10-K 1 nvb_10k.htm FORM 10-K

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

 Washington, D.C. 20549

 

FORM 10-K

 

(Mark One)

S  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2012
  
£ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________________ to _______________.

 

 Commission file number 0-10652

 

 NORTH VALLEY BANCORP


(Exact name of registrant as specified in its charter)

 

California 94-2751350
(State or other jurisdiction  (IRS Employer Identification No.)
of incorporation or organization)  
   
300 Park Marina Circle, Redding, California 96001
(Address of principal executive offices) (Zip code)

 

Registrant's telephone number, including area code (530) 226-2900

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of class:   Name of each exchange on which registered:
Common Stock, no par value   The NASDAQ Global Select Stock Market

 

Securities registered pursuant to Section 12(g) of the Act:    None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes £    No  S

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

Yes £    No  S

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  S    No £

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  S    No  £

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. £

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (Check one):

 

Large accelerated filer £   Accelerated filer S
     
Non-accelerated filer £   Smaller reporting company £

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes £ No S

 

The aggregate market value of the voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold was $85,594,000 as of June 30, 2012.

 

The number of shares outstanding of common stock as of March 11, 2013, were 6,835,192.

 

 

 
 

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of Registrant's Definitive Proxy Statement for the 2013 Annual Meeting of Shareholders are incorporated by reference in Part III, Items 10, 11, 12, 13 and 14 of this Form 10-K.

 

Table of Contents

 

Part I    
Item 1. Business 3
Item 1A. Risk Factors 17
Item 1B. Unresolved Staff Comments 20
Item 2. Properties 20
Item 3. Legal Proceedings 21
Item 4. Mine Safety Disclosures 21
     
Part II    
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 22
Item 6. Selected Financial Data 24
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 25
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 45
Item 8. Financial Statements and Supplementary Data 47
Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure 48
Item 9A. Controls and Procedures 48
Item 9B. Other Information 49
     
Part III    
Item 10. Directors, Executive Officers and Corporate Governance 49
Item 11. Executive Compensation 49
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 49
Item 13. Certain Relationships and Related Transactions, and Director Independence 49
Item 14. Principal Accounting Fees and Services 50
     
Part IV    
Item 15. Exhibits and Financial Statement Schedules 50
     
Signatures 101

 

2
 

  

PART I 
   
ITEM 1. BUSINESS  

 

Certain matters discussed or incorporated by reference in this Annual Report on Form 10-K including, but not limited to, matters described in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” are “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended, and subject to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements may contain words related to future projections including, but not limited to, words such as “believe,” “expect,” “anticipate,” “intend,” “may,” “will,” “should,” “could,” “would,” and variations of those words and similar words that are subject to risks, uncertainties and other factors that could cause actual results to differ materially from those projected. Factors that could cause or contribute to such differences include, but are not limited to, the following: (1) the duration of financial and economic volatility and actions taken by the United States Congress and governmental agencies, including the United States Department of the Treasury, to deal with challenges to the U.S. financial system; (2) variances in the actual versus projected growth in assets and return on assets; (3) loan losses; (4) expenses; (5) changes in the interest rate environment including interest rates charged on loans, earned on securities investments and paid on deposits and other borrowed funds; (6) competition effects; (7) fee and other noninterest income earned; (8) general economic conditions nationally, regionally, and in the operating market areas of the Company and its subsidiaries including State and local budget issues being addressed in California; (9) changes in the regulatory environment including government intervention in the U.S. financial system; (10) changes in business conditions and inflation; (11) changes in securities markets, public debt markets, and other capital markets; (12) data processing and other operational systems failures or fraud; (13) a further decline in real estate values in the Company’s operating market areas; (14) the effects of uncontrollable events such as terrorism, the threat of terrorism or the impact of the current military conflicts in Afghanistan and Iraq and the conduct of the war on terrorism by the United States and its allies, worsening financial and economic conditions, natural disasters, and disruption of power supplies and communications; and (15) changes in accounting standards, tax laws or regulations and interpretations of such standards, laws or regulations, as well as other factors. The factors set forth under Item 1A, “Risk Factors”, in this report and other cautionary statements and information set forth in this report should be carefully considered and understood as being applicable to all related forward-looking statements contained in this report when evaluating the business prospects of the Company and its subsidiaries.

 

Forward-looking statements are not guarantees of performance. By their nature, they involve risks, uncertainties and assumptions. Actual results and shareholder values in the future may differ significantly from those expressed in forward-looking statements. You are cautioned not to put undue reliance on any forward-looking statement. Any such statement speaks only as of the date of the report, and in the case of any documents that may be incorporated by reference, as of the date of those documents. We do not undertake any obligation to update or release any revisions to any forward-looking statements, or to report any new information, future event or other circumstances after the date of this report or to reflect the occurrence of unanticipated events, except as required by law. However, your attention is directed to any further disclosures made on related subjects in our subsequent reports filed with the Securities and Exchange Commission on Forms 10-K, 10-Q and 8-K.

 

General

 

North Valley Bancorp (the “Company”) is a bank holding company registered with and subject to regulation and supervision by the Board of Governors of the Federal Reserve System (“FRB” or the “Board of Governors”). The Company was incorporated in 1980 in the State of California. The Company owns 100% of its principal subsidiaries, North Valley Bank (“NVB” or the “Bank”), North Valley Trading Company (“Trading Company”), which is inactive, North Valley Capital Trust II, North Valley Capital Trust III, and North Valley Capital Statutory Trust IV. The Company acquired Six Rivers National Bank (based in Eureka, California) in 2000, and Yolo Community Bank (based in Woodland, California) in 2004. Over time, the former branches and operations of Six Rivers National Bank and Yolo Community Bank were combined with the branches and operations of North Valley Bank and the information contained in this report reflects their combined results of operations.

 

At December 31, 2012 the Company had $902,343,000 in total assets, $492,211,000 in total loans and $768,580,000 in total deposits. The Company does not hold deposits of any one customer or group of customers where the loss of such deposits would have a material adverse effect on the Company. The Company's business is not seasonal.

 

NVB was organized in September 1972, under the laws of the State of California, and commenced operations in February 1973. NVB is principally supervised and regulated by the California Commissioner of Financial Institutions (the “Commissioner”) and conducts a commercial and retail banking business, which includes accepting demand, savings, and money market rate deposit accounts and time deposits, and making commercial, real estate and consumer loans. It also issues cashier's checks and money orders, and provides safe deposit boxes and other customary banking services. As a state-chartered insured member bank, NVB is also subject to regulation by the Board of Governors of the Federal Reserve System (the “Board of Governors”) and its deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to the maximum amount which is $250,000 per separately insured depositor. FDIC-insured deposits are our primary source of funds. As part of our asset-liability management, we analyze the maturities and interest rates of our retail deposits in order to promote stability in our supply of funds, to the extent feasible under changing market conditions. For more deposit information, see Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Balance Sheet Analysis – Deposits.”

 

3
 

 

NVB has signed agreements with Essex National Securities, Inc., a registered broker-dealer, (“ENSI”) whereby ENSI provides broker/dealer services and standardized investment advice to NVB customers. NVB shares in the fees and commissions paid to ENSI on a pre-determined schedule. Majority ownership of ENSI is held by Samson Investment Partners, Inc., a private investment firm headquartered in New York City, New York.

 

Markets We Serve

 

The Bank’s head office is located at 300 Park Marina Circle, Redding, California 96001. As of December 31, 2012, the Bank had branch offices in Shasta County (ten branches), Trinity County (two branches), Humboldt County (five branches), Del Norte County (one branch), Yolo County (one branch), Sonoma County (one branch), Placer County (one branch) and Mendocino County (one branch). The Company views its service area as having four distinct markets:

 

The Redding market – NVB was founded in Redding, California, which is located in Shasta County, and has grown organically there since 1973. Shasta County is a mature, slow growth market that has a population of roughly 178,000. The median household income is $44,000 and the median age is 41.6 years. The unemployment rate in Shasta County as of December 2012 was 12.4%. The primary employment types are the Services Industry and Government. The major employers are the State of California – local government offices, Mercy Hospital, Shasta Regional Medical Facility and Shasta College.
   
 The Coastal market – the Company acquired its presence in the coastal market (which includes Humboldt, Del Norte, Trinity, and Mendocino Counties) through the acquisition of Six Rivers National Bank in 2000. The Coastal market is a mature, slow growth market. Most of the NVB branches are small retail facilities located in rural towns, with the exception of Eureka, which is located in Humboldt County and has a population of approximately 27,000. Humboldt County has a population of approximately 135,000, median household income of $40,000, and the median age is 37.3 years. The unemployment rate in Humboldt County as of December 2012 was 9.7%. Employment has traditionally been fishing and timber resource based. The major employers are various seafood-related companies and the State of California – local government offices.
   
 The I-80 Corridor market – the Company has a business banking office located in each of Roseville, California and Woodland, California along Interstate 80. This market is a growth market and the Company acquired its presence in this market through the acquisition of Yolo Community Bank in 2004. Roseville, which is located in Placer County, has a population of 122,000 and the county population is approximately 357,000. The county’s median household income is $75,000 and the median age 40 years. The unemployment rate in Placer County as of December 2012 was 8.2%. The local economy provides many employment types and some major employers are Kaiser Permanente, Hewlett-Packard, Sutter Health and the Union Pacific Railroad. Woodland, which is located in Yolo County, has a population of approximately 56,000 and the county population is approximately 202,000. The county’s median household income is $58,000 and the median age 30.1 years. The unemployment rate in Yolo County as of December 2012 was 9.7%. The primary employment types are agriculture, manufacturing, technology companies, services, merchants, and tourism. The major employers are the University of California at Davis, the State of California and the US Postal Service.
   
 The Santa Rosa market – the Company established its presence in the Santa Rosa market through de novo branching when it opened a business banking office in 2005. Santa Rosa, which is located in Sonoma County, is a growth market. Santa Rosa has a population of 169,000 and the county population is approximately 488,000. The county’s median household income is $64,000 and the median age 39.7 years. The unemployment rate in Sonoma County as of December 2012 was 8.7%. The primary employment types are education and health services, retail trade, tourism and the wine industry. The major employers are Kaiser Permanente, St. Joseph Health System, Agilent Technologies, and Medtronic Cardio Vascular.

 

4
 

 

Subordinated Debentures

 

The Company owns the common stock of three business trusts that have issued an aggregate of $21.0 million in trust preferred securities fully and unconditionally guaranteed by the Company. The entire proceeds of each respective issuance of trust preferred securities were invested by the separate business trusts into junior subordinated debentures issued by the Company, with identical maturity, repricing and payment terms as the respective issuance of trust preferred securities. The aggregate amount of junior subordinated debentures issued by the Company is $22.0 million, with the maturity dates for the respective debentures ranging from 2033 through 2036. Subject to regulatory approval, the Company may redeem the respective junior subordinated debentures earlier than the maturity date, with certain of the debentures being redeemable beginning in April 2008, July 2009 and March 2011.

 

On November 9, 2009, the Company elected to defer the payment of interest on these securities. The Company is allowed to defer the payment of interest for up to 20 consecutive quarterly periods without triggering an event of default. The obligation to pay interest is cumulative and continues to accrue. On May 29, 2012, the Company received approval from the Federal Reserve Bank of San Francisco and on May 9, 2012, the Company received approval from the California Department of Financial Institutions to pay all deferred interest on its junior subordinated notes underlying its trust preferred securities in the amount of $5,854,000 and to fully redeem its North Valley Capital Trust I notes in the amount of $10,310,000, bearing an interest rate of 10.25%. On July 23, 2012, the Company paid all deferred interest on its junior subordinated notes and on July 25, 2012, it redeemed, in full, the notes associated with North Valley Capital Trust I. Since then, the Company has continued to pay interest on the remaining notes when and as due. For more information about the trust preferred securities and the debentures and certain regulatory restrictions on the payment of interest, see Notes 10 and 17 to the Consolidated Financial Statements.

 

Supervision and Regulation

 

The common stock of the Company is subject to the registration requirements of the Securities Act of 1933, as amended, and the qualification requirements of the California Corporate Securities Law of 1968, as amended. The Company is also subject to the periodic reporting requirements of Section 13 of the Securities Exchange Act of 1934, as amended, which include, but are not limited to, the filing of annual, quarterly and current reports with the Securities and Exchange Commission.

 

NVB is chartered by the California Department of Financial Institutions (“DFI”), and subject to the rules and regulations of the Commissioner. NVB’s deposits are insured by the FDIC, and NVB is a member of the Federal Reserve System. Consequently, NVB is subject to the supervision of, and is regularly examined by, the Commissioner and the Board of Governors. Such supervision and regulation includes comprehensive reviews of all major aspects of the Bank’s business and condition, including its capital ratios, allowance for loan losses and other factors. However, no inference should be drawn that such authorities have approved any such factors. NVB is required to file reports with the Commissioner and the Board of Governors and provide such additional information as the Commissioner and the Board of Governors may require.

 

The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the “Bank Holding Company Act”), and is registered as such with, and subject to the supervision of, the Board of Governors. The Company is required to obtain the approval of the Board of Governors before it may acquire all or substantially all of the assets of any bank, or ownership or control of the voting shares of any bank if, after giving effect to such acquisition of shares, the Company would own or control more than 5% of the voting shares of such bank. The Bank Holding Company Act prohibits the Company from acquiring any voting shares of, or interest in, all or substantially all of the assets of, a bank located outside the State of California unless such an acquisition is specifically authorized by the laws of the state in which such bank is located. Any such interstate acquisition is also subject to the provisions of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994.

 

The Company, and its subsidiary, NVB, are deemed to be “affiliates” within the meaning of that term as defined in the Federal Reserve Act. This means, for example, that there are limitations (a) on loans between affiliates, and (b) on investments by NVB in affiliates' stock as collateral for loans to any borrower. The Company and its subsidiaries are also subject to certain restrictions with respect to engaging in the underwriting, public sale and distribution of securities.

 

Capital Adequacy. The Board of Governors and the FDIC have adopted risk-based capital guidelines for evaluating the capital adequacy of bank holding companies and banks. The guidelines are designed to make capital requirements sensitive to differences in risk profiles among banking organizations, to take into account off-balance sheet exposures and to aid in making the definition of bank capital uniform internationally. Under the guidelines, the Company and its banking subsidiaries are required to maintain capital equal to at least 8% of its assets and commitments to extend credit, weighted by risk, of which at least 4% must consist primarily of common equity (including retained earnings) and the remainder may consist of subordinated debt, cumulative preferred stock, or a limited amount of loan loss reserves. The Company and NVB are subject to regulations issued by the Board of Governors and the FDIC, which require maintenance of a certain level of capital. These regulations impose two capital standards: a risk-based capital standard and a leverage capital standard.

 

5
 

 

Assets, commitments to extend credit and off-balance sheet items are categorized according to risk and certain assets considered to present less risk than others permit maintenance of capital at less than the 8% ratio. For example, most home mortgage loans are placed in a 50% risk category and therefore require maintenance of capital equal to 4% of such loans, while commercial loans are placed in a 100% risk category and therefore require maintenance of capital equal to 8% of such loans.

 

Under the Board of Governors’ risk-based capital guidelines, assets reported on an institution’s balance sheet and certain off-balance sheet items are assigned to risk categories, each of which has an assigned risk weight. Capital ratios are calculated by dividing the institution’s qualifying capital by its period-end risk-weighted assets. The guidelines establish two categories of qualifying capital: Tier 1 capital (defined to include common stockholders’ equity and noncumulative perpetual preferred stock) and Tier 2 capital which includes, among other items, limited life (and in case of banks, cumulative) preferred stock, mandatory convertible securities, subordinated debt and a limited amount of reserve for loan losses. Tier 2 capital may also include up to 45% of the pretax net unrealized gains on certain available-for-sale equity securities having readily determinable fair values (i.e. the excess, if any, of fair market value over the book value or historical cost of the investment security). The federal regulatory agencies reserve the right to exclude all or a portion of the unrealized gains upon a determination that the equity securities are not prudently valued. Unrealized gains and losses on other types of assets, such as bank premises and available-for-sale debt securities, are not included in Tier 2 capital, but may be taken into account in the evaluation of overall capital adequacy and net unrealized losses on available-for-sale equity securities will continue to be deducted from Tier 1 capital as a cushion against risk. Each institution is required to maintain a risk-based capital ratio (including Tier 1 and Tier 2 capital) of 8%, of which at least half must be Tier 1 capital.

 

Under the Board of Governors’ leverage capital standard, an institution is required to maintain a minimum ratio of Tier 1 capital to the sum of its quarterly average total assets and quarterly average reserve for loan losses, less intangibles not included in Tier 1 capital. Period-end assets may be used in place of quarterly average total assets on a case-by-case basis. The Board of Governors and the FDIC have adopted a minimum leverage ratio for bank holding companies as a supplement to the risk-weighted capital guidelines. The leverage ratio establishes a minimum Tier 1 ratio of 3% (Tier 1 capital to total assets) for the highest rated bank holding companies or those that have implemented the risk-based capital market risk measure. All other bank holding companies must maintain a minimum Tier 1 leverage ratio of 4% with higher leverage capital ratios required for bank holding companies that have significant financial and/or operational weakness, a high risk profile, or are undergoing or anticipating rapid growth.

 

At December 31, 2012, the Company and the Bank were in compliance with the risk-based capital and leverage ratios described above. See Item 8, “Financial Statements and Supplementary Data”, and Note 17 to the Consolidated Financial Statements incorporated by reference therein, for a listing of the Company's and the Bank’s risk-based capital ratios at December 31, 2012 and 2011.

 

FDICIA. The Board of Governors, the Comptroller of the Currency (“OCC”) and the FDIC have adopted regulations implementing a system of prompt corrective action for insured financial institutions pursuant to Section 38 of the Federal Deposit Insurance Act and Section 131 of the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”). These regulations establish five capital categories with the following characteristics: (1) “Well capitalized” - consisting of institutions with a total risk-based capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 6% or greater and a leverage ratio of 5% or greater, and the institution is not subject to any written agreement, order, capital directive, or prompt corrective action directive to meet and maintain a specific capital level for any capital measure; (2) “Adequately capitalized” - consisting of institutions with a total risk-based capital ratio of 8% or greater, a Tier 1 risk-based capital ratio of 4% or greater and a leverage ratio of 4% or greater, and the institution does not meet the definition of a “well capitalized” institution; (3) “Undercapitalized” - consisting of institutions with a total risk-based capital ratio less than 8%, a Tier 1 risk-based capital ratio of less than 4%, or a leverage ratio of less than 4%; (4) “Significantly undercapitalized” - consisting of institutions with a total risk-based capital ratio of less than 6%, a Tier 1 risk-based capital ratio of less than 3%, or a leverage ratio of less than 3%; and (5) “Critically undercapitalized” - consisting of an institution with a ratio of tangible equity to total assets that is equal to or less than 2%. NVB is considered “well capitalized” under the framework for prompt corrective action.

 

6
 

 

The regulations established procedures for classification of financial institutions within the capital categories, filing and reviewing capital restoration plans required under the regulations and procedures for issuance of directives by the appropriate regulatory agency, among other matters. The regulations impose restrictions upon all institutions to refrain from certain actions which would cause an institution to be classified within any one of the three “undercapitalized” categories, such as declaration of dividends or other capital distributions or payment of management fees, if following the distribution or payment the institution would be classified within one of the “undercapitalized” categories. In addition, institutions which are classified in one of the three “undercapitalized” categories are subject to certain mandatory and discretionary supervisory actions. Mandatory supervisory actions include (1) increased monitoring and review by the appropriate federal banking agency; (2) implementation of a capital restoration plan; (3) total asset growth restrictions; and (4) limitation upon acquisitions, branch expansion, and new business activities without prior approval of the appropriate federal banking agency. Discretionary supervisory actions may include (1) requirements to augment capital; (2) restrictions upon affiliate transactions; (3) restrictions upon deposit gathering activities and interest rates paid; (4) replacement of senior executive officers and directors; (5) restrictions upon activities of the institution and its affiliates; (6) requiring divestiture or sale of the institution; and (7) any other supervisory action that the appropriate federal banking agency determines is necessary to further the purposes of the regulations. Further, the federal banking agencies may not accept a capital restoration plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution's capital. In addition, for a capital restoration plan to be acceptable, the depository institution's parent holding company must guarantee that the institution will comply with such capital restoration plan. The aggregate liability of the parent holding company under the guaranty is limited to the lesser of (i) an amount equal to 5 percent of the depository institution's total assets at the time it became undercapitalized, and (ii) the amount that is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it were “significantly undercapitalized.” FDICIA also restricts the solicitation and acceptance of and interest rates payable on brokered deposits by insured depository institutions that are not “well capitalized.” An “undercapitalized” institution is not allowed to solicit deposits by offering rates of interest that are significantly higher than the prevailing rates of interest on insured deposits in the particular institution's normal market areas or in the market areas in which such deposits would otherwise be accepted.

 

Any financial institution which is classified as “critically undercapitalized” must be placed in conservatorship or receivership within 90 days of such determination unless it is also determined that some other course of action would better serve the purposes of the regulations. Critically undercapitalized institutions are also prohibited from making (but not accruing) any payment of principal or interest on subordinated debt without the prior approval of the FDIC and the FDIC must prohibit a critically undercapitalized institution from taking certain other actions without its prior approval, including (1) entering into any material transaction other than in the usual course of business, including investment expansion, acquisition, sale of assets or other similar actions; (2) extending credit for any highly leveraged transaction; (3) amending articles or bylaws unless required to do so to comply with any law, regulation or order; (4) making any material change in accounting methods; (5) engaging in certain affiliate transactions; (6) paying excessive compensation or bonuses; and (7) paying interest on new or renewed liabilities at rates which would increase the weighted average costs of funds beyond prevailing rates in the institution's normal market areas.

 

Under FDICIA, the federal financial institution agencies have adopted regulations which require institutions to establish and maintain comprehensive written real estate lending policies which address certain lending considerations, including loan-to-value limits, loan administrative policies, portfolio diversification standards, and documentation, approval and reporting requirements. FDICIA further generally prohibits an insured state bank from engaging as a principal in any activity that is impermissible for a national bank, absent an FDIC determination that the activity would not pose a significant risk to the Bank Insurance Fund, and that the bank is, and will continue to be, within applicable capital standards. Similar restrictions apply to subsidiaries of insured state banks. The Company does not currently intend to engage in any activities which would be restricted or prohibited under FDICIA.

 

Basel III Capital. On June 7, 2012, the federal bank regulatory agencies published notices of proposed rulemakings that would revise and replace the current capital requirements. The proposed rules implement the “Basel III” regulatory capital reforms released by the Basel Committee on Banking Supervision and changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The proposed rules were subject to a comment period through October 22, 2012 and a projected effective date of January 1, 2013. After receipt of extensive comments and lobbying efforts on behalf of financial institutions, particularly smaller community banks, the federal bank regulatory agencies jointly issued a release on November 9, 2012 to delay the effective date of Basel III. No further effective date has been announced pending further review by the federal bank regulatory agencies. Therefore, it is uncertain when the proposed rules may become effective and whether the proposed rules will be implemented in the form proposed or modified in response to comments or subject to other changes that may have a material impact upon the rules as originally proposed and their application to the Company and NVB.

 

As originally proposed, the rules included new minimum capital ratio requirements to be phased in between January 1, 2013 and January 1, 2015, which would consist of the following: (i) a new common equity Tier 1 capital to total risk weighted assets ratio of 4.5%; (ii) a Tier 1 capital to total risk weighted assets ratio of 6% (increased from 4%); (iii) a total capital to total risk weighted assets ratio of 8% (unchanged from current rules); and (iv) a Tier 1 capital to adjusted average total assets (“leverage”) ratio of 4%. Certain additional changes to the calculation of risk-weighted assets and Tier 1 capital components will affect the capital ratio requirements.

 

7
 

 

The proposed rules would also establish a “capital conservation buffer,” which would require maintenance of a minimum of 2.5% of common equity Tier 1 capital to total risk weighted assets in excess of the regulatory minimum capital ratio requirements described above. The 2.5% buffer would increase the minimum capital ratios to (i) a common equity Tier 1 capital ratio of 7.0%, (ii) a Tier 1 capital ratio of 8.5%, and (iii) a total capital ratio of 10.5%. The new buffer requirement would be phased in between January 2016 and January 2019. An institution would be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital ratio level fell below the buffer amount.

 

The federal bank regulatory agencies have also proposed changes to the prompt corrective action framework (described above under “FDICIA”) which is designed to place restrictions on insured depository institutions if their capital ratios begin to show signs of weakness. As proposed, these changes would take effect January 1, 2015 and would require insured depository institutions to meet the following increased capital ratio requirements in order to qualify as “well capitalized:” (i) a new common equity Tier 1 capital ratio of 6.5%; (ii) a Tier 1 capital ratio of 8% (increased from 6%); (iii) a total capital ratio of 10% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 5% (increased from 4%).

 

Rating System. The Federal Financial Institution Examination Counsel (“FFIEC”) on December 13, 1996, approved an updated Uniform Financial Institutions Rating System (“UFIRS”). In addition to the five components traditionally included in the so-called “CAMEL” rating system which has been used by bank examiners for a number of years to classify and evaluate the soundness of financial institutions (including capital adequacy, asset quality, management, earnings and liquidity), UFIRS includes for all bank regulatory examinations conducted on or after January 1, 1997, a new rating for a sixth category identified as sensitivity to market risk. Ratings in this category are intended to reflect the degree to which changes in interest rates, foreign exchange rates, commodity prices or equity prices may adversely affect an institution’s earnings and capital. The revised rating system is identified as the “CAMELS” system.

 

CRA Compliance. Community Reinvestment Act (“CRA”) regulations evaluate banks’ lending to low and moderate income individuals and businesses across a four-point scale from “outstanding” to “substantial noncompliance,” and are a factor in regulatory review of applications to merge, establish new branches or form bank holding companies. In addition, any bank rated in “substantial noncompliance” with the CRA regulations may be subject to enforcement proceedings. NVB currently has a rating of “satisfactory” for CRA compliance.

 

Regulatory Compliance. The Bank is subject to periodic regulatory examinations in the ordinary course of business which are conducted by the Federal Reserve Bank of San Francisco and the California Department of Financial Institutions. Currently there remains pending a compliance examination of the Bank conducted by the Federal Reserve Bank of San Francisco in 2010 and the Bank has not received the final report of examination. See “Regulatory Agreements” under Item 1A, Risk Factors, at page 19.

 

Dividends. The Company’s ability to pay cash dividends is subject to restrictions set forth in the California General Corporation Law. Funds for payment of any cash dividends by the Company would be obtained from its investments as well as dividends from NVB. The ability of NVB to pay cash dividends is subject to restrictions set forth in the California Financial Code as well as restrictions established by the FDIC and the FRB. See Items 1A, “Risk Factors” and 5, “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities,” below for further information regarding the payment of cash dividends by the Company and NVB.

 

The Board of Directors of the Company decides whether to declare and pay dividends after consideration of the Company’s earnings, financial condition, future capital needs, regulatory requirements and other factors as the Board of Directors may deem relevant. The Company suspended indefinitely the payment of quarterly cash dividends on its common stock beginning in 2009. This Board decision was made to strengthen and preserve the Company’s capital base in these challenging economic times. The payment of cash dividends remains suspended at present and the payment of dividends in the future will be determined by the Board of Directors after consideration of the Company’s earnings, financial condition, future capital funds, regulatory requirements and other factors as the Board of Directors may deem relevant.

 

The Company relies upon distributions from NVB in the form of cash dividends in order to pay dividends to its shareholders. The Board of Governors of the Federal Reserve System generally prohibits a bank holding company from declaring or paying a cash dividend which would impose undue pressure on the capital of a subsidiary bank or would be funded only through borrowing or other arrangements that might adversely affect a bank holding company’s financial position. The Federal Reserve Board policy is that a bank holding company should not pay cash dividends on its common stock unless its net income is sufficient to fully fund each dividend and its prospective rate of earnings retention appears consistent with its capital needs, asset quality and overall financial condition.

 

8
 

 

Regulatory Agreement

 

The supervisory agreement signed on January 6, 2010 by and among North Valley Bancorp, North Valley Bank and the Federal Reserve Bank of San Francisco was terminated, effective as of April 16, 2012. Among other matters, the agreement restricted the payment of dividends, including any payments on trust preferred securities. Resolutions adopted by the Board of Directors of NVB at the request of the California Department of Financial Institutions were also terminated, effective March 1, 2012.

 

The Patriot Act

 

On October 26, 2001, President Bush signed the USA Patriot Act (the “Patriot Act”), which includes provisions pertaining to domestic security, surveillance procedures, border protection, and terrorism laws to be administered by the Secretary of the Treasury. Title III of the Patriot Act entitled, “International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001” includes amendments to the Bank Secrecy Act which expand the responsibilities of financial institutions in regard to anti-money laundering activities with particular emphasis upon international money laundering and terrorism financing activities through designated correspondent and private banking accounts.

 

Effective December 25, 2001, Section 313(a) of the Patriot Act prohibits any insured financial institution such as North Valley Bank, from providing correspondent accounts to foreign banks which do not have a physical presence in any country (designated as “shell banks”), subject to certain exceptions for regulated affiliates of foreign banks. Section 313(a) also requires financial institutions to take reasonable steps to ensure that foreign bank correspondent accounts are not being used to indirectly provide banking services to foreign shell banks, and Section 319(b) requires financial institutions to maintain records of the owners and agent for service of process of any such foreign banks with whom correspondent accounts have been established.

 

Effective July 23, 2002, Section 312 of the Patriot Act created a requirement for special due diligence for correspondent accounts and private banking accounts. Under Section 312, each financial institution that establishes, maintains, administers, or manages a private banking account or a correspondent account in the United States for a non-United States person, including a foreign individual visiting the United States, or a representative of a non-United States person shall establish appropriate, specific, and, where necessary, enhanced, due diligence policies, procedures, and controls that are reasonably designed to detect and record instances of money laundering through those accounts.

 

The Patriot Act contains various provisions in addition to Sections 313(a) and 312 that affect the operations of financial institutions by encouraging cooperation among financial institutions, regulatory authorities and law enforcement authorities with respect to individuals, entities and organizations engaged in, or reasonably suspected of engaging in, terrorist acts or money laundering activities. The Company and North Valley Bank are not currently aware of any account relationships between North Valley Bank and any foreign bank or other person or entity as described above under Sections 313(a) or 312 of the Patriot Act. Certain surveillance provisions of the Patriot Act were scheduled to expire on December 31, 2005, and actions to restrict the use of the Patriot Act surveillance provisions were filed by the ACLU and other organizations. On March 9, 2006, after temporary extensions of the Patriot Act, President Bush signed the “USA Patriot Improvement and Reauthorization Act of 2005” and the “USA Patriot Act Additional Reauthorizing Amendments Act of 2006,” which reauthorized all expiring provisions of the Patriot Act  and extended certain provisions related to surveillance and production of business records until December 31, 2009. The extended deadline for those provisions was subsequently further extended at various times during 2010 and 2011 and on May 26, 2011, President Obama signed a further four-year extension of the surveillance provisions.

 

The effects which the Patriot Act and any additional legislation enacted by Congress may have upon financial institutions is uncertain; however, such legislation could increase compliance costs and thereby potentially may have an adverse effect upon the Company’s results of operations.

 

The Sarbanes-Oxley Act of 2002

 

On July 30, 2002, President George W. Bush signed into law the Sarbanes-Oxley Act of 2002 (the “Act”), legislation designed to address certain issues of corporate governance and accountability. The key provisions of the Act and the rules promulgated by the SEC pursuant to the Act include the following:

 

Expanded oversight of the accounting profession by creating a new independent public company oversight board to be monitored by the SEC.
 Revised rules on auditor independence to restrict the nature of non-audit services provided to audit clients and to require such services to be pre-approved by the audit committee.

 

9
 

 

 Improved corporate responsibility through mandatory listing standards relating to audit committees, certifications of periodic reports by the CEO and CFO and making issuer interference with an audit a crime.
 Enhanced financial disclosures, including periodic reviews for largest issuers and real time disclosure of material company information.
 Enhanced criminal penalties for a broad array of white collar crimes and increases in the statute of limitations for securities fraud lawsuits.
 Disclosure of whether a company has adopted a code of ethics that applies to the company’s principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, and disclosure of any amendments or waivers to such code of ethics.
 Disclosure of whether a company’s audit committee of its board of directors has a member of the audit committee who qualifies as an “audit committee financial expert.”
 A prohibition on insider trading during pension plan black-out periods.
 Disclosure of off-balance sheet transactions.
 A prohibition on personal loans to directors and officers.
 Conditions on the use of non-GAAP (generally accepted accounting principles) financial measures.
 Standards of professional conduct for attorneys, requiring attorneys having an attorney-client relationship with a company, among other matters, to report “up the ladder” to the audit committee, to another board committee or to the entire board of directors regarding certain material violations.
 Expedited filing requirements for Form 4 reports of changes in beneficial ownership of securities, reducing the filing deadline to within 2 business days of the date on which an obligation to report is triggered.
 Accelerated filing requirements for reports on Forms 10-K and 10-Q by public companies which qualify as “accelerated filers,” with a phased-in reduction of the filing deadline for Form 10-K and Form 10-Q.  
 Disclosure concerning website access to reports on Forms 10-K, 10-Q and 8-K, and any amendments to those reports, by “accelerated filers” as soon as reasonably practicable after such reports and material are filed with or furnished to the SEC.
 Rules requiring national securities exchanges and national securities associations to prohibit the listing of any security whose issuer does not meet audit committee standards established pursuant to the Act.

 

The Company’s securities are listed on the NASDAQ Global Select Market. Consequently, in addition to the rules promulgated by the SEC pursuant to the Act, the Company must also comply with the listing standards applicable to all NASDAQ listed companies. The NASDAQ listing standards applicable to the Company include standards related to (i) director independence, (ii) executive session meetings of the board, (iii) requirements for audit, nominating and compensation committee charters, membership qualifications and procedures, (iv) shareholder approval of equity compensation arrangements, and (v) code of conduct requirements.

 

The Company has incurred and it is anticipated that it will continue to incur increased costs to comply with the Act and the rules and regulations promulgated pursuant to the Act by the Securities and Exchange Commission, NASDAQ and other regulatory agencies having jurisdiction over the Company or the issuance and listing of its securities. The Company does not currently anticipate that compliance with the Act and such rules and regulations will have a material adverse effect upon its financial position or results of its operations or its cash flows. Management is required to report on the effectiveness of internal control over financial reporting, and an external attestation report of the Company’s independent registered public accounting firm regarding internal control over financial reporting is required for the year ended December 31, 2012 but was not required for the years ended December 31, 2011 and 2010. See Item 9A, “Controls and Procedures,” below.

 

The California Corporate Disclosure Act

 

Effective January 1, 2003, the California Corporate Disclosure Act (the “CCD Act”) required publicly traded corporations incorporated or qualified to do business in California to disclose information about their past history, auditors, directors and officers. Effective September 28, 2004, the CCD Act, as currently in effect and codified at California Corporations Code Section 1502.1, requires the Company to file with the California Secretary of State and disclose within 150 days after the end of its fiscal year certain information including the following:

 

The name of the company’s independent registered accounting firm and a description of services, if any, performed for a company during the previous two fiscal years and the period from the end of the most recent fiscal year to the date of filing;
 The annual compensation paid to each director and the five most highly compensated non-director executive officers (including the CEO and CFO) during the most recent fiscal year, including all plan and non-plan compensation for all services rendered to a company as specified in Item 402 of Regulation S-K such as grants, awards or issuance of stock, stock options and similar equity-based compensation;

 

10
 

 

A description of any loans made to a director at a “preferential” loan rate during the company’s two most recent fiscal years, including the amount and terms of the loans;
 Whether any bankruptcy was filed by a company or any of its directors or executive officers within the previous 10 years;
 Whether any director or executive officer of a company has been convicted of fraud during the previous 10 years; and
 A description of any material pending legal proceedings other than ordinary routine litigation as specified in Item 103 of Regulation S-K and a description of such litigation where the company was found legally liable by a final judgment or order.

 

The Company does not believe that compliance with the CCD Act will have a material adverse effect upon its financial position or results of its operations or its cash flows.

 

Competition

 

At June 30, 2012, commercial and savings banks in competition with the Company had 392 banking offices in the counties of Del Norte, Humboldt, Mendocino, Placer, Shasta, Sonoma, Trinity and Yolo where the Company operates. In those 392 banking offices (which include the Company’s 22), there were $25.7 billion in total deposits of which the Company had an overall share of 3.0%. Additionally, the Company competes with thrifts and, to a lesser extent, credit unions, finance companies and other financial service providers for deposit and loan customers.

 

Larger banks may have a competitive advantage over the Company because of higher lending limits and major advertising and marketing campaigns. They also perform services, such as trust services and international banking which the Company is not authorized nor prepared to offer currently. The Company has arranged with correspondent banks and with others to provide some of these services for their customers. As of December 31, 2012, NVB’s lending limit to any one borrower is $30,960,000 on a fully secured basis and $18,576,000 on an unsecured basis. These limits are adequate in most instances to compete for lending relationships within the markets we currently serve.

 

In order to compete with the major financial institutions in its primary service areas, the Company, through NVB, utilizes to the fullest extent possible, the flexibility which is accorded by its independent status. This includes an emphasis on specialized services, local promotional activity, and personal contacts by the officers, directors and employees of the Company. NVB also seeks to provide special services and programs for individuals in its primary service area who are employed in the agricultural, professional and business fields, such as loans for equipment, furniture, tools of the trade or expansion of practices or businesses.

 

Banking is a business that depends heavily on net interest income. Net interest income is defined as the difference between the interest rate paid to obtain deposits and other borrowings and the interest rate received on loans extended to customers and on securities held in the Bank’s investment portfolio. Commercial banks compete with savings and loan associations, credit unions, other financial institutions and other entities for funds. For instance, yields on corporate and government debt securities and other commercial paper affect the ability of commercial banks to attract and hold deposits. Commercial banks also compete for loans with savings and loan associations, credit unions, consumer finance companies, mortgage companies and other lending institutions.

 

Monetary and Fiscal Policies

 

The net interest income of the Company, and to a large extent, its earnings, are affected not only by general economic conditions, both domestic and foreign, but also by the monetary and fiscal policies of the United States as set by statutes and as implemented by federal agencies, particularly the Board of Governors of the Federal Reserve System. The Board of Governors can and does implement national monetary policy, such as seeking to curb inflation and combat recession by its open market operations in United States government securities, adjustments in the amount of interest free reserves that banks and other financial institutions are required to maintain, and adjustments to the discount rates applicable to borrowing by banks from the Federal Reserve System. These activities influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and timing of any future changes in monetary policies and their impact on the Company are not predictable.

 

11
 

 

Deposit Insurance

 

The FDIC is an independent federal agency that insures deposits of federally insured banks (such as North Valley Bank) and savings institutions up to prescribed limits through the Deposit Insurance Fund (“DIF”). The Emergency Economic Stabilization Act of 2008 (“EESA”) temporarily raised the limit on federal deposit insurance coverage provided by the FDIC from $100,000 to $250,000 per depositor. The Dodd-Frank Act (described in more detail below) made the $250,000 amount permanent.

 

In addition, on November 9, 2010, the FDIC issued a final rule (implementing the Dodd-Frank Act) which provided unlimited deposit insurance coverage for non-interest bearing transaction accounts until December 31, 2012. This Transaction Account Guarantee (“TAG”) program was not extended and expired December 31, 2012.

 

The amount of FDIC assessments paid by each DIF member institution is based on its risk profile as measured by regulatory capital ratios and other supervisory factors. Under the assessment rate system established in 2006, the FDIC increased the assessment rates (effective January 1, 2007) for most institutions from $0.05 to $0.07 per $100 of insured deposits and established a Designated Reserve Ratio (“DRR”) for the DIF during 2007 at 1.25% of insured deposits. Since 2008, due to higher levels of bank failures and the need to maintain a strong DIF, the FDIC has increased the assessment rates of insured institutions and may continue to do so in the future. On November 17, 2009, the FDIC amended its regulations and required all insured financial institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011 and 2012 unless they were notified they were exempt from the prepayment. The FDIC exempted North Valley Bank from the requirement to prepay.

 

As required by the Dodd-Frank Act, the FDIC revised the assessment rates, effective April 1, 2011, and the deposit insurance assessment base used to calculate premiums paid to DIF, substituting the average consolidated total assets less average tangible equity of an institution in place of deposits. Also pursuant to the Dodd-Frank Act, the FDIC increased the DRR to 2.0 percent, effective January 1, 2011. For the year ended December 31, 2012, the assessment rate for North Valley Bank averaged $0.11 per $100 in assessable deposits, compared to $0.18 per $100 in assessable deposits for the year ended December 31, 2011. If economic conditions continue to impact financial institutions and there are additional bank and other financial institution failures, or if the FDIC otherwise determines, North Valley Bank may be required to pay higher FDIC premiums than the recently increased levels, which could have a material and adverse effect on the earnings of the Company.

 

Interstate Banking

 

Since 1996, California law implementing certain provisions of prior federal law has (1) permitted interstate merger transactions; (2) prohibited interstate branching through the acquisition of a branch business unit located in California without acquisition of the whole business unit of the California bank; and (3) prohibited interstate branching through de novo establishment of California branch offices. Initial entry into California by an out-of-state institution must be accomplished by acquisition of or merger with an existing whole bank, which has been in existence for at least five years. The Dodd-Frank Act authorizes national and state banks to establish branches in other states to the same extent as a bank chartered by that state would be permitted to branch.

 

Glass-Steagall Act

 

The Financial Services Modernization Act of 1999 (the “FSMA”) eliminated most of the remaining depression-era “firewalls” between banks, securities firms and insurance companies which was established by the Banking Act of 1933, also known as the Glass-Steagall Act (“Glass-Steagall). Glass-Steagall sought to insulate banks as depository institutions from the perceived risks of securities dealing and underwriting, and related activities. The FSMA repealed Section 20 of Glass-Steagall, which prohibited banks from affiliating with securities firms. Bank holding companies that can qualify as “financial holding companies” can now acquire securities firms or create them as subsidiaries, and securities firms can now acquire banks or start banking activities through a financial holding company. The FSMA includes provisions which permit national banks to conduct financial activities through a subsidiary that are permissible for a national bank to engage in directly, as well as certain activities authorized by statute, or that are financial in nature or incidental to financial activities to the same extent as permitted to a “financial holding company” or its affiliates. This liberalization of United States banking and financial services regulation applies both to domestic institutions and foreign institutions conducting business in the United States. Consequently, the common ownership of banks, securities firms and insurance firms is now possible, as is the conduct of commercial banking, merchant banking, investment management, securities underwriting and insurance within a single financial institution using a “financial holding company” structure authorized by the FSMA.

 

Prior to the FSMA, significant restrictions existed on the affiliation of banks with securities firms and on the direct conduct by banks of securities dealing and underwriting and related securities activities. Banks were also (with minor exceptions) prohibited from engaging in insurance activities or affiliating with insurers. The FSMA removed these restrictions and substantially eliminated the prohibitions under the Bank Holding Company Act on affiliations between banks and insurance companies. Bank holding companies, which qualify as financial holding companies through an application process, can now insure, guarantee, or indemnify against loss, harm, damage, illness, disability, or death; issue annuities; and act as a principal, agent, or broker regarding such insurance services.

 

12
 

 

In order for a commercial bank to affiliate with a securities firm or an insurance company pursuant to the FSMA, its bank holding company must qualify as a financial holding company. A bank holding company will qualify if (i) its banking subsidiaries are “well capitalized” and “well managed” and (ii) it files with the Board of Governors a certification to such effect and a declaration that it elects to become a financial holding company. The amendment of the Bank Holding Company Act now permits financial holding companies to engage in activities, and acquire companies engaged in activities, that are financial in nature or incidental to such financial activities. Financial holding companies are also permitted to engage in activities that are complementary to financial activities if the Board of Governors determines that the activity does not pose a substantial risk to the safety or soundness of depository institutions or the financial system in general. These standards expand upon the list of activities “closely related to banking” which to date have defined the permissible activities of bank holding companies under the Bank Holding Company Act.

 

One further effect of FSMA was to require that federal financial institution and securities regulatory agencies prescribe regulations to implement the policy that financial institutions must respect the privacy of their customers and protect the security and confidentiality of customers’ non-public personal information. These regulations will require, in general, that financial institutions (1) may not disclose non-public personal information of customers to non-affiliated third parties without notice to their customers, who must have opportunity to direct that such information not be disclosed; (2) may not disclose customer account numbers except to consumer reporting agencies; and (3) must give prior disclosure of their privacy policies before establishing new customer relationships.

 

Discharge of Materials into the Environment

 

Compliance with federal, state and local regulations regarding the discharge of materials into the environment may have a substantial effect on the capital expenditure, earnings and competitive position of the Company in the event of lender liability or environmental lawsuits. Under federal law, liability for environmental damage and the cost of cleanup may be imposed upon any person or entity that is an “owner” or “operator” of contaminated property. State law provisions, which were modeled after federal law, are substantially similar. Congress established an exemption under Federal law for lenders from “owner” and/or “operator” liability, which provides that “owner” and/or “operator” do not include “a person, who, without participating in the management of a vessel or facility, holds indicia of ownership primarily to protect his security interests in the vessel or facility.”

 

In the event that the Company was held liable as an owner or operator of a toxic property, it could be responsible for the entire cost of environmental damage and cleanup. Such an outcome could have a serious effect on the Company’s consolidated financial condition depending upon the amount of liability assessed and the amount of cleanup required.

 

The Company takes reasonable steps to avoid loaning against property that may be contaminated. In order to identify possible hazards, the Company requires that all fee appraisals contain a reference to a visual assessment of hazardous waste by the appraiser. Further, on loans proposed to be secured by industrial, commercial or agricultural real estate, an Environmental Questionnaire must be completed by the borrower and any areas of concern addressed. Additionally, the borrower is required to review and sign a Hazardous Substance Certificate and Indemnity at the time the note is signed.

 

If the investigation reveals and if certain warning signs are discovered, but it cannot be easily ascertained, that an actual environmental hazard exists, the Company may require that the owner/buyer of the property, at his/her expense, have an Environmental Inspection performed by an insured, bonded environmental engineering firm acceptable to the Company.

 

Recent Regulatory Developments

 

In response to global credit and liquidity issues involving a number of financial institutions, the United States government, particularly the United States Department of the Treasury (the “U.S. Treasury”) and the Federal financial institution regulatory agencies, have taken a variety of extraordinary measures designed to restore confidence in the financial markets and to strengthen financial institutions, including capital injections, guarantees of bank liabilities and the acquisition of illiquid assets from banks.

 

TARP and the CPP. On October 3, 2008, the EESA was signed into law. Pursuant to the EESA, the U.S. Treasury was granted the authority to take a range of actions for the purpose of stabilizing and providing liquidity to the U.S. financial markets and has implemented several programs, including the purchase by the U.S. Treasury of certain troubled assets from financial institutions under the Troubled Asset Relief Program” (the “TARP”) and the direct purchase by the U.S. Treasury of equity securities of financial institutions under the Capital Purchase Program (the “CPP”). The final investment under the CPP was made in December 2009. The Company did not participate in the CPP.

 

13
 

 

Financial Stability Plan. On February 10, 2009, the U.S. Treasury announced a Financial Stability Plan (the “FSP”) as a comprehensive approach to strengthening the financial system and addressing the credit crisis. The Plan included a Capital Assistance Program (the “CAP”) that was intended to serve as a bridge to raising private capital and to ensure sufficient capital to preserve or increase lending in a worse-than-expected economic deterioration. Eligibility to participate in the CAP was consistent with the criteria for QFI’s under the CPP. Eligible institutions with consolidated assets below $100 billion would be able to obtain capital under the CAP after a supervisory review. The CAP ended in November 2009 and the Company did not participate.

 

American Recovery and Reinvestment Act. On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (the “ARRA”) was signed into law. Section 7001 of the ARRA amended Section 111 of the EESA in its entirety. While the U.S. Treasury must promulgate regulations to implement the restrictions and standards set forth in Section 7001, the ARRA, among other things, significantly expands the executive compensation restrictions previously imposed by the EESA. Such restrictions apply to any entity that has received or will receive financial assistance under the TARP, and shall generally continue to apply for as long as any obligation arising from financial assistance provided under the TARP, including preferred stock issued under the CPP, remains outstanding. These ARRA restrictions do not apply to any TARP recipient during such time when the federal government (i) only holds any warrants to purchase common stock of such recipient or (ii) holds no preferred stock or warrants to purchase common stock of such recipient. The Company is not subject to these restrictions because it did not participate in TARP.

 

The Small Business Jobs Act of 2010

 

On September 27, 2010, President Obama signed into law the Small Business Jobs Act of 2010 (the “SBJ Act”), which, among other matters, authorizes the U.S. Treasury to buy up to $30 billion in preferred stock or subordinated debt issued by community banks (or their bank holding companies provided 90% of the funds received are downstreamed to the bank subsidiary) with assets less that $10 billion pursuant to the Small Business Lending Fund (the “SBLF”) created under the SBJ Act. Funds received as capital investments will qualify as Tier 1 capital. The SBLF investments are intended to increase the availability of credit for small businesses and thereby induce the creation of jobs in support of economic recovery.

 

The participating banks (or bank holding companies) will pay an annual dividend on the preferred stock or subordinated debt purchased by the U.S. Treasury in an amount which ranges between 5% and 1% during the initial measurement period of approximately two years determined by reducing the dividend rate 1% for every 2.5% increase in the bank’s small business lending up to a lending increase of 10%. The dividend rate will be adjusted quarterly during the initial period. If a participant’s lending activity does not increase in the initial period, the dividend rate will increase thereafter to 7%. After 4.5 years, the dividend rate increases to 9% until the SBLF funds are repaid.

 

On December 23, 2010, the federal banking agencies jointly issued guidance on underwriting standards for small business loans originated under the SBLF which require adherence to safe and sound credit standards and risk management processes. It is uncertain whether the SBLF will have the intended effect of creating jobs in sufficient numbers to positively impact the economic recovery. The Company did not participate in the SBLF.

 

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

 

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”). The Dodd-Frank Act is intended to restructure the regulation of the financial services sector by, among other things, (i) establishing a framework to identify systemic risks in the financial system implemented by a newly created Financial Stability Oversight Council and other federal banking agencies; (ii) expanding the resolution authority of the federal banking agencies over troubled financial institutions; (iii) authorizing changes to capital and liquidity requirements; (iv) changing deposit insurance assessments; and (v) enhancing regulatory supervision to improve the safety and soundness of the financial services sector. The Dodd-Frank Act is expected to have a significant impact upon our business as its provisions are implemented over time. Below is a summary of certain provisions of the Dodd-Frank Act which, directly or indirectly, may affect us.

 

Changes to Capital Requirements. The federal banking agencies are required to establish minimum leverage and risk-based capital requirements for banks and bank holding companies which will not be lower and could be higher than current regulatory capital and leverage standards for insured depository institutions. Under these requirements, trust preferred securities will be excluded from Tier 1 capital unless such securities were issued prior to May 19, 2010 by a bank holding company with less than $15 billion in assets. The Dodd-Frank Act requires capital requirements to be countercyclical so that the required amount of capital increases in times of economic expansion and decreases in times of economic contraction consistent with safety and soundness.
     

 

14
 

 

  Enhanced Regulatory Supervision. The Dodd-Frank Act increased regulatory oversight, supervision and examination of banks, bank holding companies and their respective subsidiaries by the appropriate regulatory agency.
     
  Consumer Protection. The Dodd-Frank Act created the Consumer Financial Protection Bureau (“CFPB”) within the Federal Reserve System. The CFPB is responsible for establishing and implementing rules and regulations under various federal consumer protection laws governing certain consumer products and services. The CFPB has primary enforcement authority over large financial institutions with assets of $10 billion or more, while smaller institutions will be subject to the CFPB’s rules and regulations through the enforcement authority of the federal banking agencies. States are permitted to adopt consumer protection laws and regulations that are more stringent than those laws and regulations adopted by the CFPB and state attorneys general are permitted to enforce consumer protection laws and regulations adopted by the CFPB.
     
  Deposit Insurance. The Dodd-Frank Act permanently increased the deposit insurance limit for insured deposits to $250,000 per depositor and extended unlimited deposit insurance to non-interest bearing transaction accounts through December 31, 2012. Other deposit insurance changes under the Dodd-Frank Act include (i) amendment of the assessment base used to calculate an insured depository institution’s deposit insurance premiums paid to the Deposit Insurance Fund (“DIF”) by elimination of deposits and substitution of average consolidated total assets less average tangible equity during the assessment period as the revised assessment base; (ii) increasing the minimum designated reserve ratio of the DIF from 1.15 percent to 1.35 percent of the estimated amount of total insured deposits; (iii) eliminating the requirement that the FDIC pay dividends to depository institutions when the reserve ratio exceeds certain thresholds; and (iv) repeal of the prohibition upon the payment of interest on demand deposits to be effective one year after the date of enactment of the Dodd-Frank Act. In December 2010, pursuant to the Dodd-Frank Act, the FDIC increased the reserve ratio of the DIF to 2.0 percent effective January 1, 2011.
     
  Transactions with Affiliates. The Dodd-Frank Act enhanced the requirements for certain transactions with affiliates under Section 23A and 23B of the Federal Reserve Act, including an expansion of the definition of “covered transactions” and increased the amount of time for which collateral requirements regarding covered transactions must be maintained.
     
  Transactions with Insiders. Insider transaction limitations are expanded through the strengthening of loan restrictions to insiders and the expansion of the types of transactions subject to the various limits, including derivative transactions, repurchase agreements, reverse repurchase agreements and securities lending or borrowing transactions. Restrictions are also placed on certain asset sales to and from an insider to an institution, including requirements that such sales be on market terms and, in certain circumstances, approved by the institution’s board of directors.
     
  Enhanced Lending Limitations. The Dodd-Frank Act strengthened the existing limits on a depository institution’s credit exposure to include credit exposure arising from derivative transactions, repurchase agreements, and securities lending and borrowing transactions.    
     
  Debit Card Interchange Fees.  The Dodd-Frank Act requires that the amount of any interchange fee charged by a debit card issuer with respect to a debit card transaction must be reasonable and proportional to the cost incurred by the issuer.  The Federal Reserve Board is required to establish standards for reasonable and proportional fees which may take into account the costs of preventing fraud.  The restrictions on interchange fees, however, do not apply to banks that, together with their affiliates, have assets of less than $10 billion.
     
  Interstate Branching.  The Dodd-Frank Act authorizes national and state banks to establish branches in other states to the same extent as a bank chartered by that state would be permitted to branch.  Previously, banks could only establish branches in other states if the host state expressly permitted out-of-state banks to establish branches in that state.  Accordingly, banks will be able to enter new markets more freely.
     
  Charter Conversions.  Effective one year after enactment of the Dodd-Frank Act, depository institutions that are subject to a cease and desist order or certain other enforcement actions issued with respect to a significant supervisory matter are prohibited from changing their federal or state charters, except in accordance with certain notice, application and other procedures involving the applicable regulatory agencies.    
     

 

15
 

 

  Compensation Practices. The Dodd-Frank Act provides that the appropriate federal banking regulators must establish standards prohibiting as an unsafe and unsound practice any compensation plan of a bank holding company or other “covered financial institution” that provides an insider or other employee with “excessive compensation” or could lead to a material financial loss to such firm. In June 2010, prior to the enactment of the Dodd-Frank Act, the federal bank regulatory agencies jointly issued the Interagency Guidance on Sound Incentive Compensation Policies (“Guidance”), which requires that financial institutions establish metrics for measuring the risk to the financial institution of such loss from incentive compensation arrangements and implement policies to prohibit inappropriate risk taking that may lead to material financial loss to the institution. Together, the Dodd-Frank Act and the Guidance may impact our compensation policies and arrangements.
   
  Corporate Governance. The Dodd-Frank Act will enhance corporate governance requirements to include (i) requiring publicly traded companies to give shareholders a non-binding vote on executive compensation at their first annual meeting taking place six months after the date of enactment and at least every three years thereafter and on so-called “golden parachute” payments in connection with approvals of mergers and acquisitions unless previously voted on by shareholders; (ii) authorizing the SEC to promulgate rules that would allow shareholders to nominate their own candidates for election as directors using a company’s proxy materials; (iii) directing the federal banking regulators to promulgate rules prohibiting excessive compensation paid to executives of depository institutions and their holding companies with assets in excess of $1.0 billion, regardless of whether or not the company is publicly traded; and (iv) authorizing the SEC to prohibit broker discretionary voting on the election of directors and on executive compensation matters.  

 

Many of the requirements under the Dodd-Frank Act will be implemented over an extended period of time. Therefore, the nature and extent of regulations that will be issued by various regulatory agencies and the impact such regulations will have on the operations of financial institutions such as ours is unclear. Such regulations resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and leverage ratio requirements or otherwise adversely affect our business. These changes may also require us to invest significant management attention and resources to evaluate and make necessary changes in order to comply with new statutory and regulatory requirements.

 

Future Legislation and Regulation

 

Certain legislative and regulatory proposals that could affect the Company and banking business in general are periodically introduced before the United States Congress, the California State Legislature and federal and state government agencies. It is not known to what extent, if any, legislative proposals will be enacted and what effect such legislation would have on the structure, regulation and competitive relationships of financial institutions. It is likely, however, that such legislation could subject the Company and NVB to increased regulation, disclosure and reporting requirements and increase competition and the Company’s cost of doing business.

 

In addition to legislative changes, the various federal and state financial institution regulatory agencies frequently propose rules and regulations to implement and enforce already existing legislation. It cannot be predicted whether or in what form any such rules or regulations will be enacted or the effect that such and regulations may have on the Company and NVB.

 

Employees

 

At December 31, 2012, the Company had approximately 329 employees, (which includes 316 full-time equivalent employees). None of the Company’s employees are represented by a labor union, and management considers its relations with employees to be good.

 

Website Access

 

Information on the Company and its subsidiary NVB may be obtained from the Company’s website www.novb.com. Copies of the Company’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments thereto are available free of charge on the website as soon as they are published by the SEC through a link to the Edgar reporting system maintained by the SEC. Simply select the “NOVB Investors” menu item, then click on “Shareholder Relations” and then select the “SEC Filings” link. Also made available through the “SEC Filings” link are the Section 16 reports of ownership and changes in ownership of the Company’s common stock which are filed with the Securities and Exchange Commission by the directors and executive officers of the Company and by any persons who own more than ten percent of the outstanding shares of such stock. Information on the Company website is not incorporated by reference into this report.

 

16
 

 

ITEM 1A. RISK FACTORS    

 

In addition to the risks associated with the business of banking generally, as described above under Item 1 “Description of Business”, the Company’s business, financial condition, operating results, future prospects and stock price can be adversely impacted by certain risk factors, as set forth below, any one of which could cause the Company’s actual results to vary materially from recent results or from the Company’s anticipated future results.

 

Extensive Regulation of Banking. The operations of the Company and its subsidiary, North Valley Bank, 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 such operations. The Company and North Valley Bank believe they are in substantial compliance in all material respects with laws, rules and regulations applicable to the conduct of their banking business. Because the banking business is highly regulated, the laws, rules and regulations applicable to the Company are subject to regular modification and change. These laws, rules and regulations, or any other laws, rules or regulations adopted in the future, could make compliance more difficult or expensive, restrict the Company’s 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 the Company, or otherwise adversely affect the Company’s results of operations, financial condition, or future prospects. The Dodd-Frank Act, signed into law on July 21, 2010, continues to have a broad impact on the financial services sector, including significant regulatory and compliance changes. Many of the Dodd-Frank Act requirements are being implemented over time and, given the uncertainty associated with the manner in which they will be implemented by the various regulatory agencies, the full extent of the impact such requirements will have on the Company’s operations is not clear. Changes resulting from the Dodd-Frank Act may impact the profitability of business activities, require changes to certain business practices, impose more stringent capital, liquidity and leverage requirements or otherwise adversely affect our business, results of operations or financial condition.

 

Competition. An economy characterized by a decline in real estate values, high unemployment and general uncertainty has increased competition for good quality loans among depository institutions operating in the Company’s market areas. Ultimately, the Company and North Valley Bank may not be able to compete successfully against current and future competitors. Many competitors offer the banking services that are offered by North Valley Bank. These competitors include national and super-regional banks, finance companies, investment banking and brokerage firms, credit unions, government-assisted farm credit programs, other community banks and technology-oriented financial institutions offering online services. In particular, North Valley Bank’s competitors include several 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. 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, such as Internet-based banking services that cross traditional geographic bounds, enable more companies to provide financial services. If North Valley Bank is unable to attract and retain banking customers, it may be unable to continue its level of loans and deposits, which may adversely affect its and the Company’s results of operations, financial condition and future prospects.

 

Dependence on Key Employees. The Company and North Valley Bank are dependent on the successful recruitment and retention of highly qualified personnel. Our ability to implement our business strategies is closely tied to the strengths of our chief executive officer and other key officers. Our key officers have extensive experience in the banking industry which is not easily replaced. Business banking, one of the Company’s principal lines of business, is dependent on relationship banking, in which Company personnel develop professional relationships with small business owners and officers of larger business customers who are responsible for the financial management of the companies they represent. If these employees were to leave the Company and become employed by a competing bank, the Company could potentially lose business customers. In addition, the Company relies on its customer service staff to effectively serve the needs of its consumer customers. The Company very actively recruits for all open positions and management believes that its employee relations are good.

 

Growth Strategy. The Company has pursued and continues to pursue a growth strategy which depends primarily on generating an increasing level of loans and deposits at acceptable risk levels. The Company may not be able to sustain this growth strategy without establishing new branches or new products. Therefore, the Company may expand in its current markets by opening or acquiring branch offices or may expand into new markets or make strategic acquisitions of other financial institutions or branch offices. This expansion may require significant investments in equipment, technology, personnel and site locations. Our success in implementing our growth strategy may not be possible without corresponding increases in our noninterest expenses. In addition, growth through acquisitions represents a component of our business strategy. The need to integrate the operations and personnel of acquired banks and branches may not always be successfully accomplished. Any inability to improve operating performance through integration and/or merger of operations, functions or banks could increase expenses and impact the Company’s performance.

 

17
 

 

Governmental Fiscal and Monetary Policies. The business of banking is affected significantly by the fiscal and monetary policies of the federal government and its agencies. Such policies are beyond the control of the Company. The Company is particularly affected by the policies established by the Board of Governors in relation to the supply of money and credit in the United States. The instruments of monetary policy available to the Board of Governors can be used in varying degrees and combinations to directly affect the availability of bank loans and deposits, as well as the interest rates charged on loans and paid on deposits, and this can and does have a material effect on the Company’s business, results of operations and financial condition.

 

Geographic Concentration. All of the business of the Company is located in the State of California and the banking offices of the Company are located in the Northern California Counties of Shasta, Trinity, Humboldt, Del Norte, Yolo, Sonoma, Placer and Mendocino. As a result, our financial condition, results of operations and cash flows are subject to changes in the economic conditions in those counties. Our success depends upon the business activity, population, employment and income levels, deposits and real estate activity in these markets. Adverse economic conditions and unemployment trends in those markets are affecting the ability of our customers to repay their loans which has reduced our growth rate and impacted our financial condition and results of operations. Economic conditions in the State of California are subject to various uncertainties at this time, including the budgetary and fiscal difficulties facing the California State Government. Conditions in the California economy may deteriorate and such deterioration would adversely affect the Company.

 

Commercial Loans. As of December 31, 2012, approximately 9.4% of our loan portfolio consisted of commercial business loans. The credit risk for commercial loans is a result of several factors, including the concentration of principal in a limited number of loans and borrowers, the mobility of collateral, the effect of general economic conditions and the increased difficulty of evaluating and monitoring these types of loans. In addition, unlike residential mortgage loans, which generally are made on the basis of the borrower’s ability to make repayment from his or her employment and other income and which are secured by real property whose value tends to be more easily ascertainable, commercial business loans typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business. As a result, the availability of funds for the repayment of commercial business loans may be substantially dependent on the success of the business itself and the general economic environment. If the cash flow from business operations is reduced, the borrower’s ability to repay the loan may be impaired.

 

Real Estate Values. A large portion of the loan portfolio of the Company is dependent on real estate. At December 31, 2012, real estate served as the principal source of collateral with respect to approximately 79.9% of the Company’s loan portfolio. A continuing substantial decline in the economy in general, or a continuing decline in real estate values in the Company’s primary operating market areas in particular, could have an adverse effect on the demand for new loans, the ability of borrowers to repay outstanding loans, the value of real estate and other collateral securing loans and the value of mortgage-backed securities included in the available-for-sale investment portfolio, as well as the Company’s financial condition and results of operations in general and the market value for Company common stock. Acts of nature, including fires, earthquakes and floods, which may cause uninsured damage and other loss of value to real estate that secures these loans, may also negatively impact the Company’s financial condition. In considering whether to make a loan secured by real property, we generally require an appraisal of the property. However, an appraisal is only an estimate of the value of the property at the time the appraisal is made. If the appraisal does not reflect the amount that may be obtained upon any sale or foreclosure of the property, we may not realize the amount equal to the indebtedness secured by the property in the event of foreclosure.

 

Construction and Development Loans. At December 31, 2012, real estate construction loans totaled $23.0 million, or 4.7% of our total loan portfolio. Residential construction loans, including land acquisition and development, totaled $14.9 million or 64.6% of the Company’s real estate construction portfolio, and 3.0% of the total loan portfolio. Construction, land acquisition and development lending involve additional risks because funds are advanced on 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 on 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, speculative construction loans often involve the disbursement of substantial funds with repayment dependent, in part, on the completion of the project and the ability of the borrower to sell the property, rather than the ability of the borrower or the guarantor to repay the 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. If we are forced to foreclose on a project prior to or at completion due to a default, we may not be able to recover all of the unpaid balance of, and accrued interest on, the loan, as well as related foreclosure and holding costs. In addition, we may be required to fund additional amounts to complete the project and may have to hold the property for an unspecified period of time.

 

18
 

 

Other Real Estate Owned (“OREO”). Real estate acquired through, or in lieu of, loan foreclosures is expected to be sold and is recorded at its fair value less estimated costs to sell. The amount, if any, by which the recorded amount of the loan exceeds the fair value (less estimated costs to sell) are charged to the allowance for loan losses, if necessary. The Company’s earnings could be materially and adversely affected by various expenses associated with OREO, including personnel costs, insurance and taxes, completion and repair costs, valuation adjustments, and other expenses associated with property ownership. Also, any further decrease in market prices of real estate in our market areas may lead to additional OREO write downs, with a corresponding expense in our income statement. The Company’s OREO totaled $22,423,000, $20,106,000 and $25,784,000 at December 31, 2012, 2011 and 2010, respectively.

 

Allowance for Loan Losses. Like all financial institutions, the Company maintains an allowance for loan losses to provide for loan defaults and non-performance, but the allowance for loan losses may not be adequate to cover actual loan losses. In addition, future provisions for loan losses could materially and adversely affect the Company and therefore the Company’s operating results. The Company’s allowance for loan losses is based on prior experience, as well as an evaluation of the risks in the current portfolio. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates that may be beyond the Company’s control, and these losses may exceed current estimates. Federal regulatory agencies, as an integral part of their examination process, review the Company’s loans and allowance for loan losses. We believe that the Company’s allowance for loan losses is adequate to cover current losses, but a continuing decline in real estate values combined with higher rates of unemployment or under-employment in our operating markets could result in an increase in classified loans and the allowance for loan losses. These occurrences could materially and adversely affect the Company’s earnings.

 

Nonperforming Loans. In recent years, we have experienced significant declines in the performance of loans, particularly construction, development and land loans, and unsecured commercial and consumer loans. The Company’s nonperforming loans (defined as nonaccrual loans and loans 90 days or more past due and still accruing interest) were approximately $5,835,000, $18,411,000 and $20,065,000 at December 31, 2012, 2011 and 2010, respectively. Nonperforming loans as a percentage of the Company’s total loans were 1.19%, 4.04% and 3.91% at December 31, 2012, 2011 and, 2010, respectively. Nonperforming loans adversely affect the Company’s net income in various ways. We do not record interest income on nonaccrual loans; the costs of reappraising adversely classified assets, legal and other costs associated with loan collections, and other operating costs related to foreclosed assets have increased our noninterest expense; and upon taking collateral through foreclosure or similar proceedings, we are required to mark the related loan to the then fair value of the collateral, less estimated selling costs, which may result in a loss. Until economic and market conditions improve, we expect that our level of nonperforming loans will continue to impact our earnings, and could have a substantial adverse impact if conditions deteriorate further.

 

Regulatory Agreements. The supervisory agreement signed on January 6, 2010 by and among North Valley Bancorp, North Valley Bank and the Federal Reserve Bank of San Francisco was terminated, effective as of April 16, 2012, and resolutions adopted by the Board of Directors of NVB at the request of the California Department of Financial Institutions were previously terminated, effective March 1, 2012. However, North Valley Bank has not received a final report of examination for a compliance examination of the Bank conducted by the Federal Reserve Bank of San Francisco in 2010 and the Bank has established a reserve for the anticipated settlement of criticisms expected to be contained in the report, when received. See the discussion under “Noninterest Expense” at page 34 below.

 

The Effects of Legislation in Response to Current Credit Conditions. Legislation passed at the federal level and/or by the State of California in response to current conditions affecting credit markets could cause the Company to experience higher loan losses if such legislation reduces the amount that borrowers are otherwise contractually required to pay under existing loan contracts with North Valley Bank. Such legislation could also result in the imposition of limitations upon North Valley Bank's ability to foreclose on property or other collateral or make foreclosure less economically feasible. Such events could result in increased loan losses and require a material increase in the allowance for loan losses and thereby adversely affect the Company’s results of operations, financial condition, future prospects, profitability and stock price.

 

Dilution of Common Stock. Shares of the Company’s common stock may be issued in public or private capital raising transactions, future acquisitions, joint ventures, strategic alliances, or for other corporate purchases approved by the Board of Directors. On April 22, 2010, the Company raised $40 million (in gross proceeds) in a private placement of 40,000 shares of its Mandatorily Convertible Cumulative Perpetual Preferred Stock, Series A (“Series A Preferred Stock”) to a limited number of institutional and other accredited investors, including certain directors and executive officers of the Company. The shares of Series A Preferred Stock were convertible into shares of the Company’s common stock and, on July 21, 2010, with the prior approval of the Company shareholders, all 40,000 shares of Series A Preferred Stock were converted into a 26,666,646 shares of Company common stock (resulting in a total of 34,162,463 shares of common stock outstanding on such date). Shares of the Company’s common stock remaining eligible for future sale could have a further dilutive effect on the market for the common stock and could adversely affect the market price. The Amended and Restated Articles of Incorporation of the Company currently authorize the issuance of 60,000,000 shares of common stock, of which 6,835,192 were outstanding at December 31, 2012 (after a one-for-five reverse stock split effective on December 28, 2010). Pursuant to Company stock option plans, at December 31, 2012, employees and directors of the Company had outstanding options to purchase 248,822 shares of common stock. As of December 31, 2012, there were 220,213 shares of common stock available for grants under the Company’s stock option plans.

 

19
 

 

Operations Risks. The Company is subject to a variety of operations risks, including, but not limited to, reputational risk, legal risk and compliance risk, data processing system failures and errors, operational errors resulting from faulty or disabled computer or telecommunications systems and the risk of fraud or theft by employees or outsiders, any of which may adversely affect our business and results of operations. The Company maintains a system of internal controls to mitigate against such occurrences and maintains insurance coverage for such risks, but should such an event occur that is not prevented or detected by the Company’s internal controls, uninsured or in excess of applicable insurance limits, it could have a significant adverse impact on the Company’s business, financial condition or results of operations. The Bank is subject to periodic regulatory examinations in the ordinary course of business which are conducted by the Federal Reserve Bank of San Francisco and the California Department of Financial Institutions.

 

Business Confidence and International Uncertainty. The terrorist actions on September 11, 2001, and thereafter, plus military actions taken by the United States in Afghanistan, Iraq and elsewhere, have had significant adverse effects upon the United States economy. Whether terrorist activities in the future and the actions taken by the United States and its allies in combating terrorism on a worldwide basis will adversely impact the Company, and the extent of such impact, is uncertain. However, such events have had and may continue to have an adverse effect on the United States economy and by extension, the California economy including business activity in the Company’s market areas. Further economic deterioration and a loss of business confidence, whether at the national, state or local level, could adversely affect the Company’s future results of operations by, among other matters, reducing the demand for loans and other products and services offered by the Company, increasing nonperforming loans and the amounts required to be reserved for loan losses, reducing the value of collateral held as security for the Company’s loans, and causing a decline in the Company’s stock price.

 

The Effects of Changes to FDIC Insurance Coverage Limits and Assessments. FDIC insurance assessments are uncertain and increased premiums may adversely affect the Company’s earnings. The FDIC charges insured financial institutions premiums to maintain the DIF. Current economic conditions have increased expectations for additional bank closures and, in such event, the FDIC would take control of the failed banks and guarantee payment of deposits up to applicable insured limits from the DIF. Insurance premium assessments to insured financial institutions may increase as necessary to maintain adequate funding of the DIF. The EESA of 2008 included a provision for an increase in the amount of deposits insured by the FDIC to $250,000, which was scheduled to remain in effect through December 31, 2013. With enactment of the Dodd-Frank Act on July 21, 2010, the $250,000 per depositor insurance limit was made permanent. The TAG program which provided unlimited deposit insurance for noninterest bearing transaction accounts was not extended and it expired on December 31, 2012. It is not clear how depositors will regard the increase in insurance coverage to $250,000 in the future. Despite the increase, some depositors may reduce the amount of deposits held at North Valley Bank if concerns regarding bank failures persist, which could affect the level and composition of North Valley Bank's deposit portfolio and thereby directly impact its funding costs and net interest margin. North Valley Bank’s funding costs may also be adversely affected in the event that activities of the Federal Reserve Board and the U.S. Department of the Treasury to provide liquidity for the banking system and improvement in capital markets are curtailed or are unsuccessful. Such events could reduce liquidity in the markets, thereby increasing funding costs to North Valley Bank or reducing the availability of funds to finance its existing operations and thereby adversely affect the Company’s results of operations, financial condition, future prospects, profitability and stock price.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS  
     
None.    
     
ITEM 2. DESCRIPTION OF PROPERTIES    

 

The Company’s head office is located at 300 Park Marina Circle, Redding, California 96001. As of December 31, 2012, the Bank had branch offices in Shasta County (ten branches), Trinity County (two branches), Humboldt County (five branches), Del Norte County (one branch), Yolo County (one branch), Sonoma County (one branch), Placer County (one branch) and Mendocino County (one branch).

 

The Bank owns eleven branch office locations and two non branch locations. The Bank leases eleven branch office locations, one loan production office, one administrative building, one non branch location and one storage warehouse facility. Expiration dates of the Bank’s leases range from October 2013 to September 2023. Certain properties currently leased have renewal options which could extend the use of the facility for additional specified terms, and provisions for rental increases, principally for changes in the cost of living index, property taxes and maintenance. In the opinion of management, all properties are adequately covered by insurance and existing facilities are considered adequate for present and anticipated future use.

 

20
 

 

The following table summarizes the Company’s premises, both owned and leased:

 

Office Description Office Address Office Type
     
Redding 1327 South Street, Redding Branch (Owned)
Westwood 6392-J Westside Road, Redding Branch (Leased)
Shasta Lake 4715 Shasta Dam Blvd., Shasta Lake Branch (Owned)
Country Club 2930 Bechelli Lane, Redding Former Branch (Owned)
Bechelli 2920 Bechelli Lane, Redding (Owned)
Weaverville 595 Main Street, Weaverville Branch (Owned)
Hayfork 7061 State Highway 3, Hayfork Branch (Owned)
Buenaventura 3315 Placer Street, Redding Supermarket Branch (Leased)
Anderson 2686 Gateway Drive, Anderson Branch (Owned)
Enterprise 880 E. Cypress Avenue, Redding Branch (Owned)
Cottonwood 20635 Gas Point Road, Cottonwood Supermarket Branch (Leased)
Palo Cedro 9334-A Deschutes Road, Palo Cedro Branch (Leased)
Churn Creek 2245 Churn Creek Road, Redding Branch (Owned)
Redding Warehouse   Storage Facility (Leased)
Park Marina Circle 300 Park Marina Circle, Redding Administrative/Branch (Leased)
Cypress Center 804 East Cypress, Redding Administrative (Leased)
Real Estate 836 East Cypress, Redding (Owned)
Eureka Mall 838 W. Harris, Eureka Branch (Leased)
McKinleyville 1640 Central Avenue, McKinleyville Branch (Leased)
Crescent City 1492 Northcrest Drive, Crescent City Branch (Owned)
Eureka Downtown 402 F Street, Eureka Branch (Owned)
Ferndale 394 Main Street, Ferndale Branch (Owned)
Garberville 793 Redwood Drive, Garberville Branch (Leased)
Willits 255 S. Main Street, Willits Branch (Owned)
Woodland 630 Main Street, Woodland Administrative/Branch (Leased)
Roseville 2999 Douglas Blvd., Suite 160, Roseville Branch (Leased)
Santa Rosa 100 B Street, Suite 110, Santa Rosa Branch (Leased)
Ukiah 101 N. State Street, Suite A, Ukiah Former Branch (Leased)
Ukiah 275 West Gobbi Street, Suite B, Ukiah Loan Production Office (Leased)

 

As of December 31, 2012, the Bank’s investment in premises and equipment, net of depreciation, totaled $9,181,000. See Notes 5 and 15 to the Consolidated Financial Statements.

 

From time to time, the Company, through NVB, acquires real property through foreclosure of defaulted loans. The policy of the Company is not to use or permanently retain any such properties but to resell them when practicable.

 

ITEM 3. LEGAL PROCEEDINGS  

 

There are no material legal proceedings pending against the Company or against any of its property. The Company, because of the nature of its business, is generally subject to various legal actions, threatened or filed, which involve ordinary, routine litigation incidental to its business. Although the amount of the ultimate exposure, if any, cannot be determined at this time, the Company, based on the advice of counsel, does not expect that the final outcome of threatened or filed suits will have a materially adverse effect on its consolidated financial position.

 

ITEM 4. MINE SAFETY DISCLOSURES    

 

None.

 

21
 

 

PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

Market Information

 

The North Valley Bancorp common stock is quoted and trades on the NASDAQ Global Select Market under the symbol “NOVB.” The shares were first listed with the NASDAQ Stock Market in April 1998. The table below summarizes the Common Stock high and low trading prices during the two-year period ended December 31, 2012 as reported on the NASDAQ Global Select Market. The Company did not declare any cash dividends on its common stock for the years ended 2012 and 2011.

 

   Year Ended December 31, 
   2012   2011 
   High   Low   High   Low 
First Quarter  $12.44   $9.39   $12.99   $8.10 
Second Quarter  $15.00   $12.24   $10.86   $9.61 
Third Quarter  $14.41   $13.00   $10.90   $9.02 
Fourth Quarter  $14.41   $13.65   $10.45   $8.25 

 

Holders

 

The Company had approximately 366 shareholders of record as of December 31, 2012.

 

Dividends

 

As a California corporation, the Company’s ability to pay cash dividends is subject to restrictions set forth in the California General Corporation Law (the “Corporation Law”). The Corporation Law provides that neither a corporation nor any of its subsidiaries shall make a distribution to the corporation’s shareholders unless the board of directors has determined in good faith either of the following: (1) the amount of retained earnings of the corporation immediately prior to the distribution equals or exceeds the sum of (A) the amount of the proposed distribution plus (B) the preferential dividends arrears amount; or (2) immediately after the distribution, the value of the corporation’s assets would equal or exceed the sum of its total liabilities plus the preferential rights amount. The good faith determination of the board of directors may be based upon (1) financial statements prepared on the basis of reasonable accounting practices and principles, (2) a fair valuation, or (3) any other method reasonable under the circumstances; provided, that a distribution may not be made if the corporation or subsidiary making the distribution is, or is likely to be, unable to meet its liabilities (except those whose payment is otherwise adequately provided for) as they mature. The term “preferential dividends arrears amount” means the amount, if any, of cumulative dividends in arrears on all shares having a preference with respect to payment of dividends over the class or series to which the applicable distribution is being made, provided that if the articles of incorporation provide that a distribution can be made without regard to preferential dividends arrears amount, then the preferential dividends arrears amount shall be zero. The term “preferential rights amount” means the amount that would be needed if the corporation were to be dissolved at the time of the distribution to satisfy the preferential rights, including accrued but unpaid dividends, of other shareholders upon dissolution that are superior to the rights of the shareholders receiving the distribution, provided that if the articles of incorporation provide that a distribution can be made without regard to any preferential rights, then the preferential rights amount shall be zero.

 

Funds for payment of any cash dividends by the Company would be obtained from its investments as well as dividends and/or management fees from NVB. As a California banking corporation, the ability of NVB to pay cash dividends and/or management fees is subject to restrictions set forth in the California Financial Code (the “Financial Code”). The Financial Code provides that a bank may not make a cash distribution to its shareholders in excess of the lesser of (a) the bank's retained earnings; or (b) the bank's net income for its last three fiscal years, less the amount of any distributions made by the bank or by any majority-owned subsidiary of the bank to the shareholders of the bank during such period. However, a bank may, with the approval of the Commissioner, make a distribution to its shareholders in an amount not exceeding the greater of (a) its retained earnings; (b) its net income for its last fiscal year; or (c) its net income for its current fiscal year. In the event that the Commissioner determines that the stockholders’ equity of a bank is inadequate or that the making of a distribution by the bank would be unsafe or unsound, the Commissioner may order the bank to refrain from making a proposed distribution.

 

22
 

 

The Board of Governors generally prohibits a bank holding company from declaring or paying a cash dividend which would impose undue pressure on the capital of subsidiary banks or would be funded only through borrowing or other arrangements that might adversely affect a bank holding company’s financial position. The policy of the Board of Governors is that a bank holding company should not continue its existing rate of cash dividends on its common stock unless its net income is sufficient to fully fund each dividend and its prospective rate of earnings retention appears consistent with its capital needs, asset quality and overall financial condition. Such policy also applies to the payment of cash dividends by state member banks such as NVB.

 

The FDIC may also restrict the payment of dividends by a subsidiary bank if such payment would be deemed unsafe or unsound or if after the payment of such dividends, the bank would be included in one of the “undercapitalized” categories for capital adequacy purposes pursuant to the FDIC Improvement Act of 1991.

 

The Board of Directors of the Company decides whether to declare and pay dividends after consideration of the Company’s earnings, financial condition, future capital needs, regulatory requirements and other factors as the Board of Directors may deem relevant. On January 29, 2009, primarily as a result of the Company’s operating performance for 2008, the Board of Directors determined that it was in the best interest of the Company to suspend indefinitely the payment of quarterly cash dividends on its common stock, beginning in 2009. As a result, no cash dividends were declared or paid during 2012, 2011 and 2010.

 

See Note 17 to the Consolidated Financial Statements for additional information regarding the payment of dividends, including information regarding certain limitations on the payment of dividends or distributions by the Company or NVB.

 

Performance Graph

 

The following graph compares our cumulative total shareholder return since December 31, 2007 with the NASDAQ Composite Index, the SNL $500 million - $1 billion Bank Index, and SNL Western Bank Index. The graph assumes that the value of the investment in our common stock and each index (including reinvestment of dividends) was $100.00 on December 31, 2007.

 

 

 

      Period Ending         
Index  12/31/07   12/31/08   12/31/09   12/31/10   12/31/11   12/31/12 
North Valley Bancorp   100.00    30.41    17.00    14.56    15.63    23.16 
NASDAQ Composite   100.00    60.02    87.24    103.08    102.26    120.42 
SNL Bank $500M-$1B   100.00    64.08    61.03    66.62    58.61    75.14 
SNL Western Bank   100.00    97.37    89.41    101.31    91.53    115.50 

 

23
 

 

ITEM 6. SELECTED FINANCIAL DATA

 

The following table presents our selected historical consolidated financial data, and is derived in part from our audited consolidated financial statements. The selected historical consolidated financial data should be read in conjunction with the Consolidated Financial Statements and the Notes thereto, which are included in this Annual Report on Form 10-K as well as Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Selected Consolidated Financial Data

 

   Year ended December 31, 
   2012   2011   2010   2009   2008 
   (Dollars in thousands, except per share data) 
Income Statement                    
Total interest income  $33,731   $37,145   $38,922   $43,955   $52,091 
Total interest expense   3,525    5,786    8,985    12,721    16,954 
Net interest income   30,206    31,359    29,937    31,234    35,137 
Provision for loan losses   2,100    2,650    7,970    26,500    12,100 
                         
 Net interest income after provision for loan losses   28,106    28,709    21,967    4,734    23,037 
Total noninterest income   16,419    14,365    12,944    14,010    10,152 
Total noninterest expense   39,979    39,715    42,144    53,990    38,658 
Income (loss) before (benefit) provision for income taxes   4,546    3,359    (7,233)   (35,246)   (5,469)
(Benefit) provision for income taxes   (1,744)   312    (985)   (9,394)   (3,675)
Net income (loss)   6,290    3,047    (6,248)   (25,852)   (1,794)
Preferred stock discount           (18,667)        
Net income (loss) available to common stockholders  $6,290   $3,047   $(24,915)  $(25,852)  $(1,794)
Income (loss) per share (1)                         
 Basic  $0.92   $0.45   $(6.42)  $(17.24)  $(1.20)
 Diluted  $0.92   $0.45   $(6.42)  $(17.24)  $(1.20)
                          
Statement of Condition                         
Total assets  $902,343   $904,966   $884,941   $884,362   $879,551 
Investment securities and federal funds sold  $301,686   $352,421   $274,655   $194,594   $76,366 
Net loans  $481,753   $443,559   $498,473   $583,878   $682,095 
Deposits  $768,580   $766,239   $753,790   $787,809   $754,944 
Stockholder's equity  $96,161   $89,465   $83,978   $52,302   $77,258 
                          
Common Stock Data                         
Shares outstanding   6,835,192    6,833,752    6,832,492    1,499,163    1,499,163 
Book value per share (2)  $14.07   $13.09   $12.29   $34.89   $51.53 
Cash dividends per share  $   $   $   $   $2.00 
Dividend payout ratio                   (166.56%)
                          
Performance Ratios                         
  Return (loss) on average assets   0.69%   0.34%   (0.69%)   (2.85%)   (0.20%)
  Return (loss) on average equity   6.70%   3.54%   (8.03%)   (34.92%)   (2.23%)
                          
Capital Ratios                         
Risk based capital:                         
 Total (8% minimum ratio)   18.28%   19.53%   17.63%   12.19%   12.75%
 Tier I (4% minimum ratio)   17.01%   17.99%   15.94%   9.09%   10.93%
 Leverage ratio   11.77%   11.82%   11.48%   7.16%   10.36%

 

(1) Earnings per share amounts have been adjusted to give effect to a one for five reverse stock split on December 28, 2010.

(2) Represents stockholders' equity divided by the number of shares of common stock outstanding at the end of the period indicated.

 

24
 

 

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Certain matters discussed or incorporated by reference in this Annual Report on Form 10-K including, but not limited to, matters described in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” are “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended, and subject to the safe-harbor provision of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements may contain words related to future projections including, but not limited to, words such as “believe,” “expect,” “anticipate,” “intend,” “may,” “will,” “should,” “could,” “would,” and variations of those words and similar words that are subject to risks, uncertainties and other factors that could cause actual results to differ materially from those projected. Factors that could cause or contribute to such differences include, but are not limited to, the following: (1) the duration of financial and economic volatility and actions taken by the United States Congress and governmental agencies, including the United States Department of the Treasury, to deal with challenges to the U.S. financial system; (2) variances in the actual versus projected growth in assets and return on assets; (3) loan losses; (4) expenses; (5) changes in the interest rate environment including interest rates charged on loans, earned on securities investments and paid on deposits and other borrowed funds; (6) competition effects; (7) fee and other noninterest income earned; (8) general economic conditions nationally, regionally, and in the operating market areas of the Company and its subsidiaries, including State and local budget issues being addressed in California; (9) changes in the regulatory environment including government intervention in the U.S. financial system; (10) changes in business conditions and inflation; (11) changes in securities markets, public debt markets, and other capital markets; (12) data processing and other operational systems failures or fraud; (13) a further decline in real estate values in the Company’s operating market areas; (14) the effects of uncontrollable events such as terrorism, the threat of terrorism or the impact of the current military conflicts in Afghanistan and Iraq and the conduct of the war on terrorism by the United States and its allies, worsening financial and economic conditions, natural disasters, and disruption of power supplies and communications; and (15) changes in accounting standards, tax laws or regulations and interpretations of such standards, laws or regulations, as well as other factors. The factors set forth under Item 1A, “Risk Factors,” in this report and other cautionary statements and information set forth in this report should be carefully considered and understood as being applicable to all related forward-looking statements contained in this report when evaluating the business prospects of the Company and its subsidiaries.

 

Forward-looking statements are not guarantees of performance. By their nature, they involve risks, uncertainties and assumptions. Actual results and shareholder values in the future may differ significantly from those expressed in forward-looking statements. You are cautioned not to put undue reliance on any forward-looking statement. Any such statement speaks only as of the date of the report, and in the case of any documents that may be incorporated by reference, as of the date of those documents. We do not undertake any obligation to update or release any revisions to any forward-looking statements, or to report any new information, future event or other circumstances after the date of this report or to reflect the occurrence of unanticipated events, except as required by law. However, your attention is directed to any further disclosures made on related subjects in our subsequent reports filed with the Securities and Exchange Commission on Forms 10-K, 10-Q and 8-K.

 

Critical Accounting Policies

 

General. The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our financial statements is, to a significant extent, financial information that is based on 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 earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. Other estimates that we use are related to the expected useful lives of our depreciable assets. In addition, GAAP itself 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 the accounting for such transactions could change.

 

A summary of the Company’s most significant accounting policies and accounting estimates is contained in Note 1 to the Consolidated Financial Statements. An accounting estimate recognized in the financial statements is a critical accounting estimate if the accounting estimate requires management to make assumptions about matters that are highly uncertain at the time the accounting estimate is made and different estimates that management could reasonably have used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the presentation of the Company’s financial condition, changes in financial condition, or results of operations. Management considers the Company’s allowance for loan losses, initial and subsequent valuation of other real estate owned, expenses related to the Company’s share-based payments programs, valuation of deferred tax assets and liabilities and investment impairment to be critical accounting policies.

 

25
 

 

Loans and Allowance for Loan Losses. The allowance for loan losses is an estimate of loan losses inherent in the Company's loan portfolio as of the balance-sheet date. The allowance is established through a provision for loan losses which is charged to expense. Additions to the allowance are expected to maintain the adequacy of the total allowance after loan losses and loan growth. Credit exposures determined to be uncollectible are charged against the allowance. Cash received on previously charged off amounts is recorded as a recovery to the allowance. The overall allowance consists of two primary components, specific reserves related to impaired loans and general reserves for inherent losses related to loans that are evaluated collectively for impairment.

 

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due, including principal and interest, according to the contractual terms of the original agreement. Loans determined to be impaired are individually evaluated for impairment. When a loan is impaired, the Company measures impairment based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that as a practical expedient, it may measure impairment based on a loan's observable market price, or the fair value of the collateral if the loan is collateral dependent. A loan is collateral dependent if the repayment of the loan is expected to be provided solely by the underlying collateral.

 

A restructuring of a debt constitutes a troubled debt restructuring (“TDR”) if the Company for economic or legal reasons related to the debtor's financial difficulties grants a concession to the borrower that it would not otherwise consider. Restructured loans typically present an elevated level of credit risk as the borrowers are not able to perform according to the original contractual terms. Loans that are reported as TDRs are considered impaired and measured for impairment as described above.

 

The determination of the general reserve for loans that are collectively evaluated for impairment is based on estimates made by management, to include, but not limited to, consideration of historical losses by portfolio segment, internal asset classifications, and qualitative factors to include economic trends in the Company's service areas, industry experience and trends, geographic concentrations, estimated collateral values, the Company's underwriting policies, the character of the loan portfolio, and probable losses inherent in the portfolio taken as a whole.

 

The Company calculates the allowance for each portfolio segment (loan type). These portfolio segments include commercial, real estate commercial, real estate construction (including land and development loans), real estate mortgage, installment and other loans (principally home equity loans). The allowance for loan losses attributable to each portfolio segment, which includes both individually impaired loans and loans that are collectively evaluated for impairment, is combined to determine the Company's overall allowance, which is included on the consolidated balance sheet.

 

The Company assigns a risk rating to all loans except pools of homogeneous loans and periodically performs detailed reviews of all such loans over a certain threshold to identify credit risks and to assess the overall collectability of the portfolio. These risk ratings are also subject to examination by independent specialists engaged by the Company and the Company's regulators. During these internal reviews, management monitors and analyzes the financial condition of borrowers and guarantors, trends in the industries in which borrowers operate and the fair values of collateral securing these loans. These credit quality indicators are used to assign a risk rating to each individual loan. The risk ratings can be grouped into five major categories, defined as follows:

 

Pass – A pass loan is a credit with no existing or known potential weaknesses deserving of management's close attention.

 

Special Mention – A special mention loan has potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or in the Company's credit position at some future date. Special Mention loans are not adversely classified and do not expose the Company to sufficient risk to warrant adverse classification.

 

Substandard – A substandard loan is not adequately protected by the current sound worth and paying capacity of the borrower or the value of the collateral pledged, if any. Loans classified as substandard have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. Well defined weaknesses include a project's lack of marketability, inadequate cash flow or collateral support, failure to complete construction on time or the project's failure to fulfill economic expectations. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.

 

Doubtful – Loans classified doubtful have all the weaknesses inherent in those classified as substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions and values, highly questionable and improbable.

 

26
 

 

Loss – Loans classified as loss are considered uncollectible and charged off immediately.

 

The general reserve component of the allowance for loan losses also consists of reserve factors that are based on management's assessment of the following for each portfolio segment: (1) inherent credit risk, (2) historical losses and (3) other qualitative factors. These reserve factors are inherently subjective and are driven by the repayment risk associated with each portfolio segment described below.

 

Commercial. Commercial loans generally possess more inherent risk of loss than real estate portfolio segments because these loans are generally underwritten to existing cash flows of operating businesses. Debt coverage is provided by business cash flows and economic trends influenced by unemployment rates and other key economic indicators are closely correlated to the credit quality of these loans.

 

Real Estate Commercial. Real estate commercial loans generally possess a higher inherent risk of loss than other real estate portfolio segments, except land and construction loans. Adverse economic developments or an overbuilt market impact commercial real estate projects and may result in troubled loans. Trends in vacancy rates of commercial properties impact the credit quality of these loans. High vacancy rates reduce operating revenues and the ability for properties to produce sufficient cash flow to service debt obligations.

 

Real Estate Construction. Real estate construction loans generally possess a higher inherent risk of loss than other real estate portfolio segments. A major risk arises from the necessity to complete projects within specified cost and time lines. Trends in the construction industry significantly impact the credit quality of these loans, as demand drives construction activity. In addition, trends in real estate values significantly impact the credit quality of these loans, as property values determine the economic viability of construction projects.

 

Real Estate Mortgage. The degree of risk in real estate mortgage lending depends primarily on the loan amount in relation to collateral value, the interest rate and the borrower's ability to repay in an orderly fashion. These loans generally possess a lower inherent risk of loss than other real estate portfolio segments. Economic trends determined by unemployment rates and other key economic indicators are closely correlated to the credit quality of these loans. Weak economic trends indicate that the borrowers' capacity to repay their obligations may be deteriorating.

 

Individual loans and receivables in homogeneous loan portfolio segments are not evaluated for specific impairment. Rather, the sole component of the allowance for these loan types is determined by collectively measuring impairment reserve factors based on management's assessment of the following for each homogeneous loan portfolio segment: (1) inherent credit risk, (2) delinquencies, (3) historical losses and (4) other qualitative factors. The homogenous loan portfolio segments are described in further detail below.

 

Installment – An installment loan portfolio is usually comprised of a large number of small loans scheduled to be amortized over a specific period. Most installment loans are made directly for consumer purchases. Economic trends determined by unemployment rates and other key economic indicators are closely correlated to the credit quality of these loans. Weak economic trends indicate that the borrowers' capacity to repay their obligations may be deteriorating.

 

Other (principally home equity loans) – The degree of risk in home equity loans depends primarily on the loan amount in relation to collateral value, the interest rate and the borrower's ability to repay in an orderly fashion. These loans generally possess a lower inherent risk of loss than other real estate portfolio segments. Economic trends determined by unemployment rates and other key economic indicators are closely correlated to the credit quality of these loans. Weak economic trends indicate that the borrowers' capacity to repay their obligations may be deteriorating.

 

Although management believes the allowance to be adequate, ultimate losses may vary from its estimates. At least quarterly, the Board of Directors reviews the adequacy of the allowance, including consideration of the relative risks in the portfolio, current economic conditions and other factors. If the Board of Directors and management determine that changes are warranted based on those reviews, the allowance is adjusted. In addition, the Company's primary regulators, the Federal Reserve Bank of San Francisco and the California Department of Financial Institutions, as an integral part of their examination process, review the adequacy of the allowance. These regulatory agencies may require additions to the allowance based on their judgment about information available at the time of their examinations.

 

Other Real Estate Owned (“OREO”). OREO represents properties acquired through foreclosure or physical possession. Write-downs to fair value at the time of transfer to OREO is charged to allowance for loan losses. Subsequent to foreclosure, management periodically evaluates the value of OREO held for sale and records a valuation allowance for any subsequent declines in fair value less selling costs. Subsequent declines in value are charged to operations. Fair value is based on our assessment of information available to us and depends upon a number of factors, including our historical experience, economic conditions, and issues specific to individual properties. Management’s evaluation of these factors involves subjective estimates and judgments that may change.

 

27
 

 

Share Based Compensation. At December 31, 2012, the Company had two stock-based compensation plans: the 1998 Employee Stock Incentive Plan and the 2008 Stock Incentive Plan, which are described more fully in Notes 1 and 13 to the Consolidated Financial Statements included herein in Item 8, “Financial Statements and Supplementary Data”. Compensation cost is recognized on all share-based payments over the requisite service periods of the awards based on the grant-date fair value of the options determined using the Black-Scholes-Merton based option valuation model. Critical assumptions that are assessed in computing the fair value of share-based payments include stock price volatility, expected dividend rates, the risk free interest rate and the expected lives of such options. Compensation cost recorded is net of estimated forfeitures expected to occur prior to vesting. For further information on the computation of the fair value of share-based payments, see Notes 1 and 13 to the Consolidated Financial Statements.

 

Impairment of Investment Securities. An investment security is impaired when its carrying value is greater than its fair value. Investment securities that are impaired are evaluated on at least a quarterly basis and more frequently when economic or market conditions warrant such an evaluation to determine whether such a decline in their fair value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline and the intent and ability of the Company to retain its investment in the securities for a period of time sufficient to allow for an anticipated recovery in fair value, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. The term "other than temporary" is not intended to indicate that the decline is permanent, but indicates that the prospects for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. Once a decline in value is determined to be other than temporary, and management does not intend to sell the security or it is more likely than not that the Company will not be required to sell the security before recovery, only the portion of the impairment loss representing credit exposure is recognized as a charge to earnings, with the balance recognized as a charge to other comprehensive income. If management intends to sell the security or it is more likely than not that the Company will be required to sell the security before recovering its forecasted cost, the entire impairment loss is recognized as a charge to earnings.

 

Accounting for Income Taxes. The Company files its income taxes on a consolidated basis with its subsidiary. The allocation of income tax expense (benefit) represents each entity's proportionate share of the consolidated provision for income taxes.

 

The Company applies the asset and liability method to account for income taxes. Deferred tax assets and liabilities are calculated by applying applicable tax laws to the differences between the financial statement basis and the tax basis of assets and liabilities. The effect on deferred taxes of changes in tax laws and rates is recognized in income in the period that includes the enactment date. On the consolidated balance sheet, net deferred tax assets are included in other assets.

 

The Company accounts for uncertainty in income taxes by recording only tax positions that met the more likely than not recognition threshold, that the tax position would be sustained in a tax examination.

 

When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained.  The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any.  Tax positions taken are not offset or aggregated with other positions.  Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority.  The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination.

 

The Company evaluates deferred income tax assets for recoverability based on all available evidence. This process involves significant management judgment about assumptions that are subject to change from period to period based on changes in tax laws, our ability to successfully implement tax planning strategies, or variances between our future projected operating performance and our actual results. The Company is required to establish a valuation allowance for deferred tax assets if we determine, based on available evidence at the time the determination is made, that it is more likely than not that some portion or all of the deferred tax assets will not be realized. In determining the more-likely-than-not criterion, we evaluate all positive and negative available evidence as of the end of each reporting period. The realization of deferred tax assets ultimately depends on the existence of sufficient taxable income in the carry back and carry forward periods under the tax law. Due to the Company’s cumulative tax losses in 2009 and 2010, it was determined that as of December 31, 2010, the Company was not able to meet the “more likely than not” standard as to realization of a portion of its deferred tax assets and accordingly established a partial valuation allowance of $4,500,000 against such assets. During the quarter ended December 31, 2011, the Company reversed the Federal portion of its valuation allowance in the amount of $223,000 and in the quarter ended September 30, 2012, the Company eliminated the remaining State portion of the valuation allowance of $4,277,000. The decision to reverse the remaining valuation allowance was based on the following positive evidence:

 

28
 

 

The quarter ended September 30, 2012 marked the Company’s eighth consecutive quarter of positive earnings
Continued profitability is expected for the foreseeable future
At September 2012 classified loans as a percent of total loans were 5.8% as compared to 13.3% as of December 2010
At September 2012 nonaccrual loans as a percent of total loans were 2.4% as compared to 3.6% as of December 2010
Other real estate owned totaled $21,689,000 at September 2012 compared to $25,784,000 at December 2010
Effective April 16, 2012 the supervisory agreement by and among North Valley Bancorp, North Valley Bank, and the Federal Reserve Bank of San Francisco was terminated
Implementation of various cost savings measures including reductions in the number of personnel and regulatory approval to consolidate two of its branches during the current quarter; one located in Redding, California and the other in Ukiah, California
 Approval by the Federal Reserve Bank of San Francisco and the California Department of Financial Institutions allowing North Valley Bank to upstream $16.5 million to the Company to pay all deferred interest on its subordinated debentures and to fully redeem its North Valley Capital Trust I subordinated notes in the amount of $10.3 million
 Redemption of the Company’s North Valley Capital Trust I on July 25, 2012
 The length of the carryforward period in which the Company has to utilize its net operating losses and tax credits
 The reduction of nonperforming assets and classified assets significantly reduces the risk associated with future financial projections.

 

As of December 31, 2012, the net deferred tax asset was $12,346,000. This is compared to a net deferred tax asset of $10,721,000, which included a valuation allowance of $4,277,000, as of December 31, 2011.

 

Business Organization

 

North Valley Bancorp (the “Company”) is a California corporation and a bank holding company for NVB, a state-chartered, Federal Reserve Member bank. NVB operates out of its main office located at 300 Park Marina Circle, Redding, California 96001, with twenty-two branches, including two supermarket branches. The Company’s principal business consists of attracting deposits from the general public and using the funds to originate commercial, real estate and installment loans to customers, who are predominately small and middle market businesses and middle income individuals. The Company’s primary source of revenues is interest income from its loan and investment securities portfolios. The Company is not dependent on any single customer for more than ten percent of its revenues.

 

Overview

 

Financial Results

 

For the year ended December 31, 2012, the Company recorded net operating income of $6,290,000, compared to a net operating income of $3,047,000, for the year ended December 31, 2011. For 2012, the Company realized a return on average stockholders’ equity of 6.70% and a return on average assets of 0.69%, as compared to a return on average stockholders’ equity of 3.54% and a return on average assets of 0.34% for 2011.

 

During 2012, total assets decreased $2,623,000, or 0.29%, to $902,343,000 at year end. The loan portfolio increased $35,996,000, or 7.89%, and totaled $492,211,000 at December 31, 2012 compared to $456,215,000 at December 31, 2011. The increase is primarily attributed to the increase in real estate – mortgage loans due to the purchase of jumbo residential mortgages and an increase in the Company’s commercial real estate loans. See “Loan Portfolio” on page 37 for further information. Available-for-sale investment securities decreased $26,390,000 to $285,815,000 at December 31, 2012 from $312,205,000 at December 31, 2011 due to investment sales, proceeds from maturities and principal pay downs. The loan to deposit ratio at December 31, 2012 was 64.0% as compared to 59.5% at December 31, 2011. Total deposits increased $2,341,000, or 0.31%, to $768,580,000 at December 31, 2012 compared to $766,239,000 at December 31, 2011. The overall increase in deposits was due to the increase in non-maturity deposits of $42,275,000. This was offset by a decrease in time certificates of $39,934,000 primarily due to a reduction in rates on those deposits.

 

29
 

 

Nonperforming loans (defined as nonaccrual loans and loans 90 days or more past due and still accruing interest) decreased $12,576,000, or 68.3%, to $5,835,000 at December 31, 2012 from $18,411,000 at December 31, 2011. Nonperforming loans as a percentage of total loans were 1.19% at December 31, 2012, compared to 4.04% at December 31, 2011.

 

Nonperforming assets (defined as nonperforming loans and OREO) totaled $28,258,000 at December 31, 2012, a decrease of $10,259,000 from the December 31, 2011 balance of $38,517,000. Nonperforming assets as a percentage of total assets were 3.13% at December 31, 2012 compared to 4.26% at December 31, 2011.

 

Gross charge-offs for the year ended December 31, 2012 were $4,702,000 and recoveries for the same year totaled $404,000 resulting in net charge-offs of $4,298,000, compared to gross charge-offs for the year ended December 31, 2011 of $5,525,000 and recoveries of $538,000 resulting in net charge-offs of $4,987,000.

 

On April 22, 2010, the Company completed a $40,000,000 private placement of Series A Preferred Stock, with net proceeds of $37,500,000, which further strengthened the Company’s and the Bank’s capital levels and ratios. On July 16, 2010, the Company received approval at the Annual Meeting of Shareholders to convert the 40,000 shares of Series A Preferred Stock into 26,666,646 shares of common stock. At July 21, 2010, a total of 34,162,463 shares of common stock were issued and outstanding. Under generally accepted accounting principles (“GAAP”), the conversion feature of the preferred stock had an intrinsic value of $0.70 per share, or $18,667,000, based on the difference between the conversion price of $1.50 per share and the market value of $2.20 for the Company’s common stock at the commitment date, April 22, 2010. As required by GAAP, the Company recognized this difference of $18,667,000 as a beneficial conversion discount on the preferred stock as of the July 21, 2010 conversion date. After combining this implied dividend on the preferred stock with operating results for the year ended December 31, 2011, the Company reported a loss available to common shareholders of $24,915,000, or ($6.42) per diluted share. The Company completed its 1-for-5 reverse stock split on December 28, 2010, and the Company had 6,835,192 and 6,833,752 common shares outstanding at December 31, 2012 and 2011, respectively. All common stock and EPS have been restated on an equivalent basis throughout this filing, retrospectively.

 

Regulatory Matters

 

The supervisory agreement signed on January 6, 2010 by and among North Valley Bancorp, North Valley Bank and the Federal Reserve Bank of San Francisco was terminated, effective as of April 16, 2012, and resolutions adopted by the Board of Directors of NVB at the request of the California Department of Financial Institutions were terminated effective March 1, 2012. However, North Valley Bank has not received a final report of examination for a compliance examination of the Bank conducted by the Federal Reserve Bank of San Francisco in 2010 and the Bank has established a reserve for the anticipated settlement of criticisms expected to be contained in the report, when received. See the discussion under “Noninterest Expense” at page 34 below.

 

Results of Operations

 

Net Interest Income and Net Interest Margin (fully taxable equivalent basis): Net interest income is the difference between interest earned on loans and investments and interest paid on deposits and borrowings, and is the primary revenue source for the Company. Net interest margin is net interest income expressed as a percentage of average earning assets. These items have been adjusted to give effect to $272,000, $324,000 and $360,000 in taxable-equivalent interest income on tax-free investments for the years ending December 31, 2012, 2011 and 2010.

 

Net interest income for 2012 was $30,478,000, a $1,205,000, or 3.80%, decrease from net interest income of $31,683,000 in 2011. Interest income decreased $3,466,000, or 9.25%, to $34,003,000 in 2012 due primarily to a decrease in average yield on loans. The Company also had $575,000 in foregone interest income for the loans placed on nonaccrual status during the year ended December 31, 2012 compared to $1,039,000 and $2,096,000 for the years ended December 31, 2011 and 2010, respectively. The average loans outstanding in 2012 decreased $18,198,000, or 3.77%, to $464,647,000. This lower loan volume decreased interest income by $1,088,000 in 2012. The average yield earned on the loan portfolio decreased 37 basis points to 5.61% for 2012. This decrease in yield decreased interest income by $1,713,000 in 2012. The net decrease to interest income from the loan portfolio was $2,801,000. The 2012 average balance of the investment portfolio increased $14,441,000, or 4.90%, compared to 2011, which accounted for the $298,000 increase in interest income in 2012. The 2012 average yield of the investment portfolio decreased 35 basis points which accounted for a $956,000 decrease in interest income.

 

30
 

 

Interest expense in 2012 decreased $2,261,000, or 39.08%, to $3,525,000. The decrease was primarily related to the average rates paid on time deposits which decreased 40 basis points to 0.81% and reduced interest expense by $783,000 along with a decrease in average time deposits of $22,932,000 which reduced interest expense by $277,000 during 2012. The average rate paid on savings and money market accounts decreased 23 basis points to 0.21% for 2012 compared to 0.44% for 2011, resulting in a decrease to interest expense of $525,000 in 2012. This decrease was offset partially by higher average balances in savings and money market accounts of $5,569,000 in 2012, resulting in a $25,000 increase in interest expense compared to 2011. The average rate paid on other borrowed funds decreased 141 basis points to 4.50% for 2012 compared to 5.91% for 2011, resulting in a decrease to interest expense of $426,000.

 

Net interest margin for 2012 decreased 12 basis points to 3.80% from 3.92% in 2011. The net interest margin for the fourth quarter of 2012 was 3.93%, which was a 25 basis point increase from 3.68% in the fourth quarter of 2011 and a 15 basis point increase from 3.78% in the third quarter of 2012. The increase in the net interest margin in the fourth quarter of 2012 compared to the third quarter of 2012 is primarily due to a decrease in average balance and average rate paid on the other borrowed funds.

 

Net interest income for 2011 was $31,683,000, a $1,386,000, or 4.57%, increase from net interest income of $30,297,000 in 2010. Interest income decreased $1,813,000, or 4.62%, to $37,469,000 in 2011 due primarily to a decrease in average loans. The Company also had $1,039,000 in foregone interest income for the loans placed on nonaccrual status during the year ended December 31, 2011 compared to $2,096,000 for the year ended December 31, 2010. The average loans outstanding decreased $77,018,000, or 13.76%, to $482,845,000. This lower loan volume decreased interest income by $4,575,000 in 2011. The average yield earned on the loan portfolio increased 4 basis points to 5.98% for 2011. This increase in yield increased interest income by $162,000 in 2011. The net decrease to interest income from the loan portfolio was $4,413,000. The 2011 average balance of the investment portfolio increased $93,432,000, or 46.37%, compared to 2010, which accounted for a $2,365,000 increase in interest income, an increase in average yield of taxable securities of 12 basis points increased interest income by $333,000, and a decrease in average yield of nontaxable securities of 23 basis points decreased interest income by $33,000.

 

Interest expense in 2011 decreased $3,199,000, or 35.6%, to $5,786,000. The decrease was primarily related to the average rates paid on time deposits which decreased 73 basis points to 1.21% and reduced interest expense by $1,569,000 along with a decrease in average time deposits of $43,160,000 which reduced interest expense by $837,000 during 2011. The average rate paid on savings and money market accounts decreased 24 basis points to 0.44% for 2011 compared to 0.68% for 2010, resulting in a decrease to interest expense of $529,000. This decrease was offset partially by higher average balances in savings and money market accounts of $9,846,000 in 2011, resulting in a $67,000 increase in interest expense compared to 2010. The average rate paid on other borrowed funds decreased 74 basis points to 5.91% for 2011 compared to 6.65% for 2010, resulting in a decrease to interest expense of $234,000.

 

Net interest margin for 2011 increased 23 basis points to 3.92% from 3.69% in 2010. The net interest margin for the fourth quarter of 2011 was 3.68%, which was an 8 basis point decrease from 3.76% in the fourth quarter of 2010 and a 22 basis point decrease from 3.90% in the third quarter of 2011. The decline in the net interest margin in the fourth quarter of 2011 compared to the third quarter of 2011 is primarily due to a decrease in average loan balances. The continued decrease in average loan balance during the three year period ended December 31, 2011 is due to loan pay offs or principal repayments of $147,019,000, charge-offs of $38,784,000 and transfers to other real estate owned of $51,404,000.

 

The following table sets forth the Company’s consolidated condensed average daily balances and the corresponding average yields received and average rates paid of each major category of assets, liabilities, and stockholders’ equity for each of the past three years.

 

31
 

 

Average Daily Balance Sheets

(Dollars in thousands)

 

   2012   2011   2010 
   Average   Yield/   Interest   Average   Yield/   Interest   Average   Yield/   Interest 
   Balance   Rate   Amount   Balance   Rate   Amount   Balance   Rate   Amount 
Assets                                    
Federal funds sold  $27,861    0.24%  $66   $31,103    0.23%  $73   $59,446    0.23%  $138 
Investments:                                             
Taxable securities   297,451    2.38%   7,075    280,708    2.70%   7,580    186,220    2.58%   4,809 
Nontaxable securities(1)   11,903    6.72%   800    14,205    6.71%   953    15,261    6.94%   1,059 
Total investments   309,354    2.55%   7,875    294,913    2.89%   8,533    201,481    2.91%   5,868 
Total loans (2)(3)   464,647    5.61%   26,062    482,845    5.98%   28,863    559,863    5.94%   33,276 
Total earning assets/interest income   801,862    4.24%   34,003    808,861    4.63%   37,469    820,790    4.79%   39,282 
Nonearning assets   120,321              106,836              101,192           
Allowance for loan losses   (11,888)             (14,426)             (17,294)          
Net nonearning assets   108,433              92,410              83,898           
Total assets  $910,295             $901,271             $904,688           
                                              
Liabilities and Stockholders’ Equity                                             
                                              
Transaction accounts  $180,038    0.07%  $125   $164,616    0.18%  $293   $158,169    0.25%  $393 
Savings and money market   226,070    0.21%   471    220,501    0.44%   971    210,655    0.68%   1,433 
Time deposits   193,476    0.81%   1,569    216,408    1.21%   2,629    259,568    1.94%   5,035 
Other borrowed funds   30,205    4.50%   1,360    32,012    5.91%   1,893    31,961    6.65%   2,124 
Total interest bearing liabilities/interest expense   629,789    0.56%   3,525    633,537    0.91%   5,786    660,353    1.36%   8,985 
Noninterest bearing deposits   164,437              159,242              149,696           
Other liabilities   22,163              22,386              16,789           
Total liabilities   816,389              815,165              826,838           
Stockholders’ equity   93,906              86,106              77,850           
Total liabilities and stockholders’ equity  $910,295             $901,271             $904,688           
Net interest income           $30,478             $31,683             $30,297 
Net interest spread        3.68%             3.72%             3.43%     
Net interest margin (4)        3.80%             3.92%             3.69%     

 


 

(1)    Tax-equivalent basis; nontaxable securities are exempt from federal taxation.
(2)    Loans on nonaccrual status have been included in the computations of average balances.
(3)    Includes loan fees of $361, $234 and $428 for years ended December 31, 2012, 2011 and 2010.
(4)    Net interest margin is determined by dividing net interest income by total average earning assets.

 

32
 

 

The following table summarizes changes in net interest income resulting from changes in average asset and liability balances (volume) and changes in average interest rates. The change in interest due to both rate and volume has been allocated to the change in rate (in thousands).

 

Changes in Volume/Rate

 

   2012 Compared to 2011   2011 Compared to 2010 
           Total           Total 
   Average   Average   Increase   Average   Average   Increase 
   Volume   Rate   (Decrease)   Volume   Rate   (Decrease) 
Interest Income                        
Interest on federal funds sold  $(7)  $   $(7)  $(65)  $   $(65)
Interest on investments:                              
 Taxable securities   452    (957)   (505)   2,438    333    2,771 
 Nontaxable securities   (154)   1    (153)   (73)   (33)   (106)
Total investments   298    (956)   (658)   2,365    300    2,665 
Interest on loans   (1,088)   (1,713)   (2,801)   (4,575)   162    (4,413)
Total interest income   (797)   (2,669)   (3,466)   (2,275)   462    (1,813)
                               
Interest Expense                              
Transaction accounts   28    (196)   (168)   16    (116)   (100)
Savings and money market   25    (525)   (500)   67    (529)   (462)
Time deposits   (277)   (783)   (1,060)   (837)   (1,569)   (2,406)
Other borrowed funds   (107)   (426)   (533)   3    (234)   (231)
Total interest expense   (331)   (1,930)   (2,261)   (751)   (2,448)   (3,199)
Total change in net interest income  $(466)  $(739)  $(1,205)  $(1,524)  $2,910   $1,386 

 

Provision for Loan losses. The provision for loan losses reflects changes in the credit quality of the entire loan portfolio. The provision for loan losses corresponds to management’s assessment as to the inherent risk in the portfolio for potential losses. The provision adjusts the balance in the allowance for loan losses so that the allowance is adequate to provide for the potential losses based upon historical experience, current economic conditions, the mix in the portfolio and other factors necessary in estimating these inherent losses. For further information, see discussion under “Loan Portfolio” on page 37 and “Allowance for Loan losses” on page 42.

 

The Company’s provision for loan losses was $2,100,000, $2,650,000 and $7,970,000 for the years ended December 31, 2012, 2011 and 2010, respectively. The decrease in the provision for loan losses is due primarily to a decrease in the level of charge-offs experienced of $823,000 to $4,702,000 at December 31 2012, down from $5,525,000 at December 31, 2011 and the decrease in the level of nonperforming loans to $5,835,000 at December 31, 2012, down from $18,411,000 at December 31, 2011. Loan charge-offs, net of recoveries were $4,298,000 in 2012, $4,987,000 in 2011 and $11,516,000 in 2010. The ratio of net charge-offs to average loans outstanding were 0.93% in 2012, 1.03% in 2011 and 2.06% in 2010. The ratio of the allowance for loan losses to total loans was 2.12% in 2012, 2.77% in 2011 and 2.92% in 2010. The provision of $2,100,000 for the year ended December 31, 2012 reflects management’s assessment of the required provision to maintain the overall adequacy of the allowance for loan losses. This assessment includes the consideration of the changes in nonperforming loans and the overall effect of the economy, particularly in real estate values in Northern California. Management believes that the current level of allowance for loan losses as of December 31, 2012 of $10,458,000, or 2.12% of total loans, is adequate at this time.

 

33
 

 

Noninterest Income. The following table is a summary of the Company’s noninterest income for the years ended December 31 (in thousands):

 

   2012   2011   2010 
Service charges on deposit accounts  $4,333   $4,635   $5,864 
Other fees and charges   4,715    4,663    4,566 
Earnings on cash surrender value of life insurance policies   1,363    1,359    1,376 
Gain on sale of loans   3,154    1,172    241 
Gain on sale of securities   1,877    1,677     
Other   977    859    897 
Total  $16,419   $14,365   $12,944 

  

Noninterest income for the year ended December 31, 2012 increased by $2,054,000, or 14.3%, to $16,419,000 from $14,365,000 for the year ended December 31, 2011. The increase was primarily attributed to gain on sale of loans of $3,154,000. Of the $3,154,000 gain on sale of loans for the year ended December 31, 2012, the sale of mortgage loans was $2,682,000 and the sale of SBA loans was $472,000 compared to the sale of mortgage loans of $492,000 and the sale of SBA loans of $680,000 for the same period in 2011. Service charges on deposit accounts decreased by $302,000 to $4,333,000 for the year ended December 31, 2012 compared to $4,635,000 for the same period in 2011, reflecting a continuation of the decrease from December 31, 2010 to December 31, 2011. All other sources of fees and charges increased by $52,000 to $4,715,000 for the year ended December 31, 2012 compared to $4,663,000 for the same period in 2011. The Company had a $1,877,000 gain on sale of securities for the year ended December 31, 2012, an increase of $200,000 compared to $1,677,000 for the same period in 2011.

 

Noninterest income for the year ended December 31, 2011 increased by $1,421,000, or 11.0%, to $14,365,000 from $12,944,000 for the year ended December 31, 2010. The primary reason for the increase in noninterest income in 2011 compared to 2010 was due to gains on the sale of investment securities of $1,677,000. Gain on sale of loans increased $931,000 in 2011 compared to 2010, primarily due to the gain on sale of SBA loans of $680,000. Service charges on deposit accounts decreased $1,229,000 to $4,635,000 for the year ended December 31, 2011 compared to $5,864,000 for the year ended December 31, 2010 primarily as a result of implementing FDIC guidance on the operation of account overdraft programs in the second quarter of 2011, while other fees and charges increased $97,000 to $4,663,000 for the year ended December 31, 2011 compared to $4,566,000 for the year ended December 31, 2010. Other noninterest income decreased $38,000 to $859,000 for the year ended December 31, 2011 compared to $897,000 for the year ended December 31, 2010.

 

Noninterest Expense. The following table is a summary of the Company’s noninterest expense for the years ended

December 31 (in thousands):

 

   2012   2011   2010 
Salaries and benefits  $20,277   $18,657   $16,873 
Other real estate owned expense   3,556    4,804    6,522 
Occupancy   2,547    2,786    2,850 
Data processing   2,517    2,507    2,206 
Professional services   1,105    1,090    1,704 
Furniture and equipment   938    1,062    1,434 
FDIC and state assessments   922    1,355    2,368 
Loan expense   922    337    621 
ATM and online banking   768    1,182    1,120 
Director expense   614    420    458 
Marketing   608    607    615 
Operations expense   507    652    601 
Printing and supplies   479    542    422 
Postage   477    537    524 
Messenger   447    608    570 
Telecommunications   412    305    368 
Other   2,883    2,264    2,888 
Total  $39,979   $39,715   $42,144 

 

34
 

 

Noninterest expense increased $264,000, or 0.66%, to $39,979,000 for the year ended December 31, 2012 from $39,715,000 for the same period in 2011. Salaries and employee benefits increased $1,620,000, for the year ended December 31, 2012 compared to the same period in 2011 primarily due to the hiring of production personnel and the development of production incentive plans. Occupancy and furniture and equipment expense decreased $363,000 for the year ended December 31, 2012 compared to the same period of 2011 due to a decrease in depreciation and rent expense as a result of facilities consolidation initiatives completed in 2012 and 2011. OREO expense decreased $1,248,000 to $3,556,000, for the year ended December 31, 2012 compared to $4,804,000 for the same period in 2011. For the year ended December 31, 2012, OREO expense consisted of operating expenses and losses from disposals or write-downs of $523,000 and $3,033,000, respectively, compared to $708,000 and $4,096,000, respectively, in 2011. FDIC and state assessments decreased $433,000 to $922,000 for the year ended December 31, 2012, compared to $1,355,000 for the same period in 2011, as a result of the termination of regulatory agreements with the Federal Reserve Bank of San Francisco and the California Department of Financial Institutions as well as a change in FDIC insurance assessment methodology, which changed the assessment base from total deposits to average total assets less tangible capital. All other expenses increased $688,000 to $11,739,000 for the year ended December 31, 2012 compared to $11,051,000 for the same period in 2011. Other noninterest expense for the year-ended December 31, 2012 includes a reserve of $700,000 for expenses expected to be incurred in connection with the settlement of an open compliance examination conducted by the Federal Reserve Bank of San Francisco.

 

Noninterest expenses for the year ended December 31, 2011 decreased $2,429,000 to $39,715,000 compared to $42,144,000 for the year ended December 31, 2010. The reason for the decrease was due primarily to decreases in other real estate owned expense and FDIC and state assessments of $1,718,000 and $1,013,000, respectively, for the year ended December 31, 2011 compared to the year ended December 31, 2010. The decrease in FDIC and state regulatory assessments is primarily due to a reduction in our insurance premium assessment rate in 2011. Additionally, the Company experienced decreases in occupancy expense and furniture and equipment expense of $436,000 and a decrease in professional services of $614,000. These decreases were partially offset by an increase in salaries and employee benefits of $1,784,000 to $18,657,000 for the year ended December 31, 2011 compared to $16,873,000 for the year ended December 31, 2010. The Company’s ratio of noninterest expense to average assets was 4.41% for 2011 compared to 4.63% for 2010.

 

Income Taxes. The Company recorded a benefit for income taxes for the year ended December 31, 2012 of $1,744,000, compared to a provision for income taxes of $312,000 for the year ended December 31, 2011, and a benefit for income taxes of $985,000 for the year ended December 31, 2010. The benefit for income taxes included a $4,277,000 elimination of the deferred tax asset valuation allowance offset by a $1,497,000 increase in federal deferred tax for the year ended December 31, 2012. The valuation allowance was booked as a provision for income tax in 2010. The effective tax benefit rate for state and federal income taxes was 38.4% for the year ended December 31, 2012, compared to an effective tax provision rate of 9.3% for the year ended December 31, 2011, and an effective tax benefit rate of 13.6% for the year ended December 31, 2010. The difference in the effective tax rate compared to the statutory tax rate is primarily the result of the Company’s investment in municipal securities and Company-owned life insurance policies whose income is exempt from Federal taxes. In addition, the Company receives certain tax benefits from the State of California Franchise Tax Board for operating and providing loans, as well as jobs, in designated “Enterprise Zones”.

 

The Company evaluates deferred income tax assets for recoverability based on all available evidence. This process involves significant management judgment about assumptions that are subject to change from period to period based on changes in tax laws, our ability to successfully implement tax planning strategies, or variances between our future projected operating performance and our actual results. The Company is required to establish a valuation allowance for deferred tax assets if we determine, based on available evidence at the time the determination is made, that it is more likely than not that some portion or all of the deferred tax assets will not be realized. In determining the more-likely-than-not criterion, we evaluate all positive and negative available evidence as of the end of each reporting period. The realization of deferred tax assets ultimately depends on the existence of sufficient taxable income in the carry back and carry forward periods under the tax law. Due to the Company’s cumulative tax losses in 2009 and 2010, it was determined to establish a partial valuation allowance in 2010 of $4,500,000 to reflect the portion of the deferred tax assets that the Company determined to be more likely than not that it will not be realized. During the quarter ended December 31, 2011, the Company reversed the Federal portion of its valuation allowance in the amount of $223,000, and in the quarter ended September 30, 2012, the Company eliminated the remaining valuation allowance of $4,277,000.

 

As of December 31, 2012, the Company had recorded net deferred income tax assets (which are included in other assets in the accompanying condensed consolidated balance sheet, of approximately $12,346,000. For a discussion of the Company’s deferred income tax assets, see “Critical Accounting Policies — Accounting for Income Tax” above and Note 11 of the Consolidated Financial Statements.

 

35
 

 

Balance Sheet Analysis

 

North Valley Bancorp’s total assets decreased $2,623,000, or 0.3%, to $902,343,000 at December 31, 2012 compared to $904,966,000 at December 31, 2011 with an increase in the loan portfolio offset by decreases in the investment securities.

 

Investment Securities. The investment securities portfolio decreased $26,390,000 from year end 2011 to a total of $285,821,000 at December 31, 2012.

 

The policy of the Company requires that management determine the appropriate classification of securities at the time of purchase. If management has the intent and the Company has the ability at the time of purchase to hold debt securities until maturity, they are classified as investments held-to-maturity, and carried at amortized cost. Debt securities to be held for indefinite periods of time and not intended to be held-to-maturity and equity securities are classified as available-for-sale and carried at fair value. Securities held for indefinite periods of time include securities that management intends to use as part of its asset/liability management strategy and that may be sold in response to changes in interest rates, resultant prepayment risk, and other related factors.

 

The amortized cost of securities and their approximate fair value are summarized in the following table for the years ended December 31 (in thousands):

 

   2012   2011   2010 
   Amortized   Fair   Amortized   Fair   Amortized   Fair 
   Cost   Value   Cost   Value   Cost   Value 
Available-for-Sale:                        
Obligations of U.S. government sponsored agencies  $21,003   $21,118   $15,042   $15,234   $21,096   $21,221 
Obligations of states and political subdivisions   10,698    11,197    13,811    14,455    14,342    14,551 
Government sponsored agency mortgage-backed securities   239,543    245,631    270,337    275,204    221,807    222,569 
Corporate securities   6,000    4,756    6,000    4,232    6,000    4,303 
Equity securities   3,000    3,113    3,000    3,080    3,000    3,000 
Total available-for-sale  $280,244   $285,815   $308,190   $312,205   $266,245   $265,644 
Held-to-Maturity:                              
Government sponsored agency mortgage-backed securities  $6   $6   $6   $6   $6   $6 
Total investment securities  $280,250   $285,821   $308,196   $312,211   $266,251   $265,650 

 

The following table shows estimated fair value of our investment securities, exclusive of equity securities with a fair value of $3,113,000, by year of maturity as of December 31, 2012. Expected maturities, specifically of government sponsored agency mortgage-backed securities, may differ significantly from contractual maturities because borrowers may have the right to prepay with or without penalty. Tax-equivalent adjustments have been made in calculating yields on tax exempt securities.

 

Contractual Maturity Distribution and Yields of Investment Securities are summarized in the following table (in thousands):

 

   Within   After One But Within   After Five But Within   After Ten     
   One Year   Five Years   Ten Years   Years   Total 
   Amount   Yield   Amount   Yield   Amount   Yield   Amount   Yield   Amount   Yield 
Available-for-sale securities:                                                  
Obligations of U.S. government sponsored agencies  $10,046    1.42%  $11,072    1.50%  $      $       $21,118    1.46%
Obligations of states and political subdivisions   5,442    6.80%   3,677    7.36%   993    7.02%   1,085    7.27%   11,197    7.05%
Government sponsored agency mortgage-backed securities   10,341    1.70%   195,755    2.30%   37,263    1.54%   2,272    2.52%   245,631    2.16%
Corporate securities                         4,756    2.46%   4,756    2.46%
Total securities available-for-sale  $25,829    2.67%  $210,504    2.35%  $38,256    1.69%  $8,113    3.12%  $282,702    2.31%
                                                   
Held-to-maturity securities:                                                  
Government sponsored agency mortgage-back securities  $6    2.14%  $        $        $        $6    2.14%

 

An investment security is impaired when its carrying value is greater than its fair value. Investment securities that are impaired are evaluated on at least a quarterly basis and more frequently when economic or market conditions warrant such an evaluation to determine whether such a decline in their fair value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline and the intent and ability of the Company to retain its investment in the securities for a period of time sufficient to allow for an anticipated recovery in fair value, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. The term "other than temporary" is not intended to indicate that the decline is permanent, but indicates that the prospects for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. Once a decline in value is determined to be other than temporary, and management does not intend to sell the security or it is more likely than not that the Company will not be required to sell the security before recovery, only the portion of the impairment loss representing credit exposure is recognized as a charge to earnings, with the balance recognized as a charge to other comprehensive income. If management intends to sell the security or it is more likely than not that the Company will be required to sell the security before recovering its forecasted cost, the entire impairment loss is recognized as a charge to earnings.

 

36
 

 

Loan Portfolio. The loan portfolio increased $35,996,000, or 7.9%, in 2012 and totaled $492,211,000 at December 31, 2012. The increase was primarily mortgage loans due to the purchase of jumbo residential mortgages and an increase in the Company’s commercial real estate loans. The loan to deposit ratio was 64.0%, 59.5% and 68.1% at December 31, 2012, 2011 and 2010.

 

Major classifications of loans for the years ended December 31 are summarized as follows (in thousands):

  

   2012   2011   2010   2009   2008 
Commercial  $46,078   $46,160   $54,639   $66,513   $92,029 
Real estate - commercial   295,630    276,644    291,514    313,917    327,098 
Real estate - construction   23,003    27,463    55,181    92,111    136,755 
Real estate - mortgage   74,353    47,362    49,726    59,816    62,155 
Installment   6,689    10,925    14,690    22,289    29,945 
Other   45,941    47,965    48,292    48,478    46,459 
Total loans receivable   491,694    456,519    514,042    603,124    694,441 
Deferred loan costs (fees), net   517    (304)   (576)   (707)   (1,019)
Allowance for loan losses   (10,458)   (12,656)   (14,993)   (18,539)   (11,327)
Net loans  $481,753   $443,559   $498,473   $583,878   $682,095 

 

Commercial loans decreased $82,000 or 0.2% in 2012 due to reduced loan originations and an increase in loan pay-offs and charge-offs. The Company decreased its Real Estate – Construction loans during the year by $4,460,000, or 16.2%, from $27,463,000 at December 31, 2011 to $23,003,000 at December 31, 2012. This reduction was primarily from principal reductions and pay-offs but was also a result of certain charge-offs and properties taken into OREO. Real Estate – Commercial loans increased $18,986,000, or 6.9%, during 2012 from $276,644,000 at December 31, 2011 to $295,630,000 at December 31, 2012. Real Estate – Mortgage loans increased $26,991,000, or 57.0%, due to the purchase of $29,990,000 in jumbo residential mortgages during 2012. Installment loans decreased $4,236,000, or 38.8%, due to the Company’s decision in January 2008 to discontinue its purchases of indirect auto contracts. Other loans at December 31, 2012 decreased $2,024,000, or 4.2%, from 2011.

 

At December 31, 2012 and 2011, the Company serviced Real Estate – Mortgage loans and loans guaranteed by the Small Business Administration which it had sold to the secondary market of approximately $159,010,000 and $130,876,000, respectively.

 

The Company was contingently liable under letters of credit issued on behalf of its customers for $4,713,000 and $4,946,000 at December 31, 2012 and 2011, respectively. At December 31, 2012, commercial and consumer lines of credit, and real estate loans of approximately $47,350,000 and $31,925,000, respectively, were undisbursed. At December 31, 2011, commercial and consumer lines of credit, and real estate loans of approximately $45,033,000 and $41,077,000, respectively, were undisbursed. These instruments involve, to varying degrees, elements of credit and market risk more than the amounts recognized in the balance sheet. The contractual or notional amounts of these transactions express the extent of the Company's involvement in these instruments and do not necessarily represent the actual amount subject to credit loss.

 

The Company originates loans for business, consumer and real estate activities for equipment purchases. Such loans are concentrated in the primary markets in which the Company operates. Substantially all loans are collateralized. Generally, real estate loans are secured by real property. Commercial and other loans are secured by bank deposits or business or personal assets and leases are generally secured by equipment. The Company’s policy for requiring collateral is through analysis of the borrower, the borrower’s industry and the economic environment in which the loan would be granted. The loans are expected to be repaid from cash flows or proceeds from the sale of selected assets of the borrower.

 

Maturity Distribution and Interest Rate Sensitivity of Loans and Commitments. The following table shows the maturity of certain loan categories and commitments. Also provided with respect to such loans and commitments are the amounts due after one year, classified according to the sensitivity to changes in interest rates (in thousands):

 

37
 

 

`      After One         
   Within   Through   After     
   One Year   Five Years   Five Years   Total 
                 
Commercial  $15,752   $15,328   $14,998   $46,078 
Real estate - commercial   43,825    55,213    196,592    295,630 
Real estate - construction   12,892    8,439    1,672    23,003 
Real estate - mortgage   6,222    3,531    64,600    74,353 
Installment   2,961    2,265    1,463    6,689 
Other   27,861    3,770    14,310    45,941 
   $109,513   $88,546   $293,635   $491,694 
                     
Loans maturing after one year with:                    
 Fixed interest rates       $74,754   $253,491   $328,245 
 Variable interest rates       $13,792   $40,144   $53,936 

 

Impaired, Nonaccrual, Past Due, Troubled Debt Restructuring and Other Nonperforming Assets. The Company considers a loan impaired if, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral.

 

During the portion of the year that the loans were impaired, the Company did not recognize any interest income in 2012, 2011 and 2010. The following table shows information related to impaired loans at and for the period ended (in thousands):

 

   As of December 31, 2012   As of December 31, 2011 
       Unpaid           Unpaid     
   Recorded   Principal   Related   Recorded   Principal   Related 
   Investment   Balance   Allowance   Investment   Balance   Allowance 
With no allocated allowance                              
Commercial  $585   $586   $   $   $   $ 
Real estate - commercial   2,778    2,974        1,502    1,556     
Real estate - construction   1,210    1,273        4,128    4,153     
Real estate - mortgage   684    736        643    751     
Installment   122    138        70    75     
Other   111    120        88    91     
 Subtotal   5,490    5,827        6,431    6,626     
                               
With allocated allowance                              
Commercial               1,788    1,849    450 
Real estate - commercial   184    217    171    4,496    5,302    606 
Real estate - construction   161    161    18    5,312    5,312    504 
Real estate - mortgage               295    314    37 
Installment               37    39    13 
Other                        
 Subtotal   345    378    189    11,928    12,816    1,610 
Total Impaired Loans  $5,835   $6,205   $189   $18,359   $19,442   $1,610 

 

38
 

 

The following table presents the average balance related to impaired loans for the period indicated (in thousands):

 

   Average Recorded Investment 
   December 31, 
   2012   2011     2010 
Commercial  $941   $2,056     $ 1,901 
Real estate - commercial   3,069    6,354       7,045 
Real estate - construction   1,673    9,453       13,572 
Real estate - mortgage   681    991       3,242 
Installment   139    110       68 
Other   122    91        
 Total  $6,625   $19,055     $ 25,828 

 

Loans on which the accrual of interest has been discontinued are designated as nonaccrual loans. Accrual of interest on loans is discontinued either when reasonable doubt exists as to the full and timely collection of interest or principal, or when a loan becomes contractually past due by 90 days or more with respect to interest or principal (except that when management believes a loan is well secured and in the process of collection, interest accruals are continued on loans deemed by management to be fully collectible). When a loan is placed on nonaccrual status, all interest previously accrued but not collected is reversed against current period interest income. Income on such loans is then recognized only to the extent that cash is received and where the future collection of principal is probable. Interest accruals are resumed on such loans when, in the judgment of management, the loans are estimated to be fully collectible as to both principal and interest.

 

Nonperforming assets for the years ended December 31 are summarized as follows (in thousands):

 

   2012   2011   2010   2009   2008 
Nonaccrual loans  $5,835   $18,359   $20,065   $46,598   $18,936 
Loans past due 90 days or more                         
 and still accruing interest       52             
Total nonperforming loans   5,835    18,411    20,065    46,598    18,936 
Other real estate owned   22,423    20,106    25,784    12,377    10,408 
Total nonperforming assets  $28,258   $38,517   $45,849   $58,975   $29,344 

 

At December 31, 2012 and 2011, the recorded investment in nonperforming loans (defined as nonaccrual loans and loans 90 days or more past due and still accruing interest) was approximately $5,835,000 and $18,411,000, respectively. The Company had $189,000 of specific allowance for loan losses on impaired loans of $345,000 at December 31, 2012 as compared to $1,610,000 of specific allowance for loan losses on impaired loans of $11,928,000 at December 31, 2011. Nonperforming loans as a percentage of total loans were 1.19% at December 31, 2012, compared to 4.04% at December 31, 2011. Nonperforming assets (nonperforming loans and OREO) totaled $28,258,000 at December 31, 2012, a decrease of $10,259,000 from the total at December 31, 2011. Nonperforming assets as a percentage of total assets were 3.13% at December 31, 2012 compared to 4.26% at December 31, 2011.

 

If interest on nonaccrual loans had been accrued, such income would have approximated $575,000, $1,039,000 and $2,096,000, respectively, for the years ended December 31, 2012, 2011 and 2010.

 

There were no commitments to lend additional funds to borrowers whose loans were classified as nonaccrual at December 31, 2012.

 

At December 31, 2012, net carrying value of other real estate owned increased $2,317,000 to $22,423,000 from $20,106,000 at December 31, 2011. During the year 2012, the Company transferred fourteen properties into OREO totaling $12,239,000, sold fifteen properties totaling $6,889,000, had write-downs of OREO of $2,638,000, and recorded loss on sale of OREO of $395,000. At December 31, 2012, OREO was comprised of twenty-six properties which consisted of the following: four residential construction properties totaling $3,399,000, fifteen residential land parcels totaling $13,609,000, one commercial land parcel for $382,000, two non-farm non-residential properties totaling $3,407,000 and four residential properties totaling $1,626,000. As of December 31, 2012, there were two OREO properties totaling $1,248,000, which were in escrow and pending sale.

 

39
 

  

The composition of nonperforming loans as of December 31, 2012, September 30, 2012, June 30, 2012, March 31, 2012 and December 31, 2011 was as follows (in thousands):

 

   December   September   June   March   December 
   2012   2012   2012   2012   2011 
       % of       % of       % of       % of       % of 
   Amount   total   Amount   total   Amount   total   Amount   total   Amount   total 
Commercial  $585    10.0%  $800    6.9%  $1,113    6.7%  $1,174    7.5%  $1,788    9.7%
Real estate - commercial   2,962    50.8%   7,663    66.2%   5,945    35.8%   4,390    28.1%   5,998    32.7%
Real estate - construction   1,371    23.5%   1,760    15.2%   8,381    50.4%   8,869    56.7%   9,440    51.4%
Real estate - mortgage   684    11.7%   966    8.3%   941    5.7%   905    5.8%   938    5.1%
Installment   122    2.1%   109    0.9%   136    0.8%   159    1.0%   107    0.6%
Other   111    1.9%   275    2.4%   111    0.7%   137    0.9%   88    0.5%
Total nonaccrual loans  $5,835    100.0%  $11,573    100.0%  $16,627    100.0%  $15,634    100.0%  $18,359    100.0%

 

At December 31, 2012, there were five real-estate-construction loans totaling $1,371,000, or 23.5%, of the nonperforming loans. Two of the five loans are commercial construction loans totaling $362,000. No charge-offs have been taken on these loans and specific reserves of $18,000 have been established for these loans at December 31, 2012. The remaining three loans are residential development loans totaling $1,009,000. Charge-offs of $2,000 have been taken on these loans and no specific reserve has been established for these loans at December 31, 2012.

 

At December 31, 2012, there were seven real-estate-commercial loans totaling $2,962,000, or 50.8%, of the nonperforming loans. The largest real estate-commercial loan is for a commercial real estate building located in Sacramento County for $1,231,000. Charge-offs of $720,000 have been taken on this loan and no specific reserve has been established for this loan at December 31, 2012. The remaining six real estate-commercial loans total $1,731,000 (approximate average loan balance of $288,000). Charge-offs of $570,000 have been taken on these loans and specific reserves of $171,000 have been established for these loans at December 31, 2012.

 

The following table shows an aging analysis of the loan portfolio by the amount of time past due (in thousands):

 

   As of December 31, 2012 
   Accruing Interest         
           Greater than         
       30-89 Days   90 Days         
   Current   Past Due   Past Due   Nonaccrual   Total 
                     
Commercial  $45,473   $20   $   $585   $46,078 
Real estate - commercial   292,505    163        2,962    295,630 
Real estate - construction   21,436    196        1,371    23,003 
Real estate - mortgage   72,907    762        684    74,353 
Installment   6,529    38        122    6,689 
Other   45,581    249        111    45,941 
 Total  $484,431   $1,428   $   $5,835   $491,694 

 

   As of December 31, 2011 
   Accruing Interest         
          Greater than         
       30-89 Days   90 Days         
   Current   Past Due   Past Due   Nonaccrual   Total 
                     
Commercial  $44,325   $47   $   $1,788   $46,160 
Real estate - commercial   264,143    6,503        5,998    276,644 
Real estate - construction   18,023            9,440    27,463 
Real estate - mortgage   45,170    1,254        938    47,362 
Installment   10,614    152    52    107    10,925 
Other   47,877            88    47,965 
 Total  $430,152   $7,956   $52   $18,359   $456,519 

 

During the period ending December 31, 2012, the terms of certain loans were modified as troubled debt restructurings. The modification of the terms of such loans included one or a combination of the following: a reduction of the stated interest rate of the loan; an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; or a permanent reduction of the recorded investment in the loan. The following table shows information related to Troubled Debt Restructurings as of December 31, 2012 (dollars in thousands):

 

40
 

 

   Accruing TDRs   Non Accruing TDRs 
       Pre-
Modification
   Post-
Modification
       Pre-
Modification
   Post-
Modification
 
   Number   Outstanding   Outstanding   Number   Outstanding   Outstanding 
   of   Recorded   Recorded   of   Recorded   Recorded 
   Contracts   Investment   Investment   Contracts   Investment   Investment 
Commercial      $   $    1   $529   $529 
Real estate - commercial   5   $1,350   $1,350       $   $ 
Real estate - construction   1   $343   $343    2   $398   $398 
Real estate - mortgage   2   $721   $721       $   $ 
Installment      $   $    4   $120   $120 
Other      $   $    1   $25   $25 

 

A summary of TDRs by type of loans and by accrual/non-accrual status is shown below (in thousands):

 

For the year ended December 31, 2012:

 

   Accruing TDRs 
   Rate Reduction and Maturity Extention   Maturity
Extention
   Total 
Real estate - commercial  $273   $   $273 
Real estate - mortgage  $   $423   $423 

 

   Non Accruing TDRs 
   Rate Reduction and Maturity Extention   Maturity Extention   Total 
Commercial  $529   $   $529 
Real estate - construction  $   $327   $327 
Installment  $120   $   $120 
Other  $25   $   $25 

 

At December 31, 2012, there were no specific reserves allocated to customers whose loan terms were modified in troubled debt restructurings. There are no commitments to lend additional amounts at December 31, 2012 to customers with outstanding loans that are classified as troubled debt restructurings. There were no TDR's that subsequently defaulted during the twelve months following the modification of terms.

At December 31, 2012, there were twelve loans to customers whose loan terms were modified in troubled debt restructurings. Of those twelve loans there were eight modifications involving a reduction of the stated interest rate and extension of the maturity date: two at 5.50% with a one-year extension to the maturity date, one at 4.50% with a 14-month maturity date, one at 3.00% with a 15-year maturity date, one at 8.00% with a three-month extension of the maturity date, one at 7.00% with a 10-year maturity date, and one at 4.00% with a 10-year maturity date; there were two modifications involving an extension only of the maturity dates: one for 90 days and one for 12 months; and there were two loans that did not have modifications during the last twelve months. The recorded investment in the ten loans was reduced in the aggregate amount of $665,000 during the year.

 

The following table shows information related to Troubled Debt Restructurings as of December 31, 2011 (dollars in thousands):

 

   Accruing TDRs   Non Accruing TDRs 
       Pre-
Modification
   Post-
Modification
       Pre-
Modification
   Post-
Modification
 
   Number   Outstanding   Outstanding   Number   Outstanding   Outstanding 
   of   Recorded   Recorded   of   Recorded   Recorded 
   Contracts   Investment   Investment   Contracts   Investment   Investment 
Real estate - commercial   3   $1,097   $1,097       $   $ 
Real estate - construction      $   $    3   $1,179   $1,179 
Real estate - mortgage   2   $660   $660    2   $415   $415 

 

A summary of TDRs by type of loans and by non-accrual status is shown below (in thousands):

 

For the year ended December 31, 2011:

 

   Non Accruing TDRs 
   Rate   Maturity    
   Reduction   Extention   Total 
Real estate - construction  $   $1,179   $1,179 

 

At December 31, 2011, there were a total of ten TDR’s and there were no modifications involving a reduction of the stated interest rate. There were three modifications involving an extension of the maturity dates; one for 12 months, one for 36 months, and one for 42 months. The recorded investment in three loans was reduced in the aggregate amount of $86,423 during the year. During 2011, one borrower whose loan was classified as a Troubled Debt Restructuring defaulted on loan payments. The loan was in the amount of $1,994,058 and was secured by a First Deed of Trust for light industrial/retail property located in Shasta County. Prior to the borrower’s payment default, the loan was considered an “impaired” asset and subject to individual review for a specific ALLL allocation under ASC 310-10. The net value of the collateral exceeded the loan balance, therefore; there was no specific ALLL allocation for the loan. During the fourth quarter of 2011, the loan collateral was the subject of foreclosure. The collateral property was transferred to OREO with no loan loss and no impact on ALLL.

 

41
 

 

Allowance for Loan Losses. The following table shows the changes in the allowance for loan losses (in thousands):

 

   As of December 31, 2012 
       Real Estate   Real Estate   Real Estate                 
   Commercial   Commercial   Construction   Mortgage   Installment   Other   Unallocated   Total 
                                 
Allowance for Loan Losses                                        
Balance December 31, 2011  $1,333   $7,528   $1,039   $935   $185   $736   $900   $12,656 
Charge-offs   (480)   (2,681)   (822)   (353)   (221)   (145)        (4,702)
Recoveries   110    63    80    39    103    9         404 
Provisions for loan losses   (120)   1,385    393    361    31    121    (71)   2,100 
Balance December 31, 2012  $843   $6,295   $690   $982   $98   $721   $829   $10,458 
                                         
Reserve to impaired loans  $   $171   $18   $   $   $        $189 
Reserve to non-impaired loans  $843   $6,124   $672   $982   $98   $721   $829   $10,269 

 

   As of December 31, 2011 
       Real Estate   Real Estate   Real Estate                 
   Commercial   Commercial   Construction   Mortgage   Installment   Other   Unallocated   Total 
                                 
Allowance for Loan Losses                                        
Balance December 31, 2010  $1,517   $8,439   $1,936   $956   $339   $666   $1,140   $14,993 
Charge-offs   (928)   (2,917)   (405)   (440)   (345)   (490)        (5,525)
Recoveries   212    108    10    2    206             538 
Provisions for loan losses   532    1,898    (502)   417    (15)   560    (240)   2,650 
Balance December 31, 2011  $1,333   $7,528   $1,039   $935   $185   $736   $900   $12,656 
                                         
Reserve to impaired loans  $450   $606   $504   $37   $13   $   $   $1,610 
Reserve to non-impaired loans  $883   $6,922   $535   $898   $172   $736   $900   $11,046 

 

    As of December 31, 2010  
          Real Estate     Real Estate     Real Estate                          
    Commercial     Commercial     Construction     Mortgage     Installment     Other     Unallocated     Total  
                                                 
Allowance for Loan Losses                                                                
Balance December 31, 2009   $ 2,018     $ 8,702     $ 3,800     $ 737     $ 391     $ 451     $ 2,440     $ 18,539  
Charge-offs     (862 )     (3,400 )     (6,663 )     (704 )     (732 )     (154 )             (12,515 )
Recoveries     76       391       40             490       2               999  
Provisions for loan losses     285       2,746       4,759       923       190       367       (1,300 )     7,970  
Balance December 31, 2010   $ 1,517     $ 8,439     $ 1,936     $ 956     $ 339     $ 666     $ 1,140     $ 14,993  
                                                                 
Reserve to impaired loans   $ 327     $ 563     $     $ 153     $     $             $ 1,043  
Reserve to non-impaired loans   $ 1,190     $ 7,876     $ 1,936     $ 803     $ 339     $ 666     $ 1,140     $ 13,950  

 

The following table shows the loan portfolio by segment as follows (in thousands):

 

Loans                                           
Balance December 31, 2012  $46,078   $295,630   $23,003   $74,353   $6,689   $45,941           $491,694 
Impaired Loans  $585   $2,962   $1,371   $684   $122   $111           $5,835 
Non-impaired loans  $45,493   $292,668   $21,632   $73,669   $6,567   $45,830           $485,859 
                                            
Balance December 31, 2011  $46,160   $276,644   $27,463   $47,362   $10,925   $47,965           $456,519 
Impaired Loans  $1,788   $5,998   $9,440   $938   $107   $88           $18,359 
Non-impaired loans  $44,372   $270,646   $18,023   $46,424   $10,818   $47,877           $438,160 

 

42
 

 

The following table shows the loan portfolio allocated by management’s internal risk ratings (in thousands):

 

   As of December 31, 2012 
   Pass   Special Mention   Substandard   Doubtful   Total 
Commercial  $44,486   $129   $1,463   $   $46,078 
Real estate - commercial   278,834        16,796        295,630 
Real estate - construction   21,386        1,617        23,003 
Real estate - mortgage   71,973        2,380        74,353 
Installment   6,562        127        6,689 
Other   45,658        283        45,941 
 Total  $468,899   $129   $22,666   $   $491,694 

 

   As of December 31, 2011 
   Pass   Special Mention   Substandard   Doubtful   Total 
Commercial  $39,319   $3,067   $3,774   $   $46,160 
Real estate - commercial   248,696    5,055    22,893        276,644 
Real estate - construction   17,624    167    9,672        27,463 
Real estate - mortgage   43,760    886    2,716        47,362 
Installment   10,702        223        10,925 
Other   47,638        327        47,965 
 Total  $407,739   $9,175   $39,605   $   $456,519 

  

The allowance for loan losses is established through a provision for loan losses based on management’s evaluation of the risks inherent in the loan portfolio. In determining levels of risk, management considers a variety of factors, including, but not limited to, asset classifications, economic trends, industry experience and trends, geographic concentrations, estimated collateral values, historical loan loss experience, and the Company’s underwriting policies. The allowance for loan losses is maintained at an amount management considers adequate to cover the probable losses in loans receivable. While management uses the best information available to make these estimates, future adjustments to allowances may be necessary due to economic, operating, regulatory, and other conditions that may be beyond the Company’s control. The Company also engages a third party credit review consultant to analyze the Company’s loan loss adequacy each calendar quarter. In addition, the regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance based on judgments different from those of management.

 

The allowance for loan losses is comprised of several components including the specific, formula and unallocated allowance relating to loans in the loan portfolio. Our methodology for determining the allowance for loan losses consists of several key elements, which include:

 

  · Specific Allowances. A specific allowance is established when management has identified unique or particular risks that were related to a specific loan that demonstrated risk characteristics consistent with impairment. Specific allowances are established when management can estimate the amount of an impairment of a loan.
     
  · Formula Allowance. The formula allowance is calculated by applying loss factors through the assignment of loss factors to homogenous pools of loans. Changes in risk grades of both performing and nonperforming loans affect the amount of the formula allowance. Loss factors are based on our historical loss experience and such other data as management believes to be pertinent. Management, also, considers a variety of subjective factors, including regional economic and business conditions that impact important segments of our portfolio, loan growth rates, the depth and skill of lending staff, the interest rate environment, and the results of bank regulatory examinations and findings of our internal credit examiners to establish the formula allowance.
     
  · Unallocated Allowance. The unallocated loan loss allowance represents an amount for imprecision or uncertainty that is inherent in estimates used to determine the allowance.

 

The Company also maintains a separate allowance for off-balance-sheet commitments. A reserve for unfunded commitments is maintained at a level that, in the opinion of management, is adequate to absorb probable losses associated with commitments to lend funds under existing agreements, for example, the Bank’s commitment to fund advances under lines of credit. The reserve amount for unfunded commitments is determined based on our methodologies described above with respect to the formula allowance. The allowance for off-balance-sheet commitments is included in accrued interest payable and other liabilities on the consolidated balance sheet. At December 31, 2012 and 2011, the reserve for unfunded commitments totaled $143,000 and $161,000, respectively.

 

43
 

 

Management anticipates modest growth in commercial lending and commercial real estate and to a lesser extent consumer and real estate mortgage lending, while it anticipates a further decline in construction lending. As a result, future provisions may be required and the ratio of the allowance for loan losses to loans outstanding may increase to reflect portfolio risk, increasing concentrations, loan type and changes in economic conditions. In addition, the regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses, and may require the Company to make additions to the allowance based on their judgment about information available to them at the time of their examinations.

 

Deposits. Deposits represent the Company’s primary source of funds. They are primarily core deposits in that they are demand, savings and money market, and time deposits generated from local businesses and individuals. These sources are considered to be relatively stable as they are mostly derived from long-term banking relationships. During 2012, total deposits increased $2,341,000, or 0.31%, to $768,580,000 compared to $766,239,000 at December 31, 2011. Noninterest-bearing demand deposits increased $10,349,000, or 6.18%, interest-bearing demand deposits increased $15,191,000, or 8.93% and savings and money market deposits increased $16,735,000, or 7.74% during 2012. This increase was offset by a decrease in deposits from time certificates of $39,934,000, or 18.81% during 2012 as the Bank reduced the rates paid on time certificates. The shift in deposit mix has resulted in noninterest-bearing demand deposits representing 23.1% of total deposits at December 31, 2012 compared to 21.9% of total deposits at December 31, 2011.

 

During 2011, total deposits increased $12,449,000, or 1.7%, to $766,239,000 compared to $753,790,000 at December 31, 2010. Noninterest-bearing demand deposits increased $12,007,000, or 7.7%, interest-bearing demand deposits increased $8,883,000, or 5.5% and savings and money market deposits increased $7,823,000, or 3.8% during 2011. This increase was partially offset by a decrease in deposits from time certificates of $16,264,000, or 7.1% during 2011 as the Bank reduced the rates paid on time certificates. The shift in deposit mix has resulted in noninterest-bearing demand deposits representing 21.9% of total deposits at December 31, 2011 compared to 20.6% of total deposits at December 31, 2010.

 

The following table summarizes the Company’s deposits at the indicated dates for the years ended December 31 (in thousands):

  

   2012   2011   2010 
Noninterest-bearing demand  $177,855   $167,506   $155,499 
Interest-bearing demand   185,315