affected. Despite our grandfathered status, if we acquire control of another savings association as a separate subsidiary, we would become a multiple savings and loan holding company, and our activities, and any activities of our subsidiaries (other than Los Padres Bank or any savings association), would be restricted generally to activities permissible for financial holding companies and other activities permitted for multiple savings and loan holding companies under OTS regulations, unless such other associations each also qualify as a QTL or a domestic building and loan association and were acquired in a supervisory acquisition. Furthermore, if we were in the future to sell control of Los Padres Bank to any other company, such company would not succeed to our grandfathered status and would be subject to the same business activity restrictions.
Restrictions on Acquisitions. We must obtain approval from the OTS before acquiring control of any other savings association. Such acquisitions are generally prohibited if they result in a multiple savings and loan holding company controlling savings associations in more than one state. However, such interstate acquisitions are permitted based on specific state authorization or in a supervisory acquisition of a failing savings association.
Federal law generally provides that no “person,” acting directly or indirectly or through or in concert with one or more other persons, may acquire “control,” as that term is defined in OTS regulations, of a federally insured savings association without giving at least 60 days written notice to the OTS and providing the OTS an opportunity to disapprove the proposed acquisition. In addition, no company may acquire control of such an institution without prior OTS approval. These provisions also prohibit, among other things, any director or officer of a savings and loan holding company, or any individual who owns or controls more than 25% of the voting shares of a savings and loan holding company, from acquiring control of any savings association not a subsidiary of the savings and loan holding company, unless the acquisition is approved by the OTS.
Regulation of Los Padres Bank
General. As a federally chartered, SAIF-insured savings association, Los Padres Bank is subject to extensive regulation by the OTS and the Federal Deposit Insurance Corporation (“FDIC”). Lending activities and other investments of Los Padres Bank must comply with various statutory and regulatory requirements. Los Padres Bank is also subject to certain reserve requirements promulgated by the Federal Reserve Board.
The OTS, in conjunction with the FDIC, regularly examines Los Padres Bank and prepares reports for the consideration of Los Padres Bank’s Board of Directors on any deficiencies found in the operations of Los Padres Bank. The relationship between Los Padres Bank and depositors and borrowers is also regulated by federal and state laws, especially in such matters as the deposit insurance of savings accounts and the form and content of mortgage documents utilized by Los Padres Bank.
Los Padres Bank must file reports with the OTS and the FDIC concerning its activities and financial condition, in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers with or acquisitions of other financial institutions. This regulation and supervision establishes a comprehensive framework of activities in which an institution can engage and is intended primarily for the protection of the SAIF and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such regulations, whether by the OTS, the FDIC, or the Congress could have a material adverse impact on us, Los Padres Bank, and our operations.
Insurance of Deposit Accounts. Los Padres Bank’s deposits are currently insured to a maximum of $100,000 per depositor by the FDIC except for certain retirement accounts which are insured up to $250,000. The Bank is required to pay deposit insurance premiums. The premium amount is based upon a
risk classification system established by the FDIC. Banks with higher levels of capital and a low degree of supervisory concern are assessed lower premiums than banks with lower levels of capital or a higher degree of supervisory concern. Effective January 1, 2007 the FDIC adopted a new rule for the insurance assessment on deposits. Under the new rule the charge for annual insurance deposit assessments will range from a minimum of 5 basis points to a maximum of 43 basis points per $100 of insured deposits depending upon the risk assessment category into which the institution falls. Insured institutions are not all allowed to disclose their risk assessment classification and no assurance can be given as to what the future level of premiums will be.
Under the Federal Deposit Insurance Reform Act of 2005, the Bank received a one-time initial assessment credit to recognize its past contributions to the insurance fund. The Bank’s one-time assessment credit was $338 thousand. This credit can be used to offset assessments until exhausted. The Bank’s assessment credit will be fully used by March 31, 2008.
In addition to the assessment for deposit insurance, institutions are required to make payments on bonds issued in the late 1980’s by the Financing Corporation to recapitalize a predecessor deposit insurance fund. This payment is established quarterly and during the year ending December 31, 2007 averaged 1.14 basis points of assessable deposits.
The FDIC has authority to increase insurance assessments. A significant increase in insurance premiums could have an adverse effect on the operating expenses and results of operations of the Company. Management cannot predict what insurance assessment rates will be in the future.
The FDIC is authorized to terminate a depository institution’s deposit insurance upon a finding by the FDIC that the institution’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the institution’s regulatory agency.
Regulatory Capital Requirements and Prompt Corrective Action. The prompt corrective action regulation of the OTS, requires certain mandatory actions and authorizes certain other discretionary actions to be taken by the OTS against a savings association that falls within certain undercapitalized capital categories specified in the regulation.
Under the regulation, an institution is well capitalized if it has a total risk-based capital ratio of at least 10.0%, a Tier 1 risk-based capital ratio of at least 6.0% and a leverage ratio of at least 5.0%, with no written agreement, order, capital directive, prompt corrective action directive or other individual requirement by the OTS to maintain a specific capital measure. An institution is adequately capitalized if it has a total risk-based capital ratio of at least 8.0% and a Tier 1 risk-based capital ratio of at least 4.0% and a leverage ratio of at least 4.0% (or 3.0% if it has a composite rating of “1”). The regulation also establishes three categories for institutions with lower ratios: undercapitalized, significantly undercapitalized and critically undercapitalized. At December 31, 2007, Los Padres Bank met the capital requirements of a “well capitalized” institution under applicable OTS regulations.
In general, the prompt corrective action regulation prohibits an insured depository institution from declaring any dividends, making any other capital distribution, or paying a management fee to a controlling person if, following the distribution or payment, the institution would be within any of the three undercapitalized categories. In addition, adequately capitalized institutions may accept brokered deposits only with a waiver from the FDIC and are subject to restrictions on the interest rates that can be paid on such deposits. Undercapitalized institutions may not accept, renew, or roll over brokered deposits.
If the OTS determines that an institution is in an unsafe or unsound condition, or if the institution is deemed to be engaging in an unsafe and unsound practice, the OTS may, if the institution is well capitalized,
reclassify it as adequately capitalized; if the institution is adequately capitalized but not well capitalized, require it to comply with restrictions applicable to undercapitalized institutions; and, if the institution is undercapitalized, require it to comply with certain restrictions applicable to significantly undercapitalized institutions. Finally, pursuant to an interagency agreement, the FDIC can examine any institution that has a substandard regulatory examination score or is considered undercapitalized without the express permission of the institution’s primary regulator.
OTS capital regulations also require savings associations to meet three capital standards:
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tangible capital equal to at least 1.5% of total adjusted assets,
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leverage capital (core capital) equal to 4% of total adjusted assets, and
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risk-based capital equal to 8% of total risk-weighted assets.
These capital requirements are viewed as minimum standards by the OTS, and most institutions are expected to maintain capital levels well above the minimum. Minimum capital levels higher than those provided in the regulations may be established by the OTS for individual savings associations, upon a determination that the savings association’s capital is or may become inadequate in view of its circumstances.
The following table reflects as of December 31, 2007, Los Padres Bank’s actual levels of regulatory capital and the applicable regulatory capital requirements.
The Home Owners’ Loan Act (“HOLA”) permits savings associations not in compliance with the OTS capital standards to seek an exemption from certain penalties or sanctions for noncompliance. Such an exemption will be granted only if certain strict requirements are met, and must be denied under certain circumstances. If the OTS grants an exemption, the savings association still may be subject to enforcement actions for other violations of law or unsafe or unsound practices or conditions.
Loans-to-One Borrower Limitations. Savings associations generally are subject to the lending limits applicable to national banks. With certain limited exceptions, the maximum amount that a savings association or a national bank may lend to any borrower (including certain related entities of the borrower) at one time may not exceed 15% of the unimpaired capital and surplus of the institution, plus an additional 10% of unimpaired capital and surplus for loans fully secured by readily marketable collateral. Savings associations are additionally authorized to make loans to one borrower, by order of the Director of OTS, in an amount not to exceed the lesser of $30.0 million or 30% of unimpaired capital and surplus to develop residential housing, provided:
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the savings association is in compliance with its capital requirements;
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the loans comply with applicable loan-to-value requirements; and
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the aggregate amount of loans made under this authority does not exceed 150% of unimpaired capital and surplus.
At December 31, 2007, Los Padres Bank’s loans-to-one-borrower limit was $13.8 million based upon the 15% of unimpaired capital and surplus measurement. At December 31, 2007, Los Padres Bank’s largest single lending relationship had an outstanding balance of $13.7 million, and consisted of one loan secured by commercial real estate, which was performing in accordance with its terms.
Qualified Thrift Lender Test. Savings associations must meet a QTL test, which may be met either by maintaining a specified level of assets in qualified thrift investments as specified in HOLA or by meeting the definition of a “domestic building and loan association” under the Code. Qualified thrift investments are primarily residential mortgages and related investments, including certain mortgage related securities. The required percentage of investments under HOLA is 65% of assets while the Code requires investments of 60% of assets. An association must be in compliance with the QTL test or the definition of domestic building and loan association on a monthly basis in nine out of every 12 months. Associations that fail to meet the QTL test will generally be prohibited from engaging in any activity not permitted for both a national bank and a savings association. As of December 31, 2007, Los Padres Bank was in compliance with its QTL requirement and met the definition of a domestic building and loan association.
Affiliate Transactions. Generally, transactions between a savings association or its subsidiaries and its affiliates are required to be on terms and under circumstances that are substantially the same, or at least as favorable to the savings association or its subsidiary, as transactions with non-affiliates. Certain of these transactions, such as loans or extensions of credit to an affiliate, are restricted to a percentage of the association’s capital and surplus. In addition, a savings association may not make a loan or other extension of credit to any affiliate engaged in activities not permissible for a bank holding company or purchase or invest in securities issued by most affiliates. Affiliates of a savings association include, among other entities, the savings association’s holding company and companies that are under common control with the savings association. HWFG and HWMC are considered to be affiliates of Los Padres Bank.
Capital Distribution Limitations. OTS regulations impose limitations upon all capital distributions by savings associations, like cash dividends, payments to repurchase or otherwise acquire its shares, payments to stockholders of another institution in a cash-out merger and other distributions charged against capital. Under the rule, a savings association in some circumstances may:
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be required to file an application and await approval from the OTS before it makes a capital distribution;
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be required to file a notice 30 days before the capital distribution; or
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be permitted to make the capital distribution without notice or application to the OTS.
The OTS regulations require a savings association to file an application if:
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it is not eligible for expedited treatment of its other applications under OTS regulations;
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the total amount of all of capital distributions, including the proposed capital distribution, for the applicable calendar year exceeds its net income for that year to date plus retained net income for the preceding two years;
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it would not be at least adequately capitalized, under the prompt corrective action regulations of the OTS following the distribution; or
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the association’s proposed capital distribution would violate a prohibition contained in any applicable statute, regulation, or agreement between the savings association and the OTS, or the FDIC, or violate a condition imposed on the savings association in an OTS-approved application or notice.
In addition, a savings association must give the OTS notice of a capital distribution if the savings association is not required to file an application, but:
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would not be well capitalized under the prompt corrective action regulations of the OTS following the distribution;
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the proposed capital distribution would reduce the amount of or retire any part of the savings association’s common or preferred stock or retire any part of debt instruments like notes or debentures included in capital, other than regular payments required under a debt instrument approved by the OTS; or
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the savings association is a subsidiary of a savings and loan holding company.
If neither the savings association nor the proposed capital distribution meets any of the above listed criteria, the OTS does not require the savings association to submit an application or give notice when making
the proposed capital distribution. The OTS may prohibit a proposed capital distribution that would otherwise be permitted if the OTS determines that the distribution would constitute an unsafe or unsound practice.
Community Reinvestment Act and the Fair Lending Laws. Savings associations have a responsibility under the Community Reinvestment Act and related regulations of the OTS to help meet the credit needs of their communities, including low- and moderate-income neighborhoods. In addition, the Equal Credit Opportunity Act and the Fair Housing Act prohibit lenders from discriminating in their lending practices on the basis of characteristics specified in those statutes. An institution’s failure to comply with the provisions of the Community Reinvestment Act could, at a minimum, result in regulatory restrictions on its activities and the denial of applications. In addition, an institution’s failure to comply with the Equal Credit Opportunity Act and the Fair Housing Act could result in the OTS, other federal regulatory agencies as well as the Department of Justice taking enforcement actions. Based on an examination conducted in June 2007 for the period ended March 31, 2007, Los Padres Bank received an outstanding rating with respect to its performance pursuant to the Community Reinvestment Act.
Federal Home Loan Bank System. Los Padres Bank is a member of the FHLB system. Among other benefits, each FHLB serves as a reserve or central bank for its members within its assigned region. Each FHLB is financed primarily from the sale of consolidated obligations of the FHLB system. Each FHLB makes available loans or advances to its members in compliance with the policies and procedures established by the Board of Directors of the individual FHLB. As an FHLB member, Los Padres Bank is required to own capital stock in an FHLB in an amount equal to the greater of:
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1% of its aggregate outstanding principal amount of its residential mortgage loans, home purchase contracts and similar obligations at the beginning of each calendar year; or
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5% of its FHLB advances or borrowings.
Los Padres Bank’s required investment in FHLB stock, based on December 31, 2007, financial data, was $11.8 million. At December 31, 2007, Los Padres Bank had $12.5 million of FHLB stock.
Federal Reserve System. The Federal Reserve Board requires all depository institutions to maintain noninterest bearing reserves at specified levels against their transaction accounts (primarily checking, NOW, and Super NOW checking accounts) and non-personal time deposits. At December 31, 2007 Los Padres Bank was in compliance with these requirements.
Activities of Subsidiaries. A savings association seeking to establish a new subsidiary acquires control of an existing company or conduct a new activity through a subsidiary must provide 30 days prior notice to the FDIC and the OTS and conduct any activities of the subsidiary in compliance with regulations and orders of the OTS. The OTS has the power to require a savings association to divest any subsidiary or terminate any activity conducted by a subsidiary that the OTS determines to pose a serious threat to the financial safety, soundness or stability of the savings association or to be otherwise inconsistent with sound banking practices.
Legislation
USA Patriot Act of 2001. In October 2001, the USA Patriot Act of 2001 was enacted in response to the terrorist attacks in New York, Pennsylvania and Washington, D.C. that occurred on September 11, 2001. The Patriot Act is intended to strengthen U.S. law enforcement’s and the intelligence communities’ abilities to work cohesively to combat terrorism on a variety of fronts. The potential impact of the Patriot Act on financial institutions of all kinds is significant and wide ranging. The Patriot Act contains sweeping anti-money laundering and financial transparency laws and requires various regulations, including standards for verifying customer identification at account opening, and rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. Recently, Congress passed and the President signed a bill that extends portions of the Patriot Act.
Financial Services Modernization Legislation. In November 1999, the Gramm-Leach-Bliley Act of 1999 (“GLB”) was enacted. The GLB repeals provisions of the Glass-Steagall Act which restricted the affiliation of Federal Reserve member banks with firms “engaged principally” in specified securities activities, and which restricted officer, director, or employee interlocks between a member bank and any company or person “primarily engaged” in specified securities activities.
In addition, the GLB also contains provisions that expressly preempt any state law restricting the establishment of financial affiliations, primarily related to insurance. The general effect of the law is to establish a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms, and other financial service providers by revising and expanding the Bank Holding Company Act framework to permit a holding company to engage in a full range of financial activities through a new entity known as a “financial holding company.” “Financial activities” is broadly defined to include not only banking, insurance and securities activities, but also merchant banking and additional activities that the Federal Reserve Board, in consultation with the Secretary of the Treasury, determines to be financial in nature, incidental to such financial activities, or complementary activities that do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.
The GLB provides that no company may acquire control of an insured savings association unless that company engages, and continues to engage, only in the financial activities permissible for a financial holding company, unless the company is grandfathered as a unitary savings and loan holding company. The Financial Institution Modernization Act grandfathers any company that was a unitary savings and loan holding company on May 4, 1999 or became a unitary savings and loan holding company pursuant to an application pending on that date.
The GLB also permits national banks to engage in expanded activities through the formation of financial subsidiaries. A national bank may have a subsidiary engaged in any activity authorized for national banks directly or any financial activity, except for insurance underwriting, insurance investments, real estate investment or development, or merchant banking, which may only be conducted through a subsidiary of a financial holding company. Financial activities include all activities permitted under new sections of the Bank Holding Company Act or permitted by regulation.
To the extent that the GLB permits banks, securities firms, and insurance companies to affiliate, the financial services industry may experience further consolidation. The GLB is intended to grant to community banks certain powers as a matter of right that larger institutions have accumulated on an ad hoc basis and which unitary savings and loan holding companies already possess. Nevertheless, the GLB may have the result of increasing the amount of competition that we face from larger institutions and other types of companies offering financial products, many of which may have substantially more financial resources than we have.
Sarbanes-Oxley Act. In July 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002 (“SOA”) implementing legislative reforms intended to address corporate and accounting improprieties. The SOA generally applies to all companies, both U.S. and non-U.S., that file or are required to file periodic reports with the Securities and Exchange Commission (“SEC”) under the Securities Exchange Act of 1934 (the “Exchange Act”). The SOA includes very specific additional disclosure requirements and new corporate governance rules, requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules and mandates further studies of certain issues by the SEC and the Comptroller General. The SOA represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees.
As a public reporting company, we are subject to the provisions of the SOA and related rules and regulations issued by the SEC and NASDAQ. Although we are not yet subject to compliance with section 404 of the SOA, we have taken steps to implement that section and incurred related expenses. To date, our
compliance costs related to the SOA have not been material. However, it is anticipated that we will incur additional expense as a result of the SOA, and the implementation cost of compliance with section 404 may be material.
Item 1A.
Item 1A. Risk Factors
An investment in our common stock is subject to risks inherent to our business. The material risks and uncertainties that management believes may affect our business are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this Form 10K. The risks and uncertainties described below are not the only ones facing our business. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair our business operations. This Form 10-K is qualified in its entirety by these risk factors.
If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of our common stock could decline significantly, and you could lose all or part of your investment.
The current changing economic environment poses significant challenges for us.
We are operating in a challenging and uncertain economic environment, including generally uncertain national and local conditions. Financial institutions continue to be affected by the softening of the real estate market and constrained financial markets. While we have only some direct exposure to the residential real estate market, and have no sub-prime residential loans on our books, we are nevertheless affected by these events. Continued declines in real estate values, home sales volumes and financial stress on borrowers as a result of the uncertain economic environment, including job losses, interest rate resets on adjustable rate mortgage loans and other factors could have adverse effects on our borrowers which would adversely affect our financial condition and results of operations. This deterioration in economic conditions coupled with a possible national economic recession could drive losses beyond that which is provided for in our allowance for loan losses and result in the following other consequences:
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Loan delinquencies, problem assets and foreclosures may increase;
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Demand for our products and services may decline;
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Low cost or non-interest bearing deposits may decrease; and
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Collateral for our loans, especially real estate, may decline in value, in turn reducing customers’ borrowing power, and reducing the value of assets and collateral associate with our existing loans.
Our business is subject to various lending risks which could adversely impact our results of operations and financial condition.
Our commercial real estate and multi-family residential loans involve higher principal amounts than other loans, and repayment of these loans may be dependent on factors outside our control or the control of our borrowers. At December 31, 2007, commercial real estate loans totaled $266.3 million, or 33.7%, of our total loan portfolio while multi-family real estate loans totaled $82.7 million, or 10.5%, of our total loan portfolio. Commercial and multi-family real estate lending typically involves higher loan principal amounts and the repayment of such loans generally is dependent, in large part, on the successful operation of the property securing the loan or the business conducted on the property securing the loan. These loans may be more adversely affected by conditions in the real estate markets or in the economy generally. For example, if
the cash flow from the borrower’s project is reduced due to leases not being obtained or renewed, the borrower’s ability to repay the loan may be impaired. In addition, many of our commercial real estate and multi-family residential loans are not fully amortizing and contain large balloon payments upon maturity. Such balloon payments may require the borrower to either sell or refinance the underlying property in order to make the payment.
Repayment of our commercial and industrial loans is often dependent on the cash flows of the borrower, which may be unpredictable, and the collateral securing these loans may fluctuate in value. At December 31, 2007, commercial and industrial loans totaled $117.8 million, or 14.9%, of our total loan portfolio. Our commercial and industrial loans are primarily made based on the identified cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. Most often, this collateral consists of accounts receivable, inventory or equipment. Credit support provided by the borrower for most of these loans and the probability of repayment is based on the liquidation of the pledged collateral and enforcement of a personal guarantee, if any exists. As a result, in the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. The collateral securing other loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business.
Our construction loans are based upon estimates of costs and value associated with the complete project. These estimates may be inaccurate. At December 31, 2007, construction loans totaled $126.4 million, or 16.0%, of our total loan portfolio while land acquisition and development loans totaled $45.3 million, or 5.7%, of our total loan portfolio. Construction and acquisition and development lending involve additional risks because funds are advanced upon the security of the project, which is of uncertain value prior to its completion. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation of real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the related loan-to-value ratio. As a result, construction loans and acquisition and development loans often involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property or obtain permanent take-out financing, rather than the ability of the borrower or guarantor to repay principal and interest. If our appraisal of the value of the completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project and may incur a loss.
Our consumer loans generally have a higher risk of default than our other loans. At December 31, 2007, consumer loans totaled $27.2 million, or 3.4%, of our total loan portfolio. Consumer loans typically have shorter terms and lower balances with higher yields as compared to one- to four-family residential mortgage loans, but generally carry higher risks of default. Consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by adverse personal circumstances. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on these loans.
Our investment portfolio includes securities and total rate of return swaps which are sensitive to interest rates and spread changes and which we may be required to sell at a loss to meet our liquidity needs.
Our available for sale portfolio totaled $351.5 million at December 31, 2007. The unrealized gains or losses in our available for sale portfolio are reported as a separate component of stockholders’ equity until realized upon sale. As a result, future interest rate fluctuations may impact earnings and stockholders’ equity, causing material fluctuations from quarter to quarter.
The risk of us realizing a loss upon a sale in our available for sale portfolio is a function of our liquidity needs and market conditions at the time of sale. Failure to hold our securities until maturity or until market conditions are favorable for a sale could materially and adversely affect our business, financial condition, profitability and prospects.
The underlying securities in the TROR CMBS swap position are backed by commercial mortgage loans with generally 75% original loan to value ratios, diversified among property types, generally issued in the last two years, and having 10 year balloon maturities, 25 to 30 year amortizations, and a lock-out from prepayment of principal until the balloon date. In addition, the AAA CMBS have additional credit enhancement of 20% to 30% in the form of junior securities. HWFG has invested in two types of AAA CMBS indexes: (1) the Lehman AAA 8.5+ year index having some mezzanine AAA securities, and (2) the Lehman Super Senior CMBS Index with only the most senior AAA securities. At December 31, 2007, HWFG had $80 million of the Lehman AAA CMBS 8.5+ year index swaps. The realized gains or losses associated with the TROR CMBS swaps are included in net income. See “Subsequent Events” for additional information.
Our allowance for loan losses may prove to be insufficient to absorb probable incurred losses inherent in our loan portfolio.
Like all financial institutions, every loan we make carries a certain risk that it will not be repaid in accordance with its terms or that any collateral securing it will not be sufficient to assure repayment. This risk is affected by, among other things:
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cash flow of the borrower and/or the project being financed;
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in the case of a collateralized loan, the changes and uncertainties as to the future value of the collateral;
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the credit history of a particular borrower;
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changes in economic and industry conditions; and
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the duration of the loan.
We maintain an allowance for loan losses which we believe is appropriate to provide for any probable losses inherent in our loan portfolio. The amount of this allowance is determined by management through a periodic review and consideration of several factors which are discussed in more detail under “Item 1. Business - Asset Quality - Allowance for Loan Losses.”
At December 31, 2007, our allowance for loan losses was $6.4 million. Federal regulatory agencies, as an integral part of their examination process, review our loans and allowance for loan losses. Although we believe our loan loss allowance is adequate to absorb probable incurred losses in our loan portfolio, we cannot predict these losses or whether our allowance will be adequate or that regulators will not require us to increase this allowance. Any of these occurrences could materially and adversely affect our business, financial condition, prospects and profitability.
Our business is subject to interest rate risk and variations in interest rates may negatively affect our financial performance.
Like other financial institutions, our operating results are largely dependent on our net interest income. Net interest income is the difference between interest earned on loans and securities and interest expense incurred on deposits and borrowings. Our net interest income is impacted by changes in market rates of interest, the interest rate sensitivity of our assets and liabilities, prepayments on our loans and securities and limits on increases in the rates of interest charged on our loans. We expect that we will continue to realize income from the differential or “spread” between the interest earned on loans, securities and other interest-earning assets, and interest paid on deposits, borrowings and other interest-bearing liabilities. Net interest
spreads are affected by the difference between the maturities and repricing characteristics of interest-earning assets and interest-bearing liabilities.
We cannot control or accurately predict changes in market rates of interest. The following are some factors that may affect market interest rates, all of which are beyond our control:
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inflation;
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slow or stagnant economic growth or recession;
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unemployment;
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money supply and the monetary policies of the Federal Reserve Board;
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international disorders; and
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instability in domestic and foreign financial markets.
We are vulnerable to an increase in interest rates because our interest-earning assets generally have longer maturities than our interest-bearing liabilities. Under such circumstances, material and prolonged increases in interest rates will negatively affect our net interest income. In addition, loan volume and yields are affected by market interest rates on loans, and rising interest rates generally are associated with a lower volume of loan originations. In addition, an increase in the general level of interest rates may adversely affect the ability of certain borrowers to pay the interest on and principal of their obligations. Accordingly, changes in levels of market interest rates could materially and adversely affect our net interest spread, asset quality, loan origination volume, securities portfolio, and overall profitability. Although we attempt to manage our interest rate risk, we cannot assure you that we can minimize our interest rate risk. Our net interest margin was 2.90% for the year ended December 31, 2007, compared to 2.83% for the year ended December 31, 2006, and 2.94% in the December 2007 quarter compared to 2.81% for the quarter ended December 2006.
Our business is subject to economic and other general risks which may adversely impact our results of operations and financial condition.
Changes in economic conditions, in particular an economic slowdown in the markets in which we operate, could hurt our business. Our business is directly affected by factors such as economic, political and market conditions, broad trends in industry and finance, legislative and regulatory changes, changes in government monetary and fiscal policies and inflation, all of which are beyond our control. A deterioration in economic conditions, in particular an economic slowdown in the markets in which we operate in California, Kansas or Arizona, could result in the following consequences, any of which could materially and adversely affect our business, financial condition, prospects and profitability:
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loan delinquencies may increase;
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problem assets and foreclosures may increase;
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demand for our products and services may decline;
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low cost or noninterest-bearing deposits may decrease; and
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collateral, for loans made by us, especially real estate, may decline in value, in turn reducing customers’ borrowing power.
A downturn in the real estate market may adversely affect our business. As of December 31, 2007, approximately 82.6% of the book value of our loan portfolio consisted of loans secured by various types of real estate. Approximately 67.7% of our real property collateral is located in California, approximately 14.0% is located in the Kansas City metropolitan area, and 18.3% is in the Arizona market. Negative conditions in the real estate markets where collateral for a mortgage loan is located could adversely affect the borrower’s ability to repay the loan and the value of the collateral securing the loan. Our ability to recover on defaulted loans by selling the real estate collateral would then be diminished and we would be more likely to suffer losses on defaulted loans. If there is a significant decline in real estate values, the collateral for our loans will provide less security. Real estate values are affected by various other factors, including changes in general or regional economic conditions, governmental rules or policies and among other things, earthquakes and other national disasters particular to our market areas.
We are exposed to risk of environmental liabilities with respect to properties to which we take title. In the course of our business, we may foreclose and take title to real estate, and we could be subject to environmental liabilities with respect to these properties. We may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or we may be required to investigate or clean up hazardous or toxic substances or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, as the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. If we ever become subject to significant environmental liabilities, we could suffer a material and adverse effect on our business, financial condition, prospects and profitability.
We may suffer losses in our loan portfolio despite our underwriting practices. We seek to mitigate the risks inherent in our loan portfolio by adhering to certain underwriting practices. These practices include analysis of prior credit histories, financial statements, tax returns and cash flow projections, valuation of collateral based on reports of independent appraisers and verification of liquid assets. Although we believe that our underwriting criteria are appropriate for the various kinds of loans we make, we may incur losses on loans that meet our underwriting criteria, and these losses may exceed the amounts set aside as reserves for losses in the allowance for loan losses.
We invest in interest rate contracts which can cause losses to us in excess of the value at which we carry these investments.
We invest in interest rate contracts for the purpose of reducing interest rate risk and, to a much more limited extent, to enhance spread income through asset based interest rate swaps. These interest rate contracts may include interest rate swaps, caps and floors and exchange traded futures and options. At December 31, 2007, we had invested in interest rate swaps with an aggregate notional amount of $172 million. Although, we have utilized caps, floors and exchange traded futures and options in prior periods, as of December 31, 2007, we did not have any investments in such interest rate contracts. Interest rate contracts can cause losses to us which will be reflected in our statements of earnings, and the maximum potential loss reflected in our statements of earnings may exceed the value at which we carry these instruments. These losses result from changes in the market values of such interest rate contracts. At December 31, 2007, the approximate net market value of our interest rate contracts was a loss of $5.0 million. For additional information, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Asset and Liability Management” and “Subsequent Events”.
Our interest rate contracts expose us to:
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basis or spread risk, which is the risk of loss associated with variations in the spread between the interest rate contract and the hedged item;
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credit risk, which is the risk of the insolvency or other inability of another party to the transaction to perform its obligations;
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interest rate risk;
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volatility risk, which is the risk that the expected uncertainty relating to the price of the underlying asset differs from what is anticipated; and
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liquidity risk.
If we suffer losses on our interest rate contracts, our business, financial condition and prospects may be negatively affected, and our net income will decline.
We are subject to extensive regulation which could adversely affect our business.
Our operations are subject to extensive regulation by federal, state and local governmental authorities and are subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of our operations. We believe that we are in substantial compliance in all material respects with applicable federal, state and local laws, rules and regulations. Because our business is highly regulated, the laws, rules and regulations applicable to us are subject to regular modification and change. There are currently proposed various laws, rules and regulations that, if adopted, would impact our operations. If these or any other laws, rules or regulations are adopted in the future, they could make compliance much more difficult or expensive, restrict our ability to originate, broker or sell loans, further limit or restrict the amount of commissions, interest or other charges earned on loans originated or sold by us or otherwise materially and adversely affect our business, financial condition, prospects or profitability.
Our continued pace of growth may require us to raise additional capital in the future, but that capital may not be available when it is needed.
We are required by federal regulatory authorities to maintain adequate levels of capital to support our operations. In addition, due to our business strategy which has concentrated on growth and a shift in our lending focus to more commercial lending and the size and character of our available for sale and trading securities portfolio, we may be required to hold capital in excess of well capitalized levels as defined by the OTS. To the extent that Los Padres Bank fails to comply with required capital ratios, the OTS could take such failure to comply into consideration in connection with further requests to have Los Padres Bank pay dividends to us and in additional future branch applications. Los Padres Bank’s failure to comply could also impact its overall assessment by the OTS in future regulatory examinations, which, if adverse, could also impact its FDIC insurance assessment. See “Capitalization,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Capital Resources,” “Regulation - Los Padres Bank - Regulatory Capital Requirements and Prompt Corrective Action” and “Subsequent Events”.
We anticipate that our existing capital resources will satisfy our capital requirements for the near term. However, we may at some point need to raise additional capital to support continued growth, both internally and through acquisitions. Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, we cannot assure you of our ability to raise additional capital if needed or on terms acceptable to us. If we cannot raise additional capital when needed, our ability to further expand our operations through internal growth and acquisitions could be materially impaired.
Our plan to expand the franchise with additional banking offices in California, Kansas and Arizona may not be successful, which would negatively affect our growth strategy and prospects, and profitability.
We intend to open a banking office located in Surprise, Arizona, and our third in the Phoenix metro area, in early 2008, with a fourth expected to open in Gilbert, Arizona early in 2009. The Company has also purchased a parcel for a banking office in the growing Deer Valley Airpark in north central Phoenix. Management estimates that it will take approximately 12 to 18 months for each new branch to be profitable.
These estimates are based on our financial model which reflects various assumptions, and we cannot give assurance that we will achieve profitability when estimated or that losses will not be greater than anticipated. While our management has significant experience in the Kansas and Arizona markets, we cannot be sure that our expansion in those markets will meet our expectations. In addition, although we have hired experienced personnel who are familiar with the markets and although our senior management has extensive knowledge of the area, we may not be successful in these operations and we may not be able to compete successfully. If we are unsuccessful in expanding our business in Kansas and Arizona, our growth strategy, financial condition, prospects and profitability may be adversely affected.
We are dependent on key individuals and our ability to attract and retain banking professionals with significant experience in our local markets.
We currently depend heavily on Craig J. Cerny, our Chief Executive Officer, William W. Phillips, Jr., our President, Mark Larrabee, our Region President of Kansas and Chief Commercial Lending Officer, Susan Weber, our Executive Vice President of Mortgage Lending, Vern Hansen, our Region President of Arizona, Kerril Steele, our Chief Financial Officer, John Mason our Chief Investment Officer and Rick Harrison, our President of Harrington Wealth Management Company. We believe that the prolonged unavailability or the unexpected loss of the services of these individuals could have a material adverse effect upon us because attracting suitable replacements may involve significant time and/or expense. We do not have employment agreements with Mr. Cerny, Mr. Phillips or any of our other executive officers.
In order to continue our expansion, we must attract and retain experienced banking professionals. The competition to hire experienced banking professionals is intense. If we are unable to attract qualified banking professionals, our expansion plans could be delayed or curtailed. If we are unable to retain our current banking professionals, our business, financial condition, prospects and profitability may be adversely affected.
We face strong competition from other financial institutions, financial service companies and other companies that offer banking services which can hurt our business.
We conduct our banking operations primarily along the central coast of California, the Phoenix metro, and the Kansas City metro areas. Many competitors offer the banking services that we offer in our service area, and in the areas we intend to expand in. These competitors include other savings associations, national banks, regional banks and other community banks. We also face competition from many other types of financial institutions, including finance companies, brokerage firms, insurance companies, credit unions, mortgage banks and other financial intermediaries. In particular, our competitors include major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous banking locations and mount extensive promotional and advertising campaigns. Increased competition in our market areas may result in reduced loans and deposits. Ultimately, we may not be able to compete successfully against current and future competitors.
Additionally, banks and other financial institutions with larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the credit needs of larger customers. Areas of competition include interest rates for loans and deposits, efforts to obtain deposits, and range and quality of products and services provided, including new technology-driven products and services. Technological innovation continues to contribute to greater competition in domestic and international financial services markets as technological advances enable more companies to provide financial services. We also face competition from out-of-state financial intermediaries that have opened low-end production offices or that solicit deposits in our market areas. If we are unable to attract and retain banking customers, we may be unable to continue our loan growth and level of deposits and our business, financial condition and prospects may otherwise be negatively affected.
We continually encounter technological change, and we may have fewer resources than many of our competitors to continue to invest in technological improvements.
The financial services industry is undergoing rapid technological changes, with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success will depend, in part, upon our ability to address the needs of our clients by using technology to provide products and services that will satisfy client demands for convenience, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers.
Our ability to service our Trust Preferred Securities, pay dividends, and otherwise pay our obligations as they come due is substantially dependent on capital distributions from Los Padres Bank, and these distributions are subject to regulatory limits and other restrictions.
A substantial source of our income from which we service our debt, pay our obligations and from which we can pay dividends is the receipt of dividends from Los Padres Bank. The availability of dividends from Los Padres Bank is limited by various statutes and regulations. See “Regulation - Regulation of Los Padres Bank - Capital Distributions.” It is possible; depending upon the financial condition of Los Padres Bank, and other factors, that the OTS could assert that payment of dividends or other payments is an unsafe or unsound practice. We are also subject to contractual restrictions on our ability to pay dividends under our revolving loan facility. See “Trading History and Dividend Policy.” In the event Los Padres Bank is unable to pay dividends to us, we may not be able to service our debt, pay our obligations or pay dividends on our common stock. The inability to receive dividends from Los Padres Bank would adversely affect our business, financial condition, results of operations and prospects.
Provisions in our certificate of incorporation and bylaws limit the authority of our stockholders, and therefore minority stockholders may not be able to significantly influence our governance or affairs.
Our board of directors has the authority to issue shares of preferred stock and to determine the price, rights, preferences and restrictions, including the voting rights, of those shares without any further vote or action by stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future.
Our Certificate of Incorporation and Bylaws also provide for limitations on the ability of stockholders to call special meetings and prohibit cumulative voting for directors. As a result, minority stockholder representation on the board of directors may be difficult to establish. These documents also establish advance notice requirement for nominations for election to the board of directors or for proposing matters that can be acted on by stockholders at stockholder meetings.
The provisions of our Certificate of Incorporation and Bylaws described above may, in certain circumstances, have the effect of delaying, deferring or preventing a change in control of us, may discourage bids for our common stock at a premium over the current market price of the common stock and could have an adverse effect on our stock price.
Item 1B.
Item 1B. Unresolved Staff Comments
None
Item 2.
Item 2. Properties
Office Locations
The following table sets forth certain information with respect to our offices at December 31, 2007.
Item 3.
Item 3. Legal Proceedings
We are involved in a variety of litigation matters in the ordinary course of our business and anticipate that we will become involved in new litigation matters from time to time in the future. Based on the current assessment of these matters, we do not presently believe that any one of them or all such matters taken as a whole is likely to have a material adverse impact on our financial condition, results of operations, cash flows or prospects.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Stock Information
As of March 18, 2008, we had 5,581,243 shares of common stock outstanding and approximately 91 stockholders of record, which does not include the number of persons or entities holding stock in nominee or street name through various brokers and banks.
The following table sets forth the high and low sale prices of our common stock for each of the quarters of 2007 and 2006. Our common stock began trading on the NASDAQ Global Market on November 6, 2002 under the stock symbol “HWFG.”
Dividends
In 2007, we paid a quarterly dividend of $0.125 in three quarters plus a special dividend of $0.30 per share in the third quarter. In 2006, we paid a quarterly dividend of $0.125 in all four quarters. The dividend rate on our common stock and the continued payment of dividends is determined by our board of directors, which takes into account our consolidated earnings, financial condition, liquidity and capital requirements, applicable governmental regulations and policies, and other factors deemed relevant by our board of directors. More specifically, Delaware law provides that a corporation may make a dividend to its stockholders out of the corporation’s capital surplus or, in case there shall be no surplus, out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. The holders of our common stock are entitled to receive and share equally in such dividends as may be declared by our board of directors out of funds legally available therefore. Our ability to pay dividends may also be dependent on our ability to receive dividends from Los Padres Bank, which is subject to compliance with federal regulatory requirements.
The ability to declare or pay dividends would also be restricted if we deferred quarterly interest payments due for the subordinated debt of $25.8 million. As of December 31, 2007, all interest payments due were paid in full in accordance with the capital trust securities agreements.
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
On November 1, 2007, our board of directors re-affirmed the repurchase of up to 200,000 shares of our common stock through open market or privately arranged sales. To date, no shares have been repurchased and the authorization remains in place.
Item 6.
Item 6. Selected Financial Data.
(Dollars in Thousands, Except Share and Per Share Data)
The following summary presents our selected consolidated financial information at or for the five years ended December 31, 2007. Financial information at or for each of the five years ended December 31, 2007 is derived from our audited consolidated financial statements. The selected historical consolidated financial and other data set forth below should be read in conjunction with, and is qualified in its entirety by, our historical consolidated financial statements, including the related notes, included in Item 8 herein.
(1)
Consists of service charges, wholesale mortgage banking income, other commissions and fees, other miscellaneous noninterest income and increase in cash surrender value of life insurance.
(2)
Consists of computer services, consulting fees, marketing and other miscellaneous noninterest expenses.
(3)
With the exception of return on average assets and return on average equity, all ratios are based on average daily balances.
(4)
Interest rate spread represents the difference between the weighted average yield on interest-earning assets and the weighted average rate on interest- bearing liabilities. Net interest margin represents net interest income as a percentage of average interest-earning assets.
(5)
Efficiency ratio represents noninterest expenses as a percentage of the aggregate of net interest income before provision for loan losses and noninterest income, excluding gains on sales of securities, deposits and loans.
(6)
Non-performing loans generally consist of non-accrual loans and non-performing assets generally consist of non-performing loans and real estate acquired by foreclosure or deed-in-lieu thereof.
Refer to Recent Developments in Note 22 to the consolidated financial statements for more details.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Mission
Our mission is to develop diversified and highly profitable community-focused, banking operations in the markets of the Central Coast of California, the Kansas City metro, and the Phoenix/Scottsdale metro. Although these markets are geographically dispersed, we have considerable market knowledge of each of these areas, local management with extensive experience in banking and the particular market, relationship development potential due to our ties to the communities, and each market offers favorable demographic and economic characteristics. All of these banking operations are operated under the Los Padres Bank, FSB charter so that we can gain operating efficiencies from centralized administration and operating systems. However, each region’s banking operation is distinct to its market and its clientele, and lead by a local management team responsible for developing and expanding the banking operations on a profitable basis. The Kansas City banking offices operate under the Harrington Bank (dba) brand name, and the California and Arizona offices operate under the Los Padres Bank brand name.
Multiple Market Strategy
We believe this multiple market banking strategy provides the following benefits to our stockholders:
1.
Diversification of the loan portfolio and economic and credit risk.
2.
Options to capitalize on the most favorable growth markets.
3.
The capability to deploy the Company’s diversified product mix and emphasize those products that are best suited for the market.
4.
The ability to price products strategically among the markets in an attempt to maximize profitability.
We plan to grow the banking operations in these markets opportunistically and expect the opening of two to three banking offices every 18 months through new branching. We evaluate financial institution acquisition opportunities but are value oriented. Acquisitions are expected to be accretive to earnings per share within a 12-month period.
2007 marked HWFG’s twelfth year of operations and was highlighted by a high degree of success in executing our strategy to grow our core banking franchise of loans, deposits and HWM fees, while we made further progress in identifying and acquiring new banking sites in our markets for future expansion.
Since HWFG’s acquisition of Los Padres Bank almost 12 years ago, we have approximately increased our loans by 5 times, and our deposits by 5 times. We have had a great deal of success over these 12 years and look forward to more positive results in the future.
Since 1997, we have grown from 4 banking offices to 16 banking offices including the Thousand Oaks deposit acquisition, opening the Scottsdale Airpark office in mid 2005 and opening in Olathe, Kansas in August, 2006. We have 11 full service banking offices on the Central Coast of California from Thousand Oaks to Atascadero along Highway 101, 3 banking offices in Johnson County, Kansas in the fastest growing area of the Kansas City metro, and 2 offices in Scottsdale, Arizona. We will open our third banking office in the Phoenix metro area in early 2008 and a fourth anticipated in early 2009. We are working on additional expansion opportunities in each market. Over the same period, our deposits and loans have increased by over four times and our earnings by 18 times.
Product Line Diversification
We have broadened our product lines over the last 6 years to diversify our revenue sources and to become a full service community banking company. In 1999, we added Harrington Wealth Management Company, a federally registered trust and investment management company, to provide our customers a consultative and customized investment process for their trust and investment funds. In 2000, we added a full line of commercial banking and deposit products for small to medium sized businesses and expanded our consumer lending lines to provide Home Equity Lines of Credit. In 2001, we added internet banking and bill pay services to augment our in-branch services and consultation. In 2002, we further expanded our mortgage banking and brokerage activities in all of our markets. In 2004 we added the Overdraft Privilege Program and Uvest. Uvest expanded Harrington Wealth Management’s services to include brokerage and insurance products. During this past year, with emphasis on core deposit development, HWFG introduced the successful Power-Up account and Remote Deposit Capture.
Net retail deposit growth was near HWFG’s target in 2007 propelled by the aggressive promotion of its Power-Up account. This account ties together a checking account with a required automatic transaction and a money market account. Furthermore, HWFG was successful in promoting certificate of deposit accounts in the spring of 2007 and retaining them at lower rates at renewal in the December 2007 quarter. With the full implementation of the Power-Up account in all of HWFG’s markets in 2007, the implementation of the retail deposit gathering sales plan, and the reorganization of the retail and internet banking division, HWFG expects to meet its deposit growth goals for 2008.
Modern Financial Skills
We have expertise in investment and asset liability management. Our Chief Executive Officer spent thirteen years in this field consulting on risk management practices with banking institutions and advising on mortgage and related assets managed on a short duration basis. On February 27, 2007, we announced the hiring of John R. Mason as Chief Investment Officer. Mr. Mason has over twenty years experience in the investment and risk management fields. We have completed the process of bringing all of the risk and investment management operations in-house with a marginal cost savings versus our
Portfolio and Rate Risk Analysis Agreement with Smith Breeden Associates, Inc., which terminated on April 30, 2007.
We utilize excess capital in a short duration and high credit quality investment portfolio comprised largely of mortgage and related securities. Our goal is to produce a pre-tax return on these investments of .75% to 1.00% over the related funding cost. We believe our ability to price loans and investments on an option-adjusted spread basis and manage the interest rate risk of longer term, fixed rate loans, allow us to compete effectively against other institutions that do not offer these products.
Control Banking Risks
We seek to control banking risks. We have established a disciplined credit evaluation and underwriting environment that emphasizes the assessment of collateral support, cash flows, guarantor support, and stress testing. We manage operational risk through stringent policies, procedures, and controls and interest rate risk through our modern financial and hedging skills.
Performance Measurement
We evaluate our performance based upon the primary measures of return on average equity, which we are trying to maintain in the low to mid-teens, earnings per share growth, and additional franchise value creation through the growth of deposits, loans and wealth management assets. We may forego some short term profits to invest in operating expenses for branch development in an effort to earn future profits.
Profitability Drivers
The factors that we expect to drive our profitability in the future are as follows:
1.
Growing our non-costing consumer and commercial deposits and continuing to change the mix of deposits to fewer time based certificates of deposit. This strategy is expected to lower our deposit cost and increase our net interest margin over time. We have emphasized the development of low cost business accounts and our full-service, free checking and money market accounts for consumers.
2.
Changing the mix of our loans to higher risk-adjusted spread earning categories such as business lending, commercial real estate lending, small tract construction and construction-to-permanent loan lending, and selected consumer lending activities such as home equity line of credit loans.
3.
Diversifying and growing our banking fee income through existing and new fee income sources such as our overdraft protection program and other deposit fees, loan fee income from mortgage banking, prepayment penalty fees and other loan fees, Harrington Wealth Management trust and investment fees, and other retail banking fees.
4.
Achieving a high level of performance on our investment portfolio by earning a pre-tax total return consisting of interest income plus net gains and losses on securities and related total return swaps over one month LIBOR of approximately 1.00% per annum. With our skills in investment and risk management, we utilize excess equity capital by investing in a high credit quality, mortgage and related securities portfolio managed to a short duration of three to six months. From 2001 to 2004 the investment portfolio’s performance exceeded our goals and contributed to our record profit performance due to favorable selection of securities and spread tightening on these securities. From 2005 to 2006 the investment portfolio underperformed our goal but still earned a total return in excess of one-month LIBOR. In 2007 the investment portfolio significantly underperformed our goal as a result of the severe credit market dislocation.
5.
Controlling interest rate risk of the institution and seeking high credit quality of the loan and investment portfolios. The Bank seeks to hedge the marked-to-market value of equity and net interest income to changes in interest rates by matching the effective duration of our assets to our liabilities using risk management tools and practices. The company maintains rigorous loan underwriting standards and credit risk management and review process. As such, non-performing asset levels have been low with corresponding low loan charge-offs.
Together, we believe these factors will contribute to more consistent and growing profitability. The effect of these factors on our financial results is discussed further in the following sections.
Critical Accounting Policies
General. The following discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, and the notes thereto, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make a number of estimates and assumptions that affect the reported amounts and disclosures in the consolidated financial statements. On an ongoing basis, we evaluate our estimates and assumptions based upon historical experience and various other factors and circumstances. We believe that our estimates and assumptions are reasonable in the circumstances; however, actual results may differ significantly from these estimates and assumptions, which could have a material impact on the carrying value of assets and liabilities at the balance sheet dates and our results of operations for the reporting periods.
The financial information contained in our consolidated financial statements is, to a significant extent, based on approximate measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when recognizing income or expense, recovering an asset or relieving a liability. We use historical loss factors to determine the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. We also calculate the fair value of our interest rate contracts and securities based on market prices and the expected useful lives of our depreciable assets. We enter into interest rate contracts that are classified as trading account assets or to accommodate our own risk management purposes. The interest rate contracts are generally interest swaps, caps, floors and futures contracts, although we could enter into other types of interest rate contracts. We value these contracts at fair value, using readily available, and market quoted prices. We have not historically entered into derivative contracts, which relate to credit, equity, commodity, energy or weather-related indices. Generally accepted accounting principles themselves may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change. As of December 31, 2007, we have not created any special purpose entities to securitize assets or to obtain off-balance sheet funding. Although we have sold loans in past years, those loans have been sold to third parties without recourse, subject to customary representations and warranties.
Allowance for loan losses. The allowance for loan losses is an estimate of the probable incurred losses that may be inherent in our loan portfolio. The allowance is based on two principles of accounting: (i) Statement of Financial Accounting Standards, or SFAS, No. 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimable; and (ii) SFAS No. 114, Accounting by Creditors for Impairment of a Loan and SFAS No. 118, Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. Our allowance for loan losses has four components: (i) an allocated allowance for specifically identified problem loans, (ii) a formula allowance for non-homogeneous loans, (iii) a formula allowance for large groups of smaller balance homogeneous loans and (iv) an unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses a model based on historical losses as an indicator of future losses and as a result could differ from the losses incurred in the future; however, since this history is updated with the most recent
loss information, the differences that might otherwise occur may be mitigated. The specific allowance uses various techniques to arrive at an estimate of loss. Historical loss information, discounted cash flows, fair market value of collateral and secondary market information are all used to estimate those losses. The use of these values is inherently subjective and our actual losses could be greater or less than the estimates.
Trading and Investment Portfolio. Substantially all of our securities are classified as available for sale securities and, pursuant to SFAS No. 115, are reported at fair value with unrealized gains and losses included in stockholders’ equity. We invest in a portfolio of mortgage-backed and related securities, interest rate contracts, U.S. Government agencies or government sponsored enterprise securities, and to a much lesser extent, equity securities. The Company has also entered into various total return swaps in an effort to enhance income, where cash flows are based on the level and changes in the yield spread on investment grade commercial mortgage backed security indexes relative to similar duration LIBOR swap rates. These swaps do not qualify for hedge accounting treatment and are included in the trading account assets and are reported at fair value with realized and unrealized gains and losses on these instruments recognized in income (loss) from trading account assets, pursuant to SFAS No. 115.
Hedging Activity. SFAS No.133, Accounting for Derivative Instruments and Hedging Activities was implemented on January 1, 2001. SFAS No. 133 requires an entity to recognize all interest rate contracts that meet the definition of a derivative, as either assets or liabilities in the statement of financial condition and measure those instruments at fair value. If certain conditions are met, an interest rate contract may be specifically designated as a fair value hedge, a cash flow hedge, or a hedge of foreign currency exposure. The accounting for changes in the fair value of an interest rate contract (that is, gains and losses) depends on the intended use of the interest rate contract and the resulting designation. To qualify for hedge accounting, the Company must show that, at the inception of the interest rate contracts, and on an ongoing basis, the changes in the fair value of the interest rate contracts are expected to be highly effective in offsetting related changes in the cash flows of the hedged liabilities. The Company has entered into various interest rate swaps for the purpose of hedging certain of its short-term liabilities. These interest rate swaps qualify for hedge accounting. Accordingly, the effective portion of the accumulated change in the fair value of the cash flow hedges is recorded in a separate component of stockholders’ equity, net of tax, while the ineffective portion is recognized in earnings immediately.
Results of Operations
In 2007, Harrington West Financial Group experienced the most challenging year of its almost 12 years of operations. We were confronted by a broad weakening of real estate markets, the related credit crisis in sub-prime mortgage loans that spilled over into almost all credit markets in the form of wider spreads and extremely volatile prices for fixed income securities, and an economy transitioning to slower growth.
We were able to take advantage of opportunities presented in this environment by investing in wide spread (risk-adjusted) mortgage investments of high quality while capitalizing on our rigorous management of credit risk, stringent underwriting standards, and controlled loan approval process. We succeeded in markedly improving net interest and core income during the latter quarters of the year and maintaining favorable credit quality of the loan portfolio. Our overall net income, however, was significantly lower in 2007 than 2006 because of the $2.8 million loss on our CMBS total return swap portfolio due to widening credit spreads and the $2.2 million write-down in our small home-equity net interest margin (NIM) portfolio.
Net earnings in 2007 were $4.2 million or 74 cents per diluted share compared to our 2006 results of $8.2 million and $1.48 per diluted share. Core earnings after tax increased 2.9% to $7.9 million or $1.40 cents per diluted share from $7.6 million and $1.36 cents per diluted share in 2006. This result excluded pre-tax securities gains and losses, write-downs, and mark-to-market losses on trading assets of $6.0 million and incorporated the 2007 effective tax rate of 37.3%.
The investment portfolio is reviewed and analyzed for cash flow performance to determine whether all contractually owed interest and principal can be earned over the life of the securities. As reported in the September 2007 quarter, HWFG wrote-down its $2.4 million portfolio of sub-prime net interest margin (NIM) investments by $1.9 million to $.5 million. These investments were lower rated, earn the spread between the underlying loans and issued debt securities, and therefore are more credit leveraged than the other securities in HWFG’s portfolio. These NIM securities and one lower rated sub-prime security were written down by $247 thousand in the December 2007 quarter. Based on its portfolio valuation, HWFG expects at December 31, 2007 to earn all principal and interest on its other investments; however, a more severe deterioration of the housing and credit markets, beyond stress test levels, could lead to additional write-downs. Refer to Note 22 to the Consolidated Financial Statements for more information.
Net Interest Income. Net interest income is determined by (i) our interest rate margin, which is the difference between the yields earned on our interest-earning assets and the rates paid on our interest-bearing liabilities and (ii) the relative amounts of interest-earning assets and interest-bearing liabilities.
Net interest income after provision for loan losses increased by $1.0 million or 3.4% to $31.2 million during the year ended December 31, 2007 over 2006. Although the asset mix change contributed favorably to net interest margin, deposit cost pressure (spread to LIBOR rates) and some lag in the re-pricing of floating rate loans and securities, the net interest margin was 2.90% at December 31, 2007. We believe our hedging activities will result in our maintaining relatively stable margins over time (refer to the Asset and Liability Management section of this discussion for a detailed discussion of what our strategies are for hedging of interest rate exposure and why we believe that our management of interest rate fluctuations give us a competitive advantage over other financial institutions). In addition, favorable funding dynamics, widening credit spreads, the positive effect from repositioning the investment portfolio in the June 2007 quarter drove the improvement in margin and net interest income.
Average Balances, Net Interest Income, Yields Earned and Rates Paid
The following table sets forth, for the periods indicated, information regarding (i) the total dollar amount of interest income from interest-earning assets and the resultant average yields; (ii) the total dollar amount of interest expense on interest-bearing liabilities and the resultant average rate; (iii) net interest income; (iv) interest rate spread; and (v) net interest margin. No tax equivalent adjustments were made during the periods presented. Information is based on average daily balances during the indicated periods, except non-interest-bearing deposits information is based on average monthly balances.
(1)
Includes non-accrual loans. Interest income includes fees earned on loans originated and accretion of deferred loan fees.
(2)
Consists of securities classified as available for sale and held to maturity and trading account assets. Excludes SFAS 115 adjustments to fair value, which are included in other assets.
(3)
Consists of cash and due from banks and federal funds sold.
(4)
Interest on FHLB advances is net of hedging costs. We use interest rate swaps to hedge the short-term repricing characteristics of our floating-rate FHLB advances. See “-Asset and Liability Management.”
(5)
Consists of subordinated debt.
Rate/Volume Analysis
The following table sets forth the effects of changing rates and volumes on our net interest income. Information is provided with respect to (i) effects on interest income attributable to changes in rate (changes in rate multiplied by prior volume); (ii) effects on interest income attributable to changes in volume (changes in volume multiplied by prior rate); and (iii) changes in rate/volume (change in rate multiplied by change in volume).
1)
Includes fees earned on loans originated and accretion of deferred loan fees.
2)
Consists of interest income from securities classified as available for sale, held to maturity and trading account assets.
3)
Consists of interest income from cash and due from banks and Federal funds sold.
4)
Interest expense on FHLB advances is net of hedging costs. Hedging costs include interest income and expense and ineffectiveness adjustments for cash flow hedges. The Company uses pay-fixed, receive floating LIBOR swaps to hedge the short term repricing characteristics of the floating FHLB advances.
5)
Consists of interest expense on other debt
Interest Income. Total interest income increased by $6.0 million or 8.1% for 2007 over 2006 from $74.1 million to $80.1 million. Interest income increased during the current year due to an increase in the volume of loans and securities, and higher yields from the re-pricing of the assets to market rates. The Federal Reserve Board lowered the federal funds rate during 2007, and since a substantial portion of our earning assets re-price with the general level of interest rates, our average yield on earning assets increased commensurate with the increases in federal fund rates.
Interest Expense. Total interest expense increased by $4.9 million or 11.4% during the year ended December 31, 2007 over 2006, from $43.3 million to $48.3 million. During 2007, our average interest-bearing liabilities increased by $18.3 million or 1.8%, due primarily to the increase in deposits to support our growth and the growth in new offices in Ventura, California and Overland Park, Kansas. Also, the average rate spread on deposits and borrowings was higher in 2007 than 2006 by .39%.
Provision for Loan Losses. We established provisions for loan losses of $650 thousand and $565 thousand, during the years ended December 31, 2007, and 2006, respectively. Provisions for loan losses are charged to income to bring our allowance for loan losses to a level deemed appropriate by management. For more detailed information regarding the methodology used to maintain the allowance for loan losses, refer to the Asset Quality section in Item 1 - Business.
Other Income. Total other income has fluctuated over the periods presented due to pre-tax mark-to-market losses of $2.8 million on HWFG’s $80 million (notional amount) of AAA-rated CMBS TROR swap positions, as spreads continued to widen from the ongoing credit and liquidity dislocations. For more information regarding other-than-temporary loss, refer to Note 3 to the Consolidated Financial Statements.
The following table sets forth information regarding other income for the periods shown.
(1)
Consists primarily of banking fee income such as service charges and fees on deposit accounts, fees from our trust and investment management services, other miscellaneous fees and increase in cash surrender value of life insurance.
For the full year of 2007, banking fee and cash surrender value of life insurance income was $4.3 million versus $3.8 million (without lease termination income) in 2006, growing 14.1%. Harrington Wealth Management Company (HWMC) and net BOLI income of $1.8 million drove the increase in the year, rising 14.8%, while mortgage banking and deposit fees were relatively stable in 2007 compared to 2006.
The following chart shows the comparison of banking fee and other income sources for 2007 and 2006.
Over the last three years, we have increased our recurring deposit and retail banking fee income and HWMC fees. However, mortgage brokerage and prepayment penalty fees have been volatile. Although we will continue to provide mortgage brokerage services, we are emphasizing purchase mortgage originations though our banking platform.
Other Expenses. Operating expenses were controlled in 2007, in light of the expansion of banking operations in the year and the expensing of stock options. Operating expenses were $22.9 million in 2007 compared to $22.2 million in 2006, a 3.5% increase, including the full year expenses for a new Harrington banking office in the Kansas City metro offset by lower incentive compensation expense.
The following table sets forth certain information regarding other expenses for the periods shown.
(1)
Consists primarily of regulatory fees, and other miscellancous expenses.
Total other expenses increased by $764 thousand or 3.5% to $22.9 million during the year ended December 31, 2007 over the prior year. The growth in other operating expenses has been largely attributed to the expenses required to support the growth of our banking offices and expansion of lending staff.
The principal category of our other expenses is salaries and employee benefits, which increased by $679 thousand or 5.4% during the year ended December 31, 2007, compared to the prior year. Salaries and employee benefits increased by $1.3 million, or 11.7% during 2006. The increases during periods ended December 31, 2007 and 2006 were primarily due to the implementation of FAS 123(R), the hiring of a Chief Investment Officer and additional employees in connection with the opening of new branch offices in Overland Park, Kansas in the end of 2006, Thousand Oaks location in 2005, together with our general growth in operations. The Company has plans to open three more banking offices in the Phoenix metro through 2008 to bring the offices in this market to five. An office in Surprise, Arizona in the Northeast Valley is scheduled to complete in April 2008. A parcel in Gilbert, Arizona in the Southeast Valley was acquired in December 2006, and a banking office is expected to be completed thereon in mid 2008. A banking office in North Phoenix in the Deer Valley Airpark will likely be completed near the end of 2008 or early 2009.
Premises and equipment expenses increased by $131 thousand or 3.5% during the year ended December 31, 2007, as compared to the prior year. The increase in premises and equipment expense during the year ended December 31, 2007 was primarily due to the banking office openings and general growth in operations.
Professional fees decreased by $238 thousand or 23.8% during the year ended December 31, 2007, as compared to the prior year. The decrease was primarily due to completing the process of bringing all of the risk and investment management operations in-house with a marginal cost savings versus our Portfolio and Rate Risk Analysis Agreement with Smith Breeden Associates, Inc., which terminated on April 30, 2007.
We have also made expenditures in administration and systems to support our growth and have increased consulting and internal support to implement new corporate governance regulations, such as the Sarbanes Oxley Act (SOA).
The increases in miscellaneous other expenses since 2006, primarily reflects our growth in our number of offices over the periods as well as expenses associated with our public company status and new corporate governance regulations.
Income Taxes. We incurred income tax expense of $2.5 million and $4.3 million during the years ended December 31, 2007, and 2006. The amount of our income tax expense is a function of the amount of our income before income taxes during the periods presented. Our effective tax rates were 37.3% and 34.1%, the years ended December 31, 2007 and 2006. HWFG benefited from a favorable tax ruling from the Franchise Tax Board of California in 2006, confirming the apportionment of income to states in which HWFG does business and from higher income being reported in states with lower tax rates, a benefit of HWFG’s multiple market strategy. Tax exempt income from bank-owned life insurance and tax exempt loans also helped lower HWFG’s combined tax rate in 2006 and 2007.
Changes in Financial Condition
General. At December 31, 2007, our total assets amounted to $1.2 billion, compared to $1.2 billion at December 31, 2006. The increase of $70.4 million in total assets was primarily attributable to an increase in our securities portfolio. At December 31, 2007, our total liabilities amounted to $1.2 billion, compared to $1.1 billion at December 31, 2006.
The core banking franchise continues to experience moderate growth despite the very challenging banking market. Loan growth was 2.2% on a sequential basis in the December 2007 quarter and 3.4% for the full year of 2007. This growth is below HWFG’s target rate of high single to low double-digit levels. Competition remains formidable in HWFG’s market for loans and the widening of spreads in the securitized loan markets has yet to fully translate into the community banking markets. We remain cautious on the residential construction loan market. HWFG is, however, seeing more loan opportunities in recent months and believes that with its diversified loan menu, the low end of its target range for loan growth is attainable in 2008.
Loan credit quality remains fairly stable in the weakening real estate market and with the economy transitioning to slower growth. At December 31, 2007, HWFG had a $1.8 million non-performing loan (more than 90 days delinquent) and an additional $1.4 million of non-accruing (more than 60 days delinquent by Bank policy) loans. The $1.8 million non-performing loan is a participation loan in a development near Stockton, California, which is proceeding through the foreclosure process and continued negotiations with the borrower. The non-accruing balances include 2 small commercial credits and an owner-occupied real estate loan totaling $689 thousand, and a $750 thousand land development loan near Ventura, California. The $750 thousand loan on land for development was sold as REO in January 2008 for no loss to HWFG with the recovery of all interest, fees, and expenses. HWFG recorded charge-offs of $112 thousand on the commercial loans and set up specific reserves on the remaining non-accruing loans. Additionally, HWFG added $650 thousand to its allowance for loan losses, increasing its balance to $6.4 million or .82% of loans.
Net retail deposit growth was near HWFG’s target in 2007 propelled by its Power-Up program. This program ties together a checking account with a required automatic transaction and a money market account. Furthermore, HWFG was successful in promoting certificate of deposit accounts in the spring of 2007 and retaining them at lower rates at renewal in the December 2007 quarter. With the full implementation of the Power-Up account in all of HWFG’s markets in 2007, the implementation of the retail deposit gathering sales plan, and the reorganization of the retail and internet banking division, HWFG expects to meet its high simple digit deposit growth goal for 2008.
Cash and Cash Equivalents. Cash and cash equivalents, consisting of cash and due from banks and federal funds sold, amounted to $14.4 million at December 31, 2007, and $21.2 million at December 31, 2006. We manage our cash and cash equivalents based upon our operating, investing and financing activities. We generally attempt to invest our excess liquidity into higher yielding assets such as loans or securities. See “Liquidity and Capital Resources.”
Securities. Securities classified as available for sale (AFS), which consist of mortgage-backed and related securities, amounted to $351.5 million at December 31, 2007 and $309.7 million at December 31, 2006. Securities classified as held to maturity, consisting of mortgage-backed and U.S. Government agency securities,
remained relatively stable at the end of the periods presented, amounting to $56 thousand at December 31, 2006 and $69 thousand at December 31, 2005. The decrease of $13 thousand was due primarily to principal prepayments. For additional details concerning our securities portfolio, please refer to Note 3 of the Consolidated Financial Statements.
Trading Account Assets. We also classify certain mortgage-backed and related securities and equity securities as trading securities in accordance with SFAS No. 115 and enter into interest rate contracts that do not qualify for hedge accounting treatment. These assets are collectively referred to as trading account assets. At December 31, 2007, the trading account assets totaled $2.3 million, consisting of $194 thousand in mortgage-backed securities, $656 thousand in equity securities and $1.5 million in CMBS TROR representing the unrealized gain on the $80 million of CMBS TROR. At December 31, 2006, the trading portfolio totaled $837 thousand and consisted of $237 thousand in mortgage-backed securities, $600 thousand in equity securities.
Loans Receivable. The Company’s primary focus with respect to its lending operations has historically been the direct origination of single-family and multi-family residential, commercial real estate, business, and consumer loans. As part of its strategic plan to diversify its loan portfolio, the Company, starting in 2000, has been increasing its emphasis on loans secured by commercial real estate, industrial loans and consumer loans.
At December 31, 2007, loans receivable, net of our allowance for loan losses, amounted to $782.6 million or 64.0% of total assets, as compared to $757.0 million or 65.6% of total assets at December 31, 2006. The $25.6 million or 3.4% increase in the loan portfolio during 2007, and the related loan mix change to higher spread earning loans was due to our emphasis on commercial real estate, commercial and industrial, construction, and multifamily mortgage loans and Los Padres Bank’s strategy to broker for third parties substantially all new single-family mortgage originations in order to generate fee income.
At December 31, 2007, the Bank’s regulatory limit on loans-to-one borrower was $13.8 million and its five largest loans or groups of loans-to-one borrower, including related entities, aggregated $13.7 million, $13.7 million, $13.5 million, $13.3 million and $13.0 million. These five largest loans or loan concentrations were secured by commercial real estate and development of single family residences. All of these loans or loan concentrations were performing in accordance with their payment terms at December 31, 2007.
Allowance for Loan Losses. At December 31, 2007, our allowance for loan losses totaled $6.4 million, compared to $5.9 million at December 31, 2006. At December 31, 2007, our allowance for loan losses represented approximately 0.82% of the total net loan portfolio as compared to 0.78% at December 31, 2006. The increase in our allowance for loan losses during the periods reflects the growth of our loan portfolio and the mix change to business and commercial mortgage loans which continues our favorable loss history. We establish allowances for loan losses based on the nature of the risk of the comparable historical loss exposure. For a discussion of our loan loss reserve see “Item 1. Business - Allowance for Loan Losses” on page 12.
Prepaid expenses and other assets. At December 31, 2007, prepaid expenses and other assets amounted to $2.8 million, as compared to $5.0 million as of December 31, 2006. The $2.2 million decrease in prepaid expenses and other assets as of December 31, 2007, reflects a decrease in both accounts receivable and the fair value of cash flow hedges.
Deposits. HWFG seeks to grow its deposits at high single to low double-digit rates through its controlled expansion of banking operations in the markets of the Central Coast of California, the Phoenix, Arizona metro, and the Kansas City metro. At December 31, 2007, deposits totaled $836.3 million, as compared to $732.8 million as of December 31, 2006. Retail and commercial deposits were $785.8 million at December 31, 2007 compared to $732.8 million at December 31, 2006, increasing 7.2%. Not included in these balances are $50.5 million of California State deposits added in the September 2007 quarter at a lower relative cost to retail certificates of deposit and other wholesale funding sources. HWFG’s emphasis on core deposit development (business and consumer checking, savings and money market accounts) remains a key strategy. In 2007, HWFG provided its banking centers, business developers and lending officers sales
training, product tools and incentives to better capture these deposits and to lay the foundation for growth in 2008.
HWFG is also focused on developing more low and non-costing deposits through a dual pronged program: (1) a sales development and incentive program throughout its banking centers focused on calling on viable commercial and retail DDA prospects, and (2) an incentive and training program for all business and commercial real estate lenders to gather more core deposits from commercial customers in a team approach with the banking centers. HWFG is also adding remote deposit products to enhance customer convenience.
HWFG continued to grow deposits at a high single-digit pace in 2006 and core non-costing deposits at a double-digit annual rate. With the steady rise in market interest rates and competition for insured deposits, the spreads on certificates of deposits did increase to LIBOR rates, somewhat affecting margins. We attempt to manage our overall funding costs by evaluating all potential sources of funds, including retail deposits and short and long-term borrowings, and identifying which particular source will result in an all-in cost to us that meets our funding benchmark. At the same time, Los Padres Bank has attempted to price the deposits offered through its branch system in order to promote retail deposit growth and offer a wide array of deposit products to satisfy its customers. In addition to providing a cost-efficient funding source, these retail deposits provide a source of fee income and the ability to cross-sell other products or services.
Borrowings. Advances from the FHLB of San Francisco amounted to $247.0 million at December 31, 2007 and $257.0 million at December 31, 2006. The decrease in FHLB advances in 2007 was due to our decreased utilization of such borrowings to fund our investments. At December 31, 2007, our FHLB advances had a weighted average interest rate of 4.50%, as compared to 5.44% at December 31, 2006. Our outstanding FHLB advances have maturities ranging from 2008 to 2011.
Subordinated Debt. Subordinated debt amounted to $25.8 million at December 31, 2007 and December 31, 2006. In September 2004, Harrington West Capital Trust II, issued $10.3 million of trust-preferred securities. The trust preferred securities bear an interest rate of three month LIBOR plus 1.90% will mature on October 7, 2034 and have a five-year call feature. A portion of the proceeds from the offering were used to downstream capital to Los Padres Bank to support its growth in operations. In September 2003, Harrington West Capital Trust I issued $15.5 million of trust-preferred securities. The trust preferred securities issued in September 2003 bear an interest rate of three month LIBOR plus 2.85%, will mature on October 8, 2033 and have a five-year call feature. We used $11.3 million to pay off the secured line of credit with Harris Trust and Savings Bank and US Bank, N.A. The remaining proceeds were used to expand the Los Padres Bank operations in Overland Park, Kansas, Ventura, California and Scottsdale, Arizona.
Stockholders’ Equity. Our stockholders’ equity amounted to $55.0 million at December 31, 2007, a decrease of $12.7 million from December 31, 2006. The value of cash flow hedges recorded in equity decreased by $3.4 million after tax due to increased interest rates. Furthermore, and with the extreme widening of spreads, the mark to market value of the AFS portfolio declined by $10.8 million on an after tax basis in 2007. Book value per share, therefore, was $9.91 at December 31, 2007 compared to $12.40 at the same time a year ago, as earnings during the period were less than the total of the changes in market values on the AFS portfolio and cash flow swaps and the $3.8 million of dividends declared or $.68 per share in the period. Stockholders’ equity was positively influenced by $4.2 million of net income recognized, $720 thousand of additional paid in capital from options exercised, and $373 thousand from options expensed.
Asset and Liability Management
In general, savings institutions are negatively affected by an increase in interest rates to the extent that interest-bearing liabilities mature or re-price more rapidly than interest-earning assets. The lending activities of savings institutions have historically emphasized the origination of long-term, fixed-rate loans secured by single-family residences, and the primary source of funds of such institutions has been deposits, which largely mature or are subject to re-pricing within a shorter period of time. This factor has historically caused the income and market value of portfolio equity (“MVPE”) of savings institutions to be more volatile than other financial institutions.
MVPE is defined as the net present value of the cash flows from an institution’s existing assets, liabilities and off-balance sheet instruments. The MVPE is estimated by valuing our assets, liabilities and off-balance sheet instruments under various interest rate scenarios. The extent to which assets gain or lose value in relation to the gains or losses of liabilities determines the appreciation or depreciation in equity on a market value basis. MVPE analysis is intended to evaluate the impact of immediate and sustained interest rate shifts of the current yield curve upon the market value of the current balance sheet. While having liabilities that re-price more frequently than assets is generally beneficial to net interest income and MVPE in times of declining interest rates, such an asset/liability mismatch is generally detrimental during periods of rising interest rates.
Our management believes that its asset and liability management strategy, as discussed below, provides us with a competitive advantage over other financial institutions. We believe that our ability to hedge our interest rate exposure through the use of various interest rate contracts provides us with the flexibility to acquire loans structured to meet our customer’s preferences and investments that provide attractive net risk-adjusted spreads, regardless of whether the customer’s loan or our investment is fixed-rate or adjustable-rate or short-term or long-term. Similarly, we can choose a cost-effective source of funds and subsequently engage in an interest rate swap or other hedging transaction so that the interest rate sensitivities of our interest-earning assets and interest-bearing liabilities are more closely matched.
Our asset and liability management strategy is formulated and monitored by the board of directors of Los Padres Bank. The board of director’s written policies and procedures are implemented by the Asset and Liability Committee of Los Padres Bank (“ALCO”), which is comprised of Los Padres Bank’s chief executive officer, president/chief financial officer, executive vice-president/chief lending officer, principal accounting officer, president of Harrington Bank, and four non-employee directors of Los Padres Bank. The ALCO meets at least eight times a year to review the sensitivity of Los Padres Bank’s assets and liabilities to interest rate changes, investment opportunities, the performance of the investment portfolios, and prior purchase and sale activity of securities. The ALCO also provides guidance to management on reducing interest rate risk and on investment strategy and retail pricing and funding decisions with respect to Los Padres Bank’s overall asset and liability composition. The ALCO reviews Los Padres Bank’s liquidity, cash flow needs, interest rate sensitivity of investments, deposits and borrowings, core deposit activity, current market conditions and interest rates on both a local and national level in connection with fulfilling its responsibilities.
The ALCO regularly reviews interest rate risk by utilizing analyses prepared by the Chief Investment Officer with respect to the impact of alternative interest rate scenarios on net interest income and on Los Padres Bank’s MVPE. The ALCO also reviews analyses prepared by the Chief Investment Officer concerning the impact of changing market volatility, prepayment forecast error, and changes in option-adjusted spreads and non-parallel yield curve shifts.
In the absence of our hedging activities, our MVPE would decline significantly more as a result of a general increase in market rates of interest. This decline would be due to the market values of our assets being more sensitive to interest rate fluctuations than are the market values of our liabilities due to our investment in and origination of generally longer-term assets which are funded with shorter-term liabilities. Consequently, the elasticity (i.e., the change in the market value of an asset or liability as a result of a change in interest rates) of our assets is greater than the elasticity of our liabilities.
Accordingly, the primary goal of our asset and liability management policy is to effectively increase the elasticity of our liabilities and/or effectively contract the elasticity of our assets so that the respective elasticities are matched as closely as possible. This elasticity adjustment can be accomplished internally by restructuring our balance sheet or externally by adjusting the elasticities of our assets and/or liabilities through the use of interest rate contracts. Our strategy is to hedge either internally through the use of longer-term certificates of deposit or less sensitive transaction deposits and FHLB advances or externally through the use of various interest rate contracts.
External hedging generally involves the use of interest rate swaps, caps, floors, options and futures. The notional amount of interest rate contracts represents the underlying amount on which periodic cash flows are calculated and exchanged between counterparties. However, this notional amount does not necessarily represent the principal amount of securities, which would effectively be hedged by that interest rate contract.
In selecting the type and amount of interest rate contract to utilize, we compare the elasticity of a particular contract to that of the securities to be hedged. An interest rate contract with the appropriate offsetting elasticity could have a notional amount much greater than the face amount of the securities being hedged.
We adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, on January 1, 2001. SFAS No. 133 requires that an entity recognize all interest rate contracts which meet the definition of a derivative as either assets or liabilities in the statement of financial condition and measure those instruments at fair value. If certain conditions are met, an interest rate contract may be specifically designated as a fair value hedge, a cash flow hedge, or a hedge of foreign currency exposure. The accounting for changes in the fair value of an interest rate contract (that is, gains and losses) depends on the intended use of the interest rate contract and the resulting designation. To qualify for hedge accounting, we must show that, at the inception of the interest rate contracts and on an ongoing basis, the changes in the fair value of the interest rate contracts are expected to be highly effective in offsetting related changes in the cash flows of the hedged liabilities. We have entered into various interest rate swaps for the purpose of hedging certain of our short-term liabilities. These interest rate swaps qualify for hedge accounting. Accordingly, the effective portion of the accumulated change in the fair value of the cash flow hedges is recorded in a separate component of stockholders’ equity, net of tax, while the ineffective portion is recognized in earnings immediately. We have also entered into various interest rate swaps which assist in mitigating the rate risk on a portion of our securities portfolio. These swaps do not qualify for hedge accounting treatment and are included in the trading account assets and are reported at fair value with realized and unrealized gains and losses on these instruments recognized in income (loss) from trading account assets.
An interest rate swap is an agreement where one party agrees to pay a fixed rate of interest on a notional principal amount to a second party in exchange for receiving from the second party a variable rate of interest on the same notional amount for a predetermined period of time. No actual assets are exchanged in a swap of this type and interest payments are generally netted. These swaps are generally utilized by us to synthetically convert floating-rate deposits and borrowings into fixed-rate liabilities or convert fixed-rate assets into adjustable-rate instruments, in either case without having to sell or transfer the underlying liabilities or assets.
At December 31, 2007, we held interest rate swaps, which are utilized to hedge liabilities and which qualify for hedge accounting pursuant to SFAS No. 133 and are included in other assets or other liabilities. These swap agreements had an aggregate notional amount of $172.0 million and maturities from October 2008 to October 2014. With respect to these agreements, we make fixed-rate payments ranging from 3.8% to 6.3% and receive payments based upon three-month LIBOR. These fixed-pay swaps are used to effectively modify the interest rate sensitivity of a portion of Los Padres Bank’s short-term LIBOR correlated borrowings which include short-term deposits, securities sold under agreements to repurchase and FHLB advances.
During the year ended December 31, 2007 the swaps generated $934 thousand of interest income. The interest income related to these swaps was $972 thousand for the year ended December 31, 2006. This income is included in interest expense on FHLB advances and subordinated debt in our consolidated statements of earnings. The approximate market value of the interest rate swaps was an unrealized net loss of $5.0 million, and an unrealized gain of $587 thousand as of December 31, 2007 and 2006, respectively. These gains are reflected as a separate component in stockholders’ equity, net of tax.
At December 31, 2006, we did not hold any interest rate swaps as trading account assets.
An interest rate cap or an interest rate floor consists of a guarantee given by the issuer (i.e., a broker) to the purchaser (i.e., us), in exchange for the payment of a premium. This guarantee states that if interest rates rise above (in the case of a cap) or fall below (in the case of a floor) a specified rate on a specified interest rate index, the issuer will pay to the purchaser the difference between the then current market rate and the specified rate on a notional principal amount. No funds are actually borrowed or repaid. At December 31, 2007 and 2006, we did not have any interest rate caps or floors.
Interest rate futures are commitments to either purchase or sell designated instruments at a future date for a specified price. Futures contracts are generally traded on an exchange, are marked-to-market daily and are subject to initial and maintenance margin requirements. We generally use 91-day Eurodollar certificates of deposit contracts (“Eurodollar futures contracts”) which are priced off LIBOR as well as Treasury Note and Bond futures
contracts. We will from time to time agree to sell a specified number of contracts at a specified date. To close out a contract, we will enter into an offsetting position to the original transaction.
If interest rates rise, the value of our short futures positions increase. Consequently, sales of futures contracts serve as a hedge against rising interest rates. At December 31, 2007, and 2006, we did not have any futures contracts.
Options are contracts, which grant the purchaser the right to buy or sell the underlying asset by a certain date for a specified price. Generally, we will purchase options on financial futures to hedge the changing elasticity exhibited by mortgage loans and mortgage-backed securities. The changing elasticity results from the ability of a borrower to prepay a mortgage or caps and floors on the underlying loans. As market interest rates decline, borrowers are more likely to prepay their mortgages, shortening the elasticity of the mortgages. Consequently, where interest rates are declining, the value of mortgage loans or mortgage-backed securities will increase at a slower rate than would be expected if borrowers did not have the ability to prepay their mortgage.
We are subject to the risk that our counterparties with respect to various interest rate contracts may default at or prior to maturity of a particular instrument. In such a case, we might be unable to recover any unrealized gains with respect to a particular contract. To reduce this potential risk, we generally deal with large, established investment brokerage firms when entering into these transactions. In addition, we have a policy whereby we limit our unsecured exposure to any one counterparty to 25% of Los Padres Bank’s equity during any two-month period and 35% of Los Padres Bank’s equity during any one-month period.
The OTS requires each thrift institution to calculate the estimated change in the institution’s MVPE assuming an instantaneous, parallel shift in the Treasury yield curve of 100 to 300 basis points either up or down in 100 basis point increments. The OTS permits institutions to perform this MVPE analysis using their own internal model based upon reasonable assumptions. The Chief Investment Officer performs the required calculation of the sensitivity of our market value to changes in interest rates.
The following table sets forth at December 31, 2007, the estimated sensitivity of Los Padres Bank’s MVPE to parallel yield curve shifts using our internal market value calculation. The table demonstrates the sensitivity of our assets and liabilities both before and after the inclusion of our interest rate contracts.
The table set forth above does not purport to show the impact of interest rate changes on our equity under generally accepted accounting principles. Market value changes only impact our income statement or the balance sheet to the extent the affected instruments are marked to market, and over the life of the instruments, as an impact on recorded yields.
Liquidity and Capital Resources
Liquidity. The liquidity of Los Padres Bank, a consolidated subsidiary of the Company is monitored closely for regulatory purposes at the Bank level by calculating the ratio of cash, cash equivalents (not committed, pledged or required to liquidate specific liabilities), investments and qualifying mortgage-backed securities to the sum of total deposits plus borrowings payable within one year, which was 7.3% at December 31, 2007. At December 31, 2007, Los Padres Bank’s “liquid” assets totaled approximately $71.2 million.
In general, the Bank’s liquidity, represented by cash and cash equivalents, is a product of our operating, investing and financing activities. The Company’s primary sources of internal liquidity consist of deposits, prepayments and maturities of outstanding loans and mortgage-backed and related securities, maturities of short-term investments, sales of mortgage-backed and related securities and funds provided from operations. While scheduled loan and mortgage-backed and related securities amortization and maturing short-term investments are relatively predictable sources of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. The Company’s external sources of liquidity consist of borrowings, primarily advances from the FHLB of San Francisco and a revolving line of credit loan facility, which we maintain with two banks. At December 31, 2007, we had $247.0 million in FHLB advances and we had $180.7 million of additional borrowing capacity with the FHLB of San Francisco.
Liquidity management is both a daily and long-term function of business management. Excess liquidity is generally used to pay down short-term borrowings. On a longer-term basis, we maintain a strategy of investing in various mortgage-backed and related securities and loans. We use our sources of funds primarily to meet our ongoing commitments, to pay maturing savings certificates and savings withdrawals, fund loan commitments and maintain a portfolio of mortgage-backed and related securities as well as certain other investments. At December 31, 2007, the total approved loan commitments outstanding amounted to $201.1 million. Certificates of deposit scheduled to mature in one year or less at December 31, 2007 totaled $643.3 million and FHLB borrowings and repurchase agreements that are scheduled to mature within the same period amounted to $263.0 million. Management believes that we have adequate resources to fund all of our commitments and the Company could either adjust the rate of certificates of deposit in order to retain deposits in changing interest rate environments or replace such deposits with advances from the FHLB of San Francisco if it proved to be cost-effective to do so.
A substantial source of our income from which we service our debt, pay our obligations and from which we can pay dividends is the receipt of dividends from Los Padres Bank. The availability of dividends from Los Padres Bank is limited by various statutes and regulations. Los Padres Bank was pre-approved to pay up to $5.0 million of dividends to us between July 1, 2007 and June 30, 2008, with certain limitations, primarily to maintain capital ratios at a level that would qualify Los Padres Bank as a well capitalized institution immediately prior to and after payment of any dividend. At December 31, 2007 Los Padres Bank had $2.5 million remaining of the pre-approved $5.0 million. Los Padres Bank annually requests a pre-approval of dividends to be paid to us from to OTS. Los Padres can also make larger dividends if needed, but in order to make such dividend payment, Los Padres Bank is required to provide 30 days advance notice to the OTS, during which time the OTS may object to such dividend payment. It is possible, depending upon the financial condition of Los Padres Bank, and other factors, that the OTS could object to the payment of dividends by Los Padres Bank on the basis that the payment of such dividends is an unsafe or unsound practice. In addition, we are also subject to restrictions on our ability to pay dividends under our revolving loan facility and subordinated debt. In the event Los Padres Bank is unable to pay dividends to us, we may not be able to service our debt, pay our obligations or pay dividends on our common stock.
Capital Resources. Federally insured savings institutions such as Los Padres Bank are required to maintain minimum levels of regulatory capital. Los Padres Bank’s failure to comply could also impact its overall assessment by the OTS in future regulatory examinations, which, if adverse, could also impact its FDIC insurance assessment.
Contractual Obligations and Commercial Commitments
The following tables present our contractual obligations (not including interest) and commercial commitments as of December 31, 2007.
(1)
Lines of credit with no stated maturity date are included in commitments for less than one year.
Off-Balance Sheet Arrangements
As discussed in the Asset and Liability Management section above, we utilize external hedging transactions to effectively increase the elasticity of our liabilities and/or effectively contract the elasticity of our assets so that the respective elasticities are matched as closely as possible with the use of external hedging. External hedging generally involves the use of interest rate swaps, caps, floors, options and futures, which are off-balance sheet arrangements. We use interest rate swap instruments to effectuate our external hedging strategy. At December 31, 2007, we held interest rate swaps, which are utilized to hedge liabilities and which qualify for hedge accounting pursuant to SFAS No. 133 and are included in other assets or other liabilities. These swap agreements had an aggregate notional amount of $172 million and maturities from October 2008 to October 2014. The notional amount of interest rate contracts represents the underlying amount on which periodic cash flows are calculated and exchanged between counterparties. However, this notional amount does not necessarily represent the principal amount of securities, which would effectively be hedged by that interest rate contract. Our interest rate swap instruments require that we make fixed-rate payments ranging from 3.8% to 6.3% and receive payments based upon three-month LIBOR. These fixed-pay swaps are used to effectively modify the interest rate sensitivity of a portion of Los Padres Bank’s short-term LIBOR correlated borrowings which include short-term deposits, securities sold under agreements to repurchase and FHLB advances.
At December 31, 2007 and 2006, the interest rate swaps listed below are hedging the interest rate risk of cash flows associated with short-term FHLB advances and certificates of deposit with terms between six and twelve months. These swaps qualify as cash flow hedges.
The following table sets forth the maturity distribution and weighted-average interest rates of the interest rate swaps used to limit the repricing risk of deposits and short-term borrowings as of December 31, 2007:
At December 31, 2007, HWFG had $80 million of the Lehman AAA CMBS 8.5+ year index swaps. The underlying securities in the TROR CMBS swap position are backed by commercial mortgage loans with generally 75% original loan to value ratios, diversified among property types, generally issued in the last two years, and having 10 year balloon maturities, 25 to 30 year amortizations, and a lock-out from prepayment of principal until the balloon date. In addition, the AAA CMBS have additional credit enhancement of 20% to 30% in the form of junior securities. HWFG has invested in two types of AAA CMBS indexes: (1) the Lehman AAA 8.5+ year index having some mezzanine AAA securities, and (2) the Lehman Super Senior CMBS Index with only the most senior AAA securities.
Inflation and Changing Prices
Our consolidated financial statements and related data presented in this annual report have been prepared in accordance with accounting principles generally accepted in the U.S., which require the measurement of financial position and operating results in terms of historical dollars (except with respect to securities which are carried at market value), without considering changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, substantially all of our assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on our performance than the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or in the same magnitude as the prices of goods and services.
See “Effect of Newly Issued But Not Yet Effective Accounting Standards” included in Footnote 1.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Asset and Liability Management” in Item 7 hereof.
Item 8.
Item 8. Financial Statements and Supplementary Data.
Audited consolidated financial statements and related documents required by this item are included in this Annual Report on Form 10-K on the pages indicated:
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders of
Harrington West Financial Group, Inc
Solvang, California
We have audited the accompanying consolidated statements of financial condition of Harrington West Financial Group, Inc. as of December 31, 2007 and 2006, and the related consolidated statements of earnings, stockholders’ equity and comprehensive income (loss), and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of the internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2007 and 2006, and the results of its operations and its cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.
/s/ Crowe Chizek and Company LLP
Oak Brook, Illinois
March 26, 2008
HARRINGTON WEST FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Dollars in thousands, except share data)
See notes to consolidated financial statements.
HARRINGTON WEST FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF EARNINGS
(Dollars in thousands, except share and per share data)
See notes to consolidated financial statements.
HARRINGTON WEST FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY and COMPREHENSIVE INCOME (LOSS)
(Dollars in thousands)
See notes to consolidated financial statements.
HARRINGTON WEST FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY and COMPREHENSIVE INCOME (LOSS)
(Dollars in thousands)
See notes to consolidated financial statements.
HARRINGTON WEST FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
See notes to consolidated financial statements.
HARRINGTON WEST FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
See notes to consolidated financial statements.
HARRINGTON WEST FINANCIAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Table amounts in thousands, except share and per share data)
1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Business of the Company - Harrington West Financial Group, Inc. is a savings and loan holding company incorporated on August 29, 1995 to acquire and hold all of the outstanding common stock of Los Padres Bank (the “Bank”), referred to herein on a consolidated basis as the “Company”. The Bank is a federally chartered savings bank which operates 16 branches serving individuals and small to medium-sized businesses. Eleven banking facilities are operated on the California Central Coast, three banking facilities are located in Kansas, and operated as a division under the Harrington Bank brand, and two banking facilities are located in Scottsdale, Arizona.
Harrington Wealth Management Company (“HWMC”) is a wholly owned subsidiary of the Bank and is consolidated into the Bank.. HWMC offers trust and investment management services to the customers of the Bank. HWMC performs management of investment portfolios through knowledge and analysis of the customer’s investment needs, risk tolerance, tax situation and investment horizon. At December 31, 2007, HWMC administered approximately 493 accounts and had $184.4 million of assets under management that are not included on the consolidated statements of financial condition. For the years ended December 31, 2007 and 2006, HWMC generated revenues of $964,000 and $848,000, respectively.
Basis of Presentation - The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and general practices within the banking industry. The following is a summary of significant principles used in the preparation of the accompanying consolidated financial statements. In preparing the consolidated financial statements, management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities, including the allowance for loan losses, valuation of investment securities, fair value of derivatives, fair value of financial instruments and stock-based compensation. Actual results could differ from those estimates.
Principles of Consolidation - The consolidated financial statements include the accounts of Harrington West Financial Group, Inc. and its wholly owned subsidiary, Los Padres Bank (the “Bank”), and the Bank’s wholly owned subsidiaries. All intercompany transactions and accounts have been eliminated in consolidation. The Company also has two wholly-owned subsidiaries that are statutory business trusts (the “Trusts”). In accordance with Financial Accounting Standards Board Interpretation No. 46R, Consolidation of Variable Interest Entities (“FIN No. 46R”), the Trusts are not consolidated into the accounts of Harrington West Financial Group, Inc.
Segments - The Company has a single operating segment, banking operations.
Cash and Cash Equivalents - For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks and federal funds sold. Generally, federal funds are purchased and sold for one-day periods.
Trading Account Assets - Trading account assets are debt and equity securities, as well as derivative instruments not receiving hedge treatment (as further described in Note 15) that are bought and held principally for the purpose of active management. These assets are reported at fair value and included in trading account assets on the statements of financial condition. Realized and unrealized
gains and losses are included in income (loss) from trading assets. Interest from trading assets is included in interest income.
Available for Sale Securities - Debt and equity securities not classified as either held to maturity or trading securities are classified as securities available for sale and recorded at fair value, with unrealized gains and losses, after applicable taxes, excluded from earnings and reported as a separate component of stockholders’ equity. Declines in the value of debt securities and marketable equity securities that are considered to be other than temporary are recorded as realized losses in the statement of earnings. Amortization of premiums and accretion of discounts on securities are recorded as yield adjustments on such securities using an effective interest method that considers estimates of future principal prepayments. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.
A security may become impaired. The impairment may be temporary or other than temporary. In the case of debt securities, the impairment may imply a judgment by the market that the issuer will not be able to make interest and principal payments as contractually required. Alternatively, the impairment may be due only to changes in interest rates that do not impact the issuer’s ability to meet its contractual obligations. The Company periodically reviews impaired securities to determine whether the impairment is other than temporary. Declines in the fair value of securities below their cost that are other than temporary are reflected as realized losses. In estimating other-than-temporary losses, management considers: the length of time and extent that fair value has been less than cost, the financial condition and near term prospects of the issuer, and the Company’s ability and intent to hold the security for a period sufficient to allow for any anticipated recovery in fair value.
Held to Maturity Securities - Held to maturity securities represent investments that the Bank has the positive intent and ability to hold to maturity and are reported at amortized cost. Declines in the value of held to maturity securities that are considered to be other than temporary are recorded as realized losses in the statement of earnings. Similar to available for sale securities, premiums and discounts are amortized using an effective interest method that considers estimates of future principal prepayments.
Loans Receivable - Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay off are carried at the principal amount outstanding, net of deferred loan fees, costs, premiums and allowance for loan losses.
Loan Interest Income and Fees - Interest on loans is accrued as earned, except non-accrual loans on which interest is normally discontinued whenever the payment of principal or interest is considered to be in doubt, generally when the interest becomes 60 days past due. When a loan is placed on non-accrual, all previously accrued but uncollected interest is reversed against current period income. In general, subsequent payments received are applied to the outstanding principal balance of the loan. A loan is returned to accrual status when the borrower has demonstrated a satisfactory payment trend subject to management’s assessment of the borrower’s ability to repay the loan.
Loan origination fees and certain direct loan origination costs are deferred and amortized over the lives of the related loans as an adjustment to yield using a method that approximates the level-yield method. Calculation of the yield is done on a loan-by-loan basis. Unamortized fees are recognized in interest income. Other loan fees and charges representing service costs for the repayment of loans, delinquent payments or miscellaneous loan services are recorded as income when collected.
Discounts and premiums on loans are amortized into interest income, using a method that approximates the level-yield method over the estimated life of the related loans.
Allowance for Loan Losses - Allowance for loan losses is increased by charges to income and decreased by charge-offs (net of recoveries). Charge-offs are recorded when management believes the uncollectibility of the loan balance is confirmed.
The allowance is maintained at a level believed by management to be sufficient to absorb probable incurred credit losses in the loan portfolio. Management’s determination of the adequacy of the allowance is based on periodic evaluations of the credit portfolio and other relevant factors. This evaluation is inherently subjective, as it requires material estimates, including, among others, the amounts and timing of expected future cash flows on impaired loans, estimated losses on consumer loans and residential mortgages, and general amounts for historical loss experience, economic conditions, uncertainties in estimating losses and inherent risks in the various credit portfolios, all of which may be susceptible to significant change.
In determining the adequacy of the allowance for loan losses, the Company makes specific allocations to impaired loans in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 114, Accounting by Creditors for Impairment of a Loan as amended by SFAS No. 118. Loans are identified as impaired when it is deemed probable that the borrower will be unable to meet the scheduled principal and interest payments under the terms of the loan agreement. Impairment is based on the present value of expected future cash flows discounted at the loan’s effective interest rate, except that as a practical expedient, impairment may be measured based on a loan’s observable market price or the fair value of the collateral if the loan is collateral dependent.
Allocation of the allowance for loan losses to non-homogeneous loan pools are developed by loan type and risk factor and are based on historical loss trends and management’s judgment concerning those trends and other relevant factors. These factors may include, among others, trends in criticized assets, regional and national economic conditions, changes in lending policies and procedures, trends in local real estate values and changes in volumes and terms of the loan portfolio.
Homogeneous (consumer and residential mortgage) loan allocation of the allowance for loan losses are made at a total portfolio level based on historical loss experience adjusted for portfolio activity and economic conditions.
Transfers of Financial Assets - Transfers of financial assets are accounted for as sales, when control over the assets has been relinquished. Control over transferred assets is deemed to be surrendered when the assets have been isolated from the Company, the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Premises and Equipment - Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Depreciation and amortization are computed on the straight-line method over the estimated useful lives of the assets. The depreciable lives range from 3 to 25 years for leasehold improvements, 3 to 20 years for furniture, fixtures and equipment and 15 to 39 years for the office buildings.
The Company reviews its long-lived assets for impairment annually or when events or circumstances indicate that the carrying amount of these assets may not be recoverable. An asset is considered impaired when the expected undiscounted cash flows over the remaining useful life is less than the net book value. When impairment is indicated for an asset, the amount of impairment loss is the excess of the net book value over its fair value.
Real Estate Acquired through Foreclosure - Real estate acquired through foreclosure is carried at estimated fair value at the time of foreclosure, less estimated costs to sell. Any subsequent operating expense or income, reduction in estimated values, and gains or losses on disposition of such properties are included in current operations. The Company had no real estate acquired through foreclosure at December 2007 and 2006.
Income Taxes - Income tax expense is the total of the current-year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets or liabilities shown on the statement of financial condition are adjusted to reflect differences between the tax bases of assets and liabilities and their reported amounts in the financial statements, based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income.
The Company adopted FASB Interpretation 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), as of January 1, 2007. A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. The adoption had no material affect on the Company’s consolidated financial statements. The Company recognizes interest and penalties related to income tax matters in income tax expense.
Investment in Federal Home Loan Bank of San Francisco Stock - As a member of the Federal Home Loan Bank (“FHLB”) of San Francisco, the Bank is required to own common stock in the FHLB of San Francisco based upon its balance of residential mortgage loans and outstanding FHLB advances. FHLB stock is carried at cost and may be sold back to the FHLB at its carrying value. Both cash and stock dividends received are reported as dividend income.
Cash Surrender Value of Life Insurance - The Company has purchased life insurance policies on certain key executives. Company owned life insurance is recorded at cash surrender value (or the amount that can be realized). Upon adoption of EITF 06-5, which is discussed further below, cash surrender value of life insurance is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value adjusted for other charges or other amounts due that are probable at settlement. Prior to adoption of EITF 06-5, the Company recorded cash surrender value of life insurance at its cash surrender value.
In September 2006, the FASB Emerging Issues Task Force finalized Issue No. 06-5, Accounting for Purchases of Life Insurance - Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4 (Accounting for Purchases of Life Insurance){Issue}. This Issue requires that a policyholder consider contractual terms of a life insurance policy in determining the amount that could be realized under the insurance contract. It also requires that if the contract provides for a greater surrender value if all individual policies in a group are surrendered at the same time, that the surrender value be determined based on the assumption that policies will be surrendered on an individual basis. Lastly, the Issue requires disclosure when there are contractual restrictions on the Company’s ability to surrender a policy. The adoption of EITF 06-5 on January 1, 2007 had no impact on the Company’s consolidated financial condition or results of operations.
Core Deposit Intangibles - Core deposit intangibles are established in connection with purchase business combinations of banking or thrift institutions. Core deposit intangibles are amortized over the estimated useful life of the deposit base acquired, currently 10 years, using an accelerated amortization method. At December 31, 2007 and 2006, the gross balance of core deposit intangibles was $2.4 million and the accumulated amortization was $1.7 million and $1.5 million, respectively. The amortization expense was $233 thousand and $252 thousand for the years ended December 31, 2007, and 2006, respectively. Estimated future amortization of core deposit intangibles is $148
thousand for 2008, $146 thousand for 2009, $143 thousand for 2010, $123 thousand for 2011, $44 thousand for 2012, and $98 thousand thereafter.
Goodwill - Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is no longer amortized, but instead is tested for impairment at least annually. A goodwill impairment test was completed as of September 30, 2007. No impairment loss was recorded by the Company.
Derivatives Held for Asset and Liability Management Purposes - SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended, establishes accounting and reporting standards for derivative instruments and for hedging activities. SFAS No. 133 requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial condition and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as a fair value hedge, a cash flow hedge or a hedge of foreign currency exposure. The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation.
In accordance with the standards, the Company has identified certain types of short-term interest-bearing liabilities as a source of interest rate risk to be hedged in connection with the Company’s overall asset-liability management process. Although these liabilities have contractually fixed rates of interest, their short-term maturities, together with the expectation that they will be continually refinanced or replaced with similar products, give rise to the risk of fluctuations in interest expense as interest rates rise and fall in future periods. In response to this identified risk, the Company uses interest rate swaps as cash flow hedges to hedge the interest rate risk associated with the cash flows of short-term deposits, securities sold under agreements to repurchase and FHLB advances.
To qualify for hedge accounting, the Company must show that, at the inception of the hedges and on an ongoing basis, the changes in the fair value of the hedging instruments are expected to be highly effective in offsetting related changes in the cash flows of the hedged liabilities. These interest rate swaps have been shown to be effective in hedging the exposure to the short-term liability variability in cash flows and, therefore, qualify for hedge accounting. For our cash flow hedges, the effective portion of the derivative’s gain or loss is initially reported in stockholders’ equity (as a component of accumulated other comprehensive income (loss)) and is subsequently reclassified into income, as an increase or decrease to interest expense, in the same period or periods during which the hedged forecasted transaction affects income. The ineffective portion of the gain or loss is reported as interest expense immediately. During the next twelve months, the Company expects a benefit of $2 thousand, net of tax, from the amount recorded in the separate component of stockholders’ equity to be reclassified to interest expense.
Securities Sold Under Repurchase Agreements - The Company sells securities under repurchase agreements. These transactions are accounted for as collateralized financing transactions and recorded at the amounts at which the securities were sold. The Company may have to provide additional collateral to the counterparty, as necessary.
Comprehensive Income (Loss) - Comprehensive income (loss) consists of net income and other comprehensive income or loss. Other comprehensive income or loss includes unrealized gains and losses on securities available for sale, net of tax, and unrealized gains and losses on cash flow hedges, net of tax, which are also recognized as separate components of stockholders’ equity.
Loss Contingencies - Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there now are such matters that will have a material effect on the financial statements.
Fair Value of Financial Instruments - Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.
The fair value estimates presented herein are based on pertinent information available to management as of each reporting date. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date, and therefore, current estimates of fair value may differ significantly from the amounts presented herein.
Cash Flows - Net cash flows are reported for customer loan and deposit transactions, interest bearing deposits in other financial institutions, and federal funds purchased and securities sold under repurchase agreements and other short-term borrowings with original maturities under 90 days.
Stock-Based Compensation
Effective January 1, 2006, the Company adopted SFAS No. 123(R), Share-based Payment. Under SFAS 123(R), compensation cost is calculated on the date of grant using the fair value of the option as determined using the Black Scholes model. The compensation cost is then amortized straight-line over the vesting period. The Black Scholes valuation calculation requires the Company to estimate key assumptions such as expected option term, expected volatility of the Company’s stock, the risk-free interest rate, annual dividend yield and forfeiture rates to determine the stock options fair value. The estimate of these key assumptions is based on historical information and judgment regarding market factors and trends. The Company elected to adopt the modified prospective application method as provided by SFAS 123(R), and, accordingly, the Company recorded compensation costs as the requisite service is rendered for the unvested portion of previously issued awards that remain outstanding at the initial date of adoption and for any awards issued, modified, repurchased, or cancelled after the effective date of SFAS 123(R). The Company assumes a forfeiture rate of 3% annually.
The pre-tax unearned compensation expense for the remaining three year vesting period through December 31, 2011, of the non-vested stock options is $596 thousand as of December 31, 2007.
Adoption of new accounting standards:
In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155, Accounting for Certain Hybrid Financial Instruments (SFAS No. 155), which permits fair value re-measurement for hybrid financial instruments that contain an embedded derivative that otherwise would require bifurcation. Additionally, SFAS No. 155 clarifies the accounting guidance for beneficial interests in securitizations. Under SFAS No. 155, all beneficial interests in a securitization will require an assessment in accordance with SFAS No. 133 to determine if an embedded derivative exists within the instrument. In January 2007, the FASB issued Derivatives Implementation Group Issue B40, Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets (DIG Issue B40). DIG Issue B40 provides an exemption from the embedded derivative test of paragraph 13(b) of SFAS No. 133 for instruments that would otherwise require bifurcation if the test is met solely because of a prepayment feature included within the securitized interest and prepayment is not controlled by the security holder. SFAS No. 155 and DIG Issue B40 are effective for fiscal years beginning after September 15, 2006. The adoption of SFAS No. 155 and DIG Issue B40 did not have a material impact on the Company’s consolidated financial position or results of operations.
Newly Issued, But Not Yet Effective Accounting Standards
In September 2006, the FASB issued Statement No. 157, Fair Value Measurements. This Statement defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. This Statement establishes a fair value hierarchy about the assumptions used to measure fair value and clarifies assumptions about risk and the effect of a restriction on the sale or use of an asset. The standard is effective for fiscal years beginning after November 15, 2007. We do not expect the adoption of this standard in 2008, to have a material impact on the Company’s consolidated financial position or results of operations.
In February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. The standard provides companies with an option to report selected financial assets and liabilities at fair value and establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. The new standard is effective for the Company on January 1, 2008. The Company did not elect the fair value option for any financial assets or financial liabilities as of January 1, 2008.
In September 2006, the FASB Emerging Issues Task Force finalized Issue No. 06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements. This issue requires that a liability be recorded during the service period when a split-dollar life insurance agreement continues after participants’ employment or retirement. The required accrued liability will be based on either the post-employment benefit cost for the continuing life insurance or based on the future death benefit depending on the contractual terms of the underlying agreement. This issue is effective for fiscal years beginning after December 15, 2007. The impact of adoption in 2008 was not material to the Company’s consolidated financial statements.
On November 5, 2007, the SEC issued Staff Accounting Bulletin No. 109, Written Loan Commitments Recorded at Fair Value through Earnings (“SAB 109”). Previously, SAB 105, Application of Accounting Principles to Loan Commitments, stated that in measuring the fair value of a derivative loan commitment, a company should not incorporate the expected net future cash flows related to the associated servicing of the loan. SAB 109 supersedes SAB 105 and indicates that the expected net future cash flows related to the associated servicing of the loan should be included in measuring fair value for all written loan commitments that are accounted for at fair value through earnings. SAB 105 also indicated that internally-developed intangible assets should not be recorded as part of the fair value of a derivative loan commitment, and SAB 109 retains that view. SAB 109 is effective for derivative loan commitments issued or modified in fiscal quarters beginning after December 15, 2007. The impact of adoption in 2008 was not material to the Company’s consolidated financial statements.
Reclassifications - Certain reclassifications have been made to the prior financial statements to conform to the current year presentation.
2. LOANS RECEIVABLE
The Bank’s loan portfolio as of December 31 is summarized as follows:
Activity in the allowance for loan losses is summarized as follows:
Loans for which impairment has been recognized are as follows:
At December 31, 2007 and 2006, we had one and two non-performing loans with $1.8 million and $98, respectively. There were no restructured loans or real estate acquired through foreclosure at December 31, 2007 and 2006. There were no accruing loans past due 90 days or more.
At December 31, 2007 and 2006, the Bank had the following outstanding loan commitments:
Unfunded Loan Commitments as of December 31,
Commitments to make loans are generally made for periods of 60 days or less. As of December 31, 2007, loan commitments included $10 million of fixed rate commercial real estate loans with rates from 6.65% to 7.79% and terms of 25 months to 84 months.
3. SECURITIES
All securities held do not have a single maturity date. The amortized cost and estimated fair values of securities available for sale are summarized as follows:
The fair values and unrealized losses of the securities classified as available-for-sale or held-to-maturity with unrealized losses as of December 31, 2007 and 2006 segregated by investments that have been in a continuous unrealized loss position for less than 12 months and investments that have been in a continuous unrealized loss position for 12 months or longer are summarized below:
Our mortgage-backed securities - pass-throughs are issued by U.S. government agencies and government sponsored enterprises, which primarily include Freddie Mac, Fannie Mae and the Government National Mortgage Association (“Ginnie Mae”). As of December 31, 2007, there are 91 mortgage-backed securities in an unrealized loss position; of those, 41 have been in an unrealized loss position for twelve months or more. At December 31, 2006, 84 mortgage-backed securities were in an unrealized loss position; of those, 73 had been in an unrealized loss position for over twelve months. Management believes that the unrealized losses associated with these investments are attributable to changes in interest rates and spreads, and accordingly, the unrealized losses are not “other-than-temporary impairments.” Management intends to hold these securities until recovery.
As of December 31, 2007 and December 31, 2006, there are 32 and 14, respectively, collateralized mortgage obligation securities in an unrealized loss position. Of the 32 securities in an unrealized loss position as of December 31, 2007, 1 has been in an unrealized loss position for over twelve months; and at December 31, 2006, of the 14 securities that were in an unrealized loss position, 3 had been in an unrealized loss position for over twelve months.
At December 31, 2006, our commercial mortgaged-backed securities were issued by various entities or trusts and all were rated as investment grade by a nationally recognized rating agency. As of December 31, 2007, we had no commercial mortgaged-backed securities. At December 31, 2006, there were 5 commercial mortgage-backed securities in an unrealized loss position with one security in an unrealized loss position for over twelve months.
All of our asset-backed securities are issued by private entities or trusts and, as of December 31, 2007, all but 10 are rated as investment grade by a nationally recognized rating agency. The underlying collateral of these investments are single-family mortgages with the exception of the securities discussed in the next paragraph. As of December 31, 2007, there are 81 asset-backed securities that are in an unrealized loss position with 7 securities in an unrealized loss position for twelve months or more. As of December 31, 2006, there are 25 asset-backed securities that are in an unrealized loss position, with 11 securities in an unrealized loss position for twelve months or more. As to the mortgage-related asset backed securities, management believes that the unrealized losses associated with these investments are attributable to changes in interest rates and spreads, and accordingly, the unrealized losses are not “other-than-temporary impairments.” Management intends to hold these securities until recovery.
Based on HWFG’s December 31, 2007 evaluation of its available for sale mortgage securities portfolio and the stress-testing of the cash flows on its $166.7 million of sub-prime asset backed, home equity securities for various delinquency, foreclosure, and recovery rate scenarios on the underlying loans, HWFG seeks to determine the likelihood of earning all scheduled interest and principal on these securities. Of the $166.7 million in sub-prime securities, $82.0 million were purchased in 2007 in order to capitalize on the extreme widening of spreads and are rated AAA or AA by one or more rating agencies. 99% of HWFG’s sub-prime securities portfolio remains rated A or higher by one or more rating agency. During the third quarter evaluation, it was determined that all $2.4 million book value of non-insured, NIM home equity securities
were impaired, and these securities were written down by $1.9 million to market value through earnings in the September 2007 quarter. An additional $247 thousand of other-than-temporary loss was recorded in the fourth quarter of 2007.
The asset-backed securities are collateralized by student loans, a pool of loans and leases on medical equipment and medical business loans and they have a fair value of $1.7 million and $2.7 million as of December 31, 2007 and 2006, respectively. The securities are of the senior tranches with priority cash flow rights and are rated CCC by Fitch and B1 by Moody’s, as of December 31, 2007. Management believes the increase in the unrealized loss from $43,000 as of December 31, 2006 to $167,000 as of December 31, 2007 is attributed to generally poor market conditions. The delinquencies on the underlying loans of these securities have decreased from 13.5% per the December 2006 servicer report to 11.3% per the December 2007 servicer report. Furthermore, management performs a stress test of the cash flows based on various delinquency, default and recovery rates on the underlying loans. Based on this analysis, all payments can be made on this security and, as such, the current unrealized loss associated with this investment is not an “other-than-temporary impairment.” Management intends to hold these securities until recovery.
At December 31, 2007, $300.6 million, or 85.6% of our mortgage-backed and related securities were pledged to secure various obligations (such as Federal Home Loan Bank (“FHLB”) advances, repurchase agreements and collateral for interest rate swaps.
Proceeds from sales of available for sale securities were $36.0 million and $44.3 million with related gross realized gains of $0, and $110,000 for 2007, and 2006, respectively. There were $1.0 million realized losses during the year ended December 31, 2007, with $723,000 realized losses in 2006.
Securities Held to maturity
December 31, 2006
4. PREMISES AND EQUIPMENT
Premises and equipment consist of the following at December 31:
Depreciation expense was $1,252 and $1,223 for the years ended 2007 and 2006, respectively.
5. DEPOSITS
A summary of deposits by type of account as of December 31 is as follows:
(1) Weighted Average interest rate as of the end of the period.
Total deposits include two California State deposits in the amount of $50.5 million as of December 31, 2007. These deposits are secured by two letters of credit issued by the Federal Home Loan Bank in the amount of $27.5 million each. There were no California State deposits at December 31, 2006.
As of December 31, 2007, certificates of deposits are scheduled to mature as follows:
6. FEDERAL HOME LOAN BANK ADVANCES
We obtain both long-term fixed-rate and overnight advances from the FHLB of San Francisco upon the security of certain of our residential first mortgage loans, mortgage-backed securities or FHLB stock. FHLB of San Francisco advances are available for general business purposes to expand lending and investing activities. Advances from the FHLB of San Francisco are made pursuant to several different credit programs, each of which has its own interest rate and range of maturities. Our advances are limited to 35% of our total Bank assets, or $427.7 million and $403.5 million at December 31, 2007 and 2006, respectively.
FHLB advances are collateralized by the investment in the stock of the FHLB and certain mortgage loans aggregating $287.6 million and $227.2 million at December 31, 2007 and 2006, respectively, and mortgage-backed securities aggregating $199.4 million and $144.5 million, market value, at December 31, 2007 and 2006, respectively. The weighted-average interest rate on all advances was 4.50% and 5.44% at December 31, 2007 and 2006 respectively.
The maturities of FHLB advances at December 31, are as follows:
7. NOTE PAYABLE
At December 31, 2006, the Company had a loan facility from two banks consisting of a revolving line of credit of $15.0 million. There were no draws on the line of credit during 2007 or 2006. The lines of credit matured on September 30, 2007 and were not renewed.
8. SUBORDINATED DEBT
Two trusts formed by the Company, closed pooled private offerings of 10,310 and 15,464 trust preferred securities with a liquidation amount of $1 per security. The Company issued $10,000 and $15,000 of subordinated debentures to the two separate trusts in exchange for ownership of all of the common security of the trusts and the proceeds of the preferred securities sold by the trust. In accordance with FASB Interpretation 46R, the trusts are not consolidated with the Company’s financial statements, but rather the subordinated debentures are shown as a liability. The Company’s investment in the common stock of the trusts totaled $774 and is included in other assets.
The Company may redeem the subordinated debentures, in whole or in part on or after the fifth anniversary of the respective issuance dates at 100% of the principal amount, plus accrued and unpaid interest. The subordinated debentures are also redeemable in whole or in part from time to time, upon the occurrence of specific events defined within the trust indenture. The Company has the option to defer interest payments on the subordinated debentures from time to time for a period not to exceed five consecutive years.
The subordinated debentures may be included in Tier I capital (with certain limitations applicable) under current regulatory guidelines and interpretations.
9. SECURITIES SOLD UNDER REPURCHASE AGREEMENTS
We obtain funds from the sales of securities to investment dealers under agreements to repurchase, known as reverse repurchase agreements. In a reverse repurchase agreement transaction, we will generally sell a mortgage-backed security agreeing to repurchase either the same or a substantially identical security on a specific later date. For agreements in which we have agreed to repurchase substantially identical securities, the dealers may sell, loan or otherwise dispose of our securities in the normal course of their operations; however, such dealers or third party custodians safe-keep the securities which are to be specifically repurchased by us. At December 31, 2007 and 2006, the Company had $61.0 million and $70.7 million of mortgage-backed securities from the available-for-sale portfolio, which were pledged as collateral for our repurchase agreements. Reverse repurchase transactions are accounted for as financing
arrangements rather than as sales of such securities, and the obligation to repurchase such securities is reflected as a liability in our consolidated financial statements.
At December 31, 2007 and 2006, we had three and four wholesale repurchase agreements, respectively, with Citigroup Financial Services totaling $45.0 million and $59.0 million with maturities ranging from May 2007 to July 2010. We also had retail repurchase agreements with our customers of $5.0 million and $6.1 million at December 31, 2007 and 2006, respectively. Information concerning securities sold under agreements to repurchase is summarized as follows:
10. INCOME TAXES
The provision for taxes on income consists of the following components for the years ended December 31:
The actual tax rates differed from the statutory rates as follows for the years ended December 31:
The following is a summary of the components of the net deferred tax asset at December 31:
11. STOCKHOLDERS’ EQUITY
Retained earnings are restricted to the extent that earnings deducted for tax purposes as bad debt deductions are not available for payment of cash dividends or other distributions to stockholders without payment of federal income taxes by the Company at the then-prevailing corporate tax rates. At December 31, 2007, this restricted amount was $671 thousand, net of deferred tax totaling $399 thousand.
Qualified Stock Option Plan - The Company has a qualified stock option plan that provides for the granting of stock options to key employees of the Bank. Options granted under the plan are vested ratably over a four-year period. The option price is based on a determination of a price that is not less than the fair value of the shares at the date of grant by the Compensation Committee and ratified by the Board of Directors.
2005 Equity Based Compensation Plan - In May 2005, Company stockholders approved the 2005 Equity Based Compensation Plan (the “Plan”). The principal purpose of the 2005 Plan is to promote the success of the Company by attracting, motivating, and retaining key employees, including officers, and directors of the Company, through the grant of stock-based compensation awards and incentives for high levels of individual performance and improved financial performance of the Company. The availability of stock options and other equity awards combined with the ability to condition vesting of those awards on performance based criteria can provide the Company flexibility not currently found in the 1996 Stock Option Plan. This flexibility will help the Company formulate compensation practices that better align management’s interests with those of the stockholders.
The Board also considered a number of other issues in adopting the 2005 Plan. The 1996 Stock Option Plan commenced in July 1996 and expired in 2005. A significant portion of the total options
authorized in the 1996 Stock Option Plan are granted and, therefore, are already included in the Company’s diluted share count and earnings per share calculations. Accordingly, the Company expects additional dilution from unvested shares in the 1996 Stock Option Plan will be minimal. The shares of Company stock subject to the 2005 Plan are limited to ten percent (10%) of the number of shares issued and outstanding at any time to minimize future dilution.
The material aspects of the 2005 Plan are as follows:
Incentive Stock Options;
Non-Qualified Stock Options;
Stock Appreciation Rights (“SARs”);
Restricted Stock Awards;
Restricted Stock Units; and
Performance Share Cash Only Awards
•
vesting restrictions on awards may be time based and/or performance based;
•
participation in the 2005 Plan is limited to officers at the level of Vice President or above and other employees who provide substantial services to the Company as well as the Company’s directors;
•
the 2005 Plan provides for a maximum of a “floating” ten percent (10%) of the Company’s issued and outstanding shares of common stock that may be delivered for awards subject to adjustment as set forth therein; and
•
the right to acquire stock may not remain outstanding more than 10 years after the grant date, and any ISO Award granted to any eligible employee owning more than 10% of the Company’s stock must be granted at 110% of the fair market value of the stock. Awards do not vest or become exercisable until six months after the date of grant.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:
Information related to the stock option plan during each year follows:
A summary of the status of the Company’s stock options as of December 31 and changes during the years are presented below:
The outstanding options have prices ranging from $6.94 to $18.28. Remaining available options to be issued under the 2005 Equity Compensation Plan at December 31, 2007, were 320,400. There are no available options remaining under the 1996 Stock Option Plan. The plan expired May 24, 2005.
12. REGULATORY CAPITAL REQUIREMENTS
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. 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 Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures that have been established by regulation to ensure capital adequacy require the Bank to maintain minimum capital amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defines). Management believes, as of December 31, 2007, that the Bank meets all capital adequacy requirements to which it is subject.
The Bank’s primary regulatory agency, the Office of Thrift Supervision (“OTS”), currently requires that the Bank maintain minimum ratios of tangible capital (as defined in the regulations) to tangible assets of 1.5%, core capital (as defined) to adjusted tangible assets of 4%, and total capital (as defined) to risk-weighted assets of 8%. These capital requirements are viewed as minimum standards by the OTS, and most institutions are expected to maintain capital levels well above the minimum. Minimum capital levels higher than those provided in the regulations may be established by the OTS for individual savings associations, upon a determination that the savings association’s capital is or may become inadequate in view of its circumstances.
As of December 31, 2007 and 2006, the most recent notification from the OTS categorized the Bank as “well capitalized” under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier I risk-based and Tier I leverage ratios as set forth in the table below. There are no conditions or events since that notification which management believes have changed the Bank’s category. Also see Note 22 to the consolidated financial statements for more information.
Federal regulations place certain restrictions on dividends paid by the Bank to the Company. The total amount of dividends that may be paid at any date is generally limited to the retained earnings of the Bank. At December 31, 2007, the Bank’s retained earnings available for the payment of dividends were $17.6 million. In addition, dividends paid by the Bank to the Company would be prohibited if the effect thereof would cause the Bank’s capital to be reduced below applicable minimum capital requirements.
Harrington West Financial Group, Inc. cannot issue or renew any debt, increase any current lines of credit, or guarantee the debt of any entity without advance notification to the OTS.
REGULATORY CAPITAL
FINANCIAL STATEMENT FOOTNOTE
Actual and required capital amounts (dollars in thousands) and ratios for the Bank are presented below:
13. EARNINGS PER SHARE
The following tables represent the calculations of earnings per share (“EPS”) for the periods presented.
Anti-dilutive options totaling 321,700 and 200,750 are excluded from the calculation of earnings per share for the years ended December 31, 2007 and 2006, respectively.
14. COMMITMENTS AND CONTINGENCIES
Aggregate minimum lease commitments under long-term operating leases as of December 31, 2007 are as follows:
Minimum lease payments for the Bank’s premises are adjusted annually based upon the Consumer Price Index. Rental expense was $1.3 million and $1.3 million for the years ended December 31, 2007 and 2006, respectively.
Neither the Company nor the Bank is involved in any material legal proceedings at December 31, 2007. The Bank, from time to time, is a party to litigation which arises in the ordinary course of business, such as claims to enforce liens, claims involving the origination and servicing of loans, and other issues related to the business of the Bank. After taking into consideration information furnished by counsel to the Company and the Bank, management believes that the resolution of such issues will not
have a material adverse impact on the financial position, results of operations, or liquidity of the Company or the Bank.
15. TRADING ACCOUNT ASSETS
Derivative Instruments Not Receiving Hedge Treatment - The Bank is a party to a variety of interest rate contracts such as interest rate swaps, caps, floors, futures, options and total return swaps (“Interest Rate Agreements”), which are recorded in the financial statements at fair value with changes in fair value and periodic payments recorded in income from trading account assets.
Interest rate swaps are contracts in which the parties agree to exchange fixed and floating rate payments for a specified period of time on a specified (“notional”) amount. The notional amount is only used to calculate the amount of the periodic interest payments to be exchanged and does not represent the amount at risk.
At December 31, 2006, there were no outstanding interest rate agreements accounted for as trading account assets.
The following is a summary of the Interest Rate Agreements as of December 31:
The Interest Rate Agreements used have an active secondary market and are included in trading account assets at fair value with realized and unrealized gains and losses on these instruments recognized immediately in other income.
The Bank’s exposure to credit risk from derivative financial instruments is represented by the fair value of the instruments. Credit risk amounts represent the replacement cost the Bank could incur should counterparties with contracts in a gain position completely fail to perform under the terms of those contracts. Counterparties are subject to the credit approval and credit monitoring policies and procedures of the Bank. The Bank limits its credit exposure by entering into International Swap Dealer Association (“ISDA”) Master Agreements with each counterparty. ISDA Master Agreements set the legal framework for transactions with counterparties in over the counter derivative markets. The Bank only deals with counterparties that are investment grade.
The following table shows the various components of the Company’s recorded net gain (loss) on its trading account assets for the years ended December 31.
The following table shows the Company’s trading securities included in trading account assets as of December 31:
16. DERIVATIVES HELD FOR ASSET AND LIABILITY MANAGEMENT
At December 31, 2007, the swaps listed below are hedging the interest rate risk of cash flows associated with borrowings. These swaps qualify as cash flow hedges. During 2007 and 2006, the ineffective portion of the change in fair value of the cash flow hedges was ($1) thousand and ($6) thousand, respectively. The fair values for the cash flow swaps in a gain position are reported in Other assets, those in a loss position are reported in Other liabilities. No cash flow hedges were discontinued during fiscal years 2007 or 2006.
The following table sets forth the maturity distribution and weighted-average interest rates of the interest rate swaps used to limit the re-pricing risk of borrowings as of December 31, 2007:
The Bank is dedicated to managing credit risks associated with investment and interest rate risk management activities. The Bank maintains positions with a variety of counterparties or obligors (“counterparties”). To limit credit exposure arising from such transactions, the Bank evaluates the credit standing of counterparties, establishes limits for the total exposure to any one counterparty, monitors exposure against the established limits, and monitors investment portfolio composition to manage concentrations.
The Bank pledges certain mortgage-backed securities as collateral for our interest rate swaps.
17. FAIR VALUES OF FINANCIAL INSTRUMENTS
SFAS No. 107, Disclosures about Fair Value of Financial Instruments, requires that the Company disclose estimated fair values for its financial instruments. The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies; however, considerable judgment is required to interpret market data to develop estimates of fair value.
Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts at December 31:
The methods and assumptions used to estimate the fair value of each class of financial instrument for which it is practicable to estimate that value are explained below:
Cash and Cash Equivalents - The carrying amounts approximate fair values due to the short-term nature of these instruments.
Trading Account Assets - The fair values of trading securities included in trading account assets are obtained from market bids or from independent securities brokers or dealers. Fair values of interest rate contracts are based on quoted market price or dealer quotes.
Securities - The fair values of securities are generally obtained from market bids for similar or identical securities or are obtained from independent security brokers or dealers.
Loans - Fair values are estimated for portfolios of loans with similar financial characteristics, primarily fixed and adjustable rate interest terms. The fair values of mortgage loans are based upon discounted cash flows utilizing applicable risk-adjusted discount rates relative to available mortgage-backed securities having similar rate and re-pricing characteristics, as well as anticipated prepayment schedules. No adjustments have been made for changes in credit within the loan portfolio. It is management’s opinion that the allowance for estimated loan losses pertaining to performing and nonperforming loans results in a fair valuation of such loans.
FHLB Stock - It was not practicable to determine the fair value of FHLB stock due to restrictions on its transferability.
Accrued Interest Receivable - The carrying amount of accrued interest receivable approximates fair value due to its short-term nature.
Deposits - The fair values of deposits are estimated based upon the type of deposit product. Demand accounts, which include passbooks and transaction accounts, are presumed to have equal book and fair values, since the interest rates paid on these accounts are based on prevailing market rates and the amounts are payable upon demand. The estimated fair values of time deposits are determined by discounting the cash flows of settlements of deposits having similar maturities and current rates, utilizing a LIBOR swap curve adjusted for Federal Deposit Insurance Corporation (“FDIC”) insurance that approximates the prevailing rates offered on the Company’s term borrowings less the cost of FDIC insurance as of the reporting date.
FHLB Advances - The fair values of FHLB advances are based upon discounted cash flows utilizing applicable risk-adjusted spreads relative to the current pricing for similar advances.
Securities Sold under Repurchase Agreements - The Company has entered into sales of securities under agreements to repurchase. At both December 31, 2007 and December 31, 2006, $45 million of the securities sold under repurchase agreements are long-term in nature and the fair value is calculated by discounting future cash flows based on expected maturities or re-pricing dates, utilizing estimated market discount rates at each reporting date. The call features of these instruments are also considered in the determination of fair values.
Subordinated Debt - The carrying amount approximates fair value, as the rate is based on current market rates.
Due to/Due from Broker - The carrying amount of due to/due from broker approximates fair value due to its short-term nature.
Accrued Interest Payable - The carrying amount of accrued interest payable approximates fair value due to its short-term nature.
Hedging instruments consist of interest rate swaps used to modify the interest rate sensitivity of certain short-term certificates of deposit, a portion of the Bank’s securities sold under agreements to repurchase and the short-term FHLB advances. Fair values are based on quoted market prices or dealer quotes. Where such quotes are not available, fair value is estimated by using quoted market prices for similar securities or by discounting future cash flows at a risk-adjusted spread to the LIBOR-based swap curve.
Commitments to Extend Credit, and Standby and Commercial Letters of Credit - The fair values of commitments to extend credit and standby letters of credit were not significant at either December 31, 2007 or 2006, as these instruments predominantly have adjustable terms and are of a short-term nature.
Accrued Interest Payable - The carrying amount of accrued interest payable approximates fair value due to its short-term nature.
18. RELATED-PARTY TRANSACTIONS
Prior to the first quarter of 2007, the Bank contracted with Smith Breeden Associates (SBA) to provide investment advisory services and interest rate risk analysis. Until January 30, 2007, a principal of SBA was a director for the Company and the Bank. Several principals and employees of SBA are stockholders of the Company. The amount of consulting expense relating to SBA for the years ended December 31, 2007 and 2006 was $122 thousand and $405 thousand, respectively.
The Bank grants loans to principal officers and directors and their affiliates. Other than draws on existing lines of credit, there were no new loans granted in 2007 and 2006.
The following table is a roll-forward of the related party loan activity and outstanding balances on previously granted loans as of December 31:
At December 31, 2007 and 2006 the principal officers and directors and their affiliates held deposits at the Bank totaling $705 thousand and $612 thousand, respectively.
19. EMPLOYEE BENEFIT PLAN
The Company sponsors a defined contribution plan for the benefit of its employees. The Company’s contributions to the plan are determined annually by the Board of Directors in accordance with plan requirements. For tax purposes, eligible participants may contribute up to a maximum of 15% of their compensation, not to exceed the dollar limit imposed by the Internal Revenue Service. The expense associated with the employee benefit plan is included in salary and employee benefits in the consolidated statements of earnings. For the plan years ended December 31, 2007 and 2006, the Company contributed $273 thousand and $345 thousand, respectively.
20. PARENT COMPANY ONLY FINANCIAL INFORMATION
Condensed Statements of Financial Condition
Condensed Statements of Earnings
Condensed Statements of Cash Flows
21. QUARTERLY FINANCIAL INFORMATION (Unaudited)
Non-interest income was reduced in the September 2007 quarter by a pre-tax mark to market loss of $387 thousand on commercial mortgage backed securities (CMBS) total return swaps (TROR) in HWFG’s trading portfolio and a $1.9 million pre-tax write down of all $2.4 million of HWFG’s non-insured sub-prime, net interest margin (NIM) securities due to deteriorating credit quality of the underlying loans.
Non-interest income was reduced in the December 2007 quarter included pre-tax mark-to-market losses of $2.4 million on HWFG’s $80 million (notional amount) of AAA-rated Commercial Mortgage Backed Security (CMBS), total rate of return (TROR) swap positions, as spreads continued to widen from the ongoing credit and liquidity dislocations.
22. SUBSEQUENT EVENTS (Unaudited)
Recent Developments in 2008
In the third quarter of 2007, as credit spreads widened, HWFG started to rebuild an $80 million portfolio of AAA-rated, Commercial Mortgage Backed Securities (CMBS), total rate of return swaps (TROR) with swap terms of 6 months, where HWFG earns the yield on an index of AAA CMBS over the matched duration LIBOR swap yield (plus an additional spread) and the gain or loss from spread changes of this index yield to the duration matched LIBOR rate. During the period from 2003 to 2006, before allowing its positions to expire at December 31, 2006 in the very tight spread environment at that time, HWFG had earned a total profit of $3.6 million after-tax on such TROR swaps, including asset backed TROR swaps.
The underlying securities in the TROR CMBS swap position are backed by commercial mortgage loans with generally 75% original loan to value ratios, diversified among property types, generally issued in the last two years, and having 10 year balloon maturities, 25 to 30 year amortizations, and a lock-out from prepayment of principal until the balloon date. In addition, the AAA CMBS have additional credit enhancement of 20% to 30% in the form of junior securities. HWFG has invested in two types of AAA CMBS indexes: (1) the Lehman AAA 8.5+ year index having some mezzanine AAA securities, and (2) the Lehman Super Senior CMBS Index with only the most senior AAA securities. At December 31, 2007, HWFG had $80 million of the Lehman AAA CMBS 8.5+ year index swaps, and at March 1, 2008 had $50 million of the Lehman Super Senior index swaps expiring on March 31, 2008, and $10 million of the Lehman 8.5 year + CMBS index swaps expiring at April 30, 2008. Although HWFG believes that the underlying AAA CMBS securities have extremely low probability of loss of principal and interest, the credit and liquidity crisis of the latter half of 2007 emanating from the weakening residential real estate market and the poor performance of sub-prime single family mortgage loans has spilled into almost all credit segments and continued into the March 2008 quarter, resulting in a continued widening of CMBS spreads.
HWFG has lowered it CMBS TROR exposure from $80MM as of December 31, 2007 to $60MM in the March 2008 quarter by limiting its investment to $50MM of the Super Senior AAA CMBS index swaps with a 30% credit enhancement, and $10MM of the Lehman 8.5+ year index swaps. With the extreme stress in all credit markets, however, both CMBS indexes widened precipitously from December 31, 2007 to February 29, 2008, and HWFG sustained additional mark-to-market losses of approximately $5.9 million after-tax during this period. (The Super Senior widened by 152 bps and the Lehman 8.5 year + by 200 bps during this two month period, approximately ten standard deviations of monthly spread changes for the last five years. A 10 bps change in spreads on a $10 million notional amount of CMBS TROR swap has a $70,000 market value change.) Given the volatility of spreads in the current environment and their effect on HWFG’s earnings, HWFG will allow the CMBS TROR swap positions to expire at maturity. HWFG may invest in selected AAA rated CMBS securities held as available for sale to earn the wide spread income and to capitalize on the existing opportunity. As credit spreads continued to widen on almost all mortgage loan and related securities in the first quarter of 2008, the available for sale portfolio’s mark-to-market value declined by $5.1 million on an after tax basis from December 31, 2007 to February 29, 2008. HWFG believes the spreads on these high credit quality securities are extremely wide for the associated risk and expects these spreads to narrow over the next 12 to 18 months with a corresponding recovery in market values. In recent weeks, this narrowing of spreads on commercial and residential mortgage securities to duration-matched LIBOR/swap benchmarks has begun with a related increase in value of these securities.
HWFG announced on March 26, 2008 that it has executed stock purchase agreements for $4.3 million in equity capital through a private placement of 550 thousand common shares at $7.75 per share to eleven
accredited investors and directors of the Company and Bank. This offering was priced on March 25, 2008 and will close on March 27, 2008. $2.1 million of this offering or 269 thousand shares are subject to regulatory approval of a rebuttal of control filing and is expected to close in the June 2007 quarter. No investment banking fees were incurred in the transaction. The sale of the shares was completed in reliance on the exception provided by Section 4(2) of the Securities Act of 1933. The proceeds from this offering will be used to fund the banking franchise growth of the Company and to weather the volatility in the spreads and prices of its high credit quality mortgage securities portfolio in the current environment. In addition to this capital-raising, HWFG is exploring other alternatives to increase equity capital for its future needs with a particular emphasis on strategies that would not be dilutive to shareholders. HWFG is committed to keeping Los Padres Bank well capitalized.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
The registrant hereby incorporates by reference the change in Accounting Firms pursuant to Regulation S-K, Section 229.304 in its 8-K, Item 4.01, filed on April 5, 2006.
Item 9A.
Item 9A. Controls and Procedures
As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer along with our Senior Vice President and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to the Exchange Act Rule 13a-15(b). Based upon that evaluation, our Chief Executive Officer along with our Senior Vice President and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting us to material information relating to us (including our consolidated subsidiaries) required to be included in our periodic SEC filings.
There have been no material changes in our internal control over financial reporting during our most recent quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Item 9A(T). Controls and Procedures
The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting is a process designed under the supervision of the Company’s Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external purposes in accordance with U.S. generally accepted accounting principles.
As of December 31, 2007, management assessed the effectiveness of the Company’s internal control over financial reporting based on the criteria for effective internal control over financial reporting established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and guidance issued by the Securities and Exchange Commission. Based on the assessment, management determined that the Company maintained effective internal control over financial reporting as of December 31, 2007, based on those criteria.
The Company’s management, including its Chief Executive Officer and Chief Financial Officer, does not expect that its disclosure controls and procedures, or its internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefit of controls must be
considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.
This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.
Item 9B.
Item 9B. Other Information
Not applicable.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
Our board of directors has adopted a Code of Ethics, a copy of which was filed as Exhibit 14 to the 2003 Annual Report on Form 10-K. The Code of Ethics can also be viewed on the Bank’s website at www.HWFG.com.
There were no material changes to the procedures by which our stockholders may recommend nominees to our board of directors during 2007.
The balance of the information required by Item 10 is incorporated by reference from our definitive proxy statement for our 2007 Annual Meeting of Stockholders (“Proxy Statement”) which will be filed pursuant to Regulation 14A.
Item 11.
Item 11. Executive Compensation.
This information is incorporated by reference from our Proxy Statement which will be filed pursuant to Regulation 14A.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
This information with respect to beneficial ownership by beneficial owners and management is incorporated by reference from our Proxy Statement which will be filed pursuant to Regulation 14A.
EQUITY COMPENSATION PLAN INFORMATION
The following table presents information for all equity compensation plans with individual compensation arrangements (whether with employees or non-employees such as directors), in effect as of December 31, 2007.
Item 13.
Item 13. Certain Relationships and Related Transactions.
This information is incorporated by reference from our Proxy Statement which will be filed pursuant to Regulation 14A.
Item 14.
Item 14. Principal Accountant Fees and Services
The information is incorporated by reference from our Proxy Statement which will be filed pursuant to Regulation 14A.
Part IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules.
(a)
Documents filed as part of this report.
(1) The following documents are filed as part of this Annual Report on Form 10-K and are incorporated herein by reference to Item 8 hereof:
Report of Independent Registered Public Accounting Firm
Consolidated Statements of Financial Condition as of December 31, 2007 and 2006.
Consolidated Statements of Earnings for the Years Ended December 31, 2007 and 2006.
Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2007 and 2006.
Consolidated Statements of Cash Flows for the Years Ended December 31, 2007 and 2006.
Notes to Consolidated Financial Statements.
(2) All schedules for which provision is made in the applicable accounting regulation of the SEC are omitted because they are not applicable or the required information is included in the Consolidated Financial Statements or notes thereto.
(b)
The following exhibits are filed as part of this Form 10-K, and this list includes the Exhibit Index.
10.2.3
Sixth Amendment to Amended and Restated Credit Agreement dated October 30, 2003. (2)
10.2.4
Seventh Amendment to Amended and Restate Credit Agreement dated September 16, 2004.(2)
10.3
Investment and Interest Rate Advisory Agreement between Los Padres Savings Bank, FSB and Smith Breeden Associates, Inc., dated February 3, 1997. (1)
10.4
Purchase and Assumption Agreement by and between Los Padres Bank, FSB and Harrington Bank, FSB dated as of May 30, 2001. (1)
10.5
Los Padres Mortgage Company, LLC Operating Agreement by and between Resource Marketing Group, Inc. and Los Padres Bank FSB dated June 13, 2002. (1)
10.6
Option Agreement, dated as of April 4, 1996 by and between Smith Breeden Associates, Inc. and Harrington West Financial Group, Inc. Assignment of Option, dated as of January 19, 2001, by and between Craig Cerny and Smith Breeden Associates, Inc. (1)
10.7
Stock Purchase Agreement by and between Harrington Bank, FSB and Los Padres Bank, FSB dated as of May 30, 2001. (1)
10.8
2005 Equity Based Compensation Plan (2)
10.9
Smith Breeden Associates, Inc. Portfolio Advisory & Rate Risk Analysis Agreement (2)
Statement re computation of per share earnings - Reference is made to Item 8. “Financial Statements and Supplementary Data” for the required information.
Code of Ethics (3)
23.1
Consent of Crowe Chizek and Company LLP
31.1
Section 302 Certification by Chief Executive Officer filed herewith.
31.2
Section 302 Certification by Chief Financial Officer filed herewith.
Section 906 Certification by Chief Executive Officer and Chief Financial Officer furnished herewith.
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.
HARRINGTON WEST FINANCIAL GROUP, INC.
March 26, 2008 By: /s/ Craig J. Cerny
Craig J. Cerny Chairman of the Board and Chief Executive Officer (Principal Executive Officer)
March 26, 2008 By: /s/ William W. Phillips, jr.
William W. Phillips, Jr.
President, Chief Operating Officer
(Principal Executive Officer)
March 26, 2008 By: /s/ Kerry Steele
Kerry Steele
Sr. Vice-President, Chief Financial Officer (Principle Financial and Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.