10-K 1 a14-2880_110k.htm 10-K

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549


 

FORM 10-K


 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2013.

 

Commission file number:  000-25020

(Exact name of registrant as specified in its charter)

 

California

 

77-0388249

(State or other jurisdiction of

 

(I.R.S. Employer

incorporation or organization)

 

Identification No.)

 

1222 Vine Street,

Paso Robles, California 93446

(Address of principal executive offices) (Zip Code)

(805) 369-5200

(Registrant’s telephone number, including area code)

 

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

 

Title of each class

 

Name of exchange on which registered

Common Stock, no par value

 

The NASDAQ Capital 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 [X]

 

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 [X]

 

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 of 1934 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 [X]   No [  ]

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes [X]   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 the 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 smaller reporting company.  See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  Large accelerated filer [  ] Accelerated filer [X ] 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 [X]

 

The aggregate market value of the voting common equity held by non-affiliates of the registrant at June 30, 2013 was $111.7 million based on the closing sales price of a share of Common Stock of $6.17 as of June 30, 2013.

 

As of February 25, 2014, the registrant had 25,427,238 shares of Common Stock outstanding.

 

 

 



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Documents Incorporated By Reference

 

The information required in Part III, Items 10 through 14 are incorporated herein by reference to the registrant’s definitive proxy statement for the 2014 annual meeting of shareholders.

 

Heritage Oaks Bancorp

and Subsidiaries

 

Table of Contents

 

 

 

Page

Part I

 

 

 

 

 

Item 1.

Business

5

Item 1A.

Risk Factors

14

Item 1B.

Unresolved Staff Comments

20

Item 2.

Properties

21

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 Operation

25

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

52

Item 8.

Financial Statements and Supplementary Data

55

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

110

Item 9A.

Controls and Procedures

110

Item 9B.

Other Information

110

 

 

 

Part III

 

 

 

 

 

Item 10.

Directors, Executive Officers and Corporate Governance

111

Item 11.

Executive Compensation

111

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

111

Item 13.

Certain Relationships and Related Transactions, and Director Independence

111

Item 14.

Principal Accounting Fees and Services

111

 

 

 

Part IV

 

 

 

 

 

Item 15.

Exhibits and Financial Statement Schedules

111

 

 

 

Signatures

 

113

 

 

 

Exhibit Index

 

114

 

 

 

Certifications

 

117

 

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Part I

 

Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995

 

This Annual Report on Form 10-K may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended.  You can find many (but not all) of these statements by looking for words such as “approximates,” “believes,” “expects,” “anticipates,” “estimates,” “intends,” “plans,” “would,” “may” and other similar expressions in this Annual Report on Form 10-K.  With respect to any such forward-looking statements, the Company claims the protection of the safe harbor provided for in the Private Securities Litigation Reform Act of 1995.  The Company cautions investors that any forward-looking statements presented in this Annual Report on Form 10-K, or those that the Company may make orally or in writing from time to time, are based on the beliefs of, on assumptions made by, and information available to, management at the time such statements are first made.  Actual outcomes will be affected by known and unknown risks, trends, uncertainties and factors that are beyond the Company’s control or ability to predict.  Although the Company believes that management’s beliefs and assumptions are reasonable, they are not guarantees of future performance and some will inevitably prove to be incorrect.  As a result, the Company’s actual future results can be expected to differ from management’s expectations, and those differences may be material and adverse to the Company’s business, results of operations and financial condition.  Accordingly, investors should use caution in relying on forward-looking statements to anticipate future results or trends.

 

Some of the risks and uncertainties that may cause the Company’s actual results, performance or achievements to differ materially from those expressed include the following:

 

·      Difficult market conditions have adversely affected and may continue to have a material and adverse effect on our business.

 

·      We are highly dependent on the real estate market on the Central Coast of California and a renewed downturn in the real estate market may have a material and adverse effect on our business.

 

·      We have a concentration in commercial real estate loans.

 

·      The cost and other effects of the full implementation of the Dodd-Frank Act remain unknown and may have a material and adverse effect on our business.

 

·      Implementation of new Basel III capital rules adopted by the federal bank regulatory agencies will require increased capital levels that we may not be able to satisfy and could impede our growth and profitability.

 

·      Our business is subject to credit exposure and our allowance for loan losses may not be sufficient to cover actual loan losses.

 

·      The Company’s business is subject to interest rate risk and variations in interest rates may negatively affect its financial performance.

 

·      Competition from within and outside the financial services industry may materially and adversely affect our business.

 

·      Liquidity risk could impair our ability to fund operations and negatively impact our financial condition.

 

·      Declines in the market value of our investment portfolio may adversely affect our financial performance, liquidity and capital.

 

·      Failure to successfully execute our strategic plan may adversely affect our performance.

 

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·      The treatment of Mission Community Bank’s largest shareholder, Carpenter, and its affiliates by the Federal Reserve Board as a bank holding company, which will control the Company and indirectly Heritage Oaks Bank after the merger could adversely impact the operations of the Company or restrict its growth.

 

·      We may not be able to attract and retain skilled people.

 

·      The Company faces operational risks that may result in unexpected losses.

 

·      The Company’s information systems may experience an interruption or security breach that may result in unexpected losses.

 

·      Necessary changes in technology could be costly.

 

·      The Company relies on third party service providers for key systems, placing us at risk if the vendor has service outages, work stoppages or is subjected to attacks on their IT systems that expose information relating to us and our customers.

 

·      Our operations face severe weather, natural disasters, acts of war or terrorism and other external risks.

 

·      Maintaining our reputation as a community bank is critical to our success and the failure to do so may materially and adversely affect our performance.

 

·      The other risks set forth in the Company’s reports filed with the U.S. Securities and Exchange Commission. For further discussion of these and other factors, see “Item 1A. Risk Factors.”; and

 

·      The Company’s success at managing the risks involved in the foregoing items.

 

Any forward-looking statements in this Annual Report on Form 10-K and all subsequent written and oral forward-looking statements attributable to the Company or any person acting on behalf of the Company are expressly qualified in their entirety by the cautionary statements contained or referred to in this section.  The Company does not undertake any obligation to release publicly any revisions to forward-looking statements in this Annual Report on Form 10-K to reflect events or circumstances after the date of this Annual Report on Form 10-K, and hereby specifically disclaims any intention to do so, unless required by law.

 

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ITEM 1.                BUSINESS

 

Organizational Structure and History

 

Heritage Oaks Bancorp (the “Company”) is a California corporation organized in 1994 and registered as a bank holding company. The Company acquired all of the outstanding common stock of Heritage Oaks Bank (the “Bank”) and its subsidiaries in 1994.  The Bank is licensed by the California Department of Business Oversight, Division of Financial Institutions (“DBO”) and commenced operation in January 1983.  As a California state bank, the Bank is subject to primary supervision, examination and regulation by the DBO and the Federal Deposit Insurance Corporation (“FDIC”).  The Bank is also subject to certain other federal laws and regulations.  The deposits of the Bank are insured by the FDIC up to the applicable limits.

 

The Company formed Heritage Oaks Capital Trust II (the “Trust II”) in October 2006.  Trust II is a statutory business trust formed under the laws of the State of Delaware and is a wholly-owned, non-financial, non-consolidated subsidiary of the Company.  The Company has also incorporated a subsidiary, CCMS Systems, Inc., which is currently inactive and has not been capitalized. As used in this Annual Report on Form 10-K, any reference to the term “Management” refers to the executive management team of the Company and its subsidiaries.

 

The Company is authorized to engage in a variety of banking activities with the prior approval of the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”), the Company’s principal regulator.  However, banking activities primarily occur at the Bank.  As a legal entity separate and distinct from its subsidiaries, the Company’s principal source of funds is dividends received from the Bank, as well as, capital and/or debt it directly raises. Legal limitations are imposed on the amount of dividends that may be paid by the Bank to the Company. See Item 1. Business – Supervision and Regulation and Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities - Dividends.

 

Banking Activities

 

Headquartered in Paso Robles, California, the Bank is a community-oriented financial services firm that provides banking products and services to small and medium sized businesses and consumers.  Products and services are offered primarily through 12 retail branches located on the Central Coast of California, in San Luis Obispo and Santa Barbara Counties and through other direct channels, including two loan production offices in Santa Barbara and Ventura Counties.

 

Business Strategy

 

The Company’s business objective is to be the leading community bank on the Central Coast of California to targeted businesses and consumers. We seek to achieve this objective by employing our business strategies as follows:

 

Deliver Superior Customer Service

 

We believe that it is imperative for us to deliver superior customer service to be successful.  The pursuit of superior customer service is not a slogan for us but rather a fundamental aspect of our culture.  A key element to superior customer service is providing authority to local decision makers so that customers are given a quick response to their financial needs, while at the same time providing the proper tools to the local decision makers to ensure that the products and services offered are profitable for us.

 

Enhance Product Delivery to Our Customers

 

We believe that our customers should have a positive experience at every point of contact with us.  The primary point of contact with our customers continues to be our retail offices.  We expect to continue remodeling existing locations and anticipate identifying potential opportunities to expand retail locations to further enhance product delivery.  In addition, we continue to implement user-friendly technologies for our customers who want to interact with us through electronic channels such as the internet, phone, or other mobile devices.  We currently offer online banking, bill pay, and cash management; remote deposit capture; Automated Clearing House (“ACH”) and positive payments; automatic payroll deposits; eDelivery; prepaid gift and payroll cards; some advanced function ATMs; and mobile banking.  We expect to continue to expand our electronic delivery channels as customer preferences change and newer devices and technologies are developed.  We believe the combination of high touch service in retail locations and user-friendly electronic banking services enhances our customer experience.  It also provides us additional delivery channels to attract more customers.

 

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Maintain Strong Brand Awareness

 

We expend a considerable amount of resources maintaining and expanding our retail brand. We believe that our brand should reflect the superior customer service we offer as a community bank and our commitment to the communities where we operate.  Maintaining strong brand awareness requires a consistent brand design; effective use of marketing and merchandising; participation and sponsorship in community based events, and usage of multiple media sources.  We hold service marks issued by the U.S. Patent and Trademark Office for the “Acorn” design; the “Oakley” design; and the tag lines “Deeply Rooted in Your Hometown”, and “Heritage Oaks Bank – Expect More”.  We continually evaluate the effectiveness of our brand and from time to time will take steps to improve our overall brand awareness in the markets we serve.

 

Increase Market Share in Existing Markets and Expand into New Markets

 

During the recent economic downturn, there have been a number of community banks, which operated in the Central Coast of California, that have been acquired by larger commercial banks.  We believe these acquisitions provide us with the opportunity to increase market share in San Luis Obispo and Santa Barbara Counties and potentially expand into new markets contiguous to these counties, such as our 2012 expansion in Ventura County with the opening of a loan production office.  We continue to evaluate opportunities to either open de novo retail offices; purchase branches from other financial institutions; or to acquire financial institutions in proximity to our geographic footprint, as evidenced by our December 2012 purchase of the Morro Bay branch of Coast National Bank and our recently announced merger with Mission Community Bank, which is more fully discussed below.

 

On October 21, 2013, the Company signed a definitive agreement and plan of merger (“Merger Agreement”) whereby the Company will acquire Mission Community Bancorp (“Mission Community”) and merge their banking subsidiary, Mission Community Bank into our banking subsidiary, Heritage Oaks Bank.  Under the terms of the Merger Agreement, holders of Mission Community’s common stock, warrants and options will receive aggregate cash consideration of $8.0 million and aggregate stock consideration of 7,541,353 shares of the Company’s common stock.  The merger closed effective February 28, 2014 and the total value of the merger consideration is $68.3 million, based on a $7.99 closing price of the Company’s common stock on February 28, 2014.  Mission Community, with assets of approximately $0.4 billion at December 31, 2013, is headquartered in San Luis Obispo, California.  Its primary subsidiary, Mission Community Bank, has five branches in the Central Coast area of California (in the cities of San Luis Obispo, Paso Robles, Atascadero, Arroyo Grande and Santa Maria) and has two loan production offices in San Luis Obispo and Oxnard, California.

 

The Company believes the combination of the two organizations creates a more valuable community bank franchise, with a low cost core deposit base, strong capital ratios, attractive net interest margins, lower operating costs, and better overall returns for the shareholders of the combined institution.  It also should create a banking platform that is well positioned for future growth, both organically and through strategic mergers.  As set forth in the merger agreement, the Company will add two experienced banking professionals, Howard N. Gould and Stephen P. Yost, to its Board of Directors effective March 10, 2014.

 

Community Service

 

We strongly believe in enhancing the economic vitality and welfare of the communities where we work and live.  In 2013, Bank employees provided approximately 3,000 hours in direct volunteer support of local community activities, projects, and events.  The Bank also provided in-kind support throughout the year including providing meeting rooms, and giving surplus furniture and used computers to local partners.  Bank employees also serve on key board and staff positions for local non-profit and charitable organizations.  Finally, we donated over $0.2 million during 2013 to local organizations to support community related activities.

 

Products and Services

 

We offer a full array of financial products and services to targeted businesses and consumers.  We regularly monitor our customers’ financial needs to determine whether we should design or offer new products and services.  We also regularly monitor the pricing and profitability of these financial products and services to ensure that we are able to achieve a reasonable rate of return for the risks we assume in offering such products and services.  The Bank offers to its commercial clients commercial loans secured by real estate, other commercial loans and lines of credit, agricultural loans, construction financing, other real estate loans and SBA loans.  For consumers, the Bank offers residential mortgages, equity lines of credit and other consumer loans.  The Bank employs relationship managers focused on the development and origination of new loan and banking relationships across the markets it serves.  Deposits are obtained primarily through retail deposit gathering efforts as well as through commercial account relationships.  However, in 2013 the Bank expanded the use of listing services and direct deposit gathering from state and local government customers.  Deposit products offered include personal and business checking and savings accounts, time deposit accounts, individual retirement accounts (“IRAs”) and money market accounts.  The Bank also offers online banking, mobile banking, wire transfers, safe deposit boxes, cashier’s checks, traveler’s checks, bank-by-mail, night depository services and other customary banking services.

 

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Competition and Market

 

The banking and financial services industry in California generally, and in the Company’s service area specifically, is highly competitive.  In our primary market areas, money center banks and large regional banks generally hold dominant market share positions. By virtue of their larger capital bases, these institutions have significantly larger lending limits than we do and generally have more expansive branch networks. Competition also includes other community-focused commercial banks. In addition, credit unions also present a significant competitive challenge for us. Credit unions currently enjoy an exemption from income tax and as a result can offer higher deposit rates and lower loan rates than we can on a comparable basis. Credit unions are not currently subject to certain regulatory constraints, such as the Community Reinvestment Act, which, among other things, requires us to implement procedures to make and monitor loans throughout the communities we serve. Adhering to such regulatory requirements raises the costs associated with our lending activities, and reduces potential operating margins.

 

As the industry becomes increasingly dependent upon and oriented toward technology-driven delivery systems, permitting transactions to be conducted by telephone, computer and the internet, non-bank institutions are able to attract funds and provide lending and other financial services without offices located in our primary service area. The increasingly competitive environment is a result primarily of changes in regulation, changes in technology and product delivery systems and the accelerating pace of consolidation among financial services providers.

 

In order to compete with other financial institutions in our service area, we principally rely upon direct personal contact by officers, directors and employees, local advertising programs, and specialized services.  We emphasize to our customers the advantages of dealing with a locally owned and community oriented bank.  We also seek to provide special services and programs for businesses and individuals in our primary service area who are employed in the agricultural, professional and business fields, such as loans for equipment, tools of trade or expansion of practices or businesses.

 

The economy in the Company’s primary market area (San Luis Obispo, Santa Barbara and Ventura Counties) is based primarily on agriculture, hospitality, light industry, oil and retail trade. Additionally, the local economy in San Luis Obispo County and to a lesser degree Santa Barbara County is dependent on the level of employment generated by state and local government agencies.  Services supporting these industries have also developed in the areas of medical, financial and educational services.  The populations of San Luis Obispo County, the City of Santa Maria (in Northern Santa Barbara County), and the City of Santa Barbara totaled approximately 270,000, 100,000, and 89,000 respectively, according to the most recent economic data provided by the 2010 U.S. Census.

 

The moderate climate allows a year round growing season in the local economy’s agricultural sector.  The Central Coast’s leading agricultural industry is the production of wine grapes and the related production of premium quality wines. Vineyards in production have grown significantly over the past several years throughout the Company’s service area.  In addition, cattle ranching represents a major part of the agriculture industry in the Company’s market.  Furthermore, access to numerous recreational activities and destinations including lakes, mountains and beaches provide a relatively stable tourism industry from many areas including the Los Angeles/Orange County basin, the San Francisco Bay area and the San Joaquin Valley.

 

The general business climate in 2008 through 2011 proved to be challenging not only on the national level, but within the state of California and more specifically the Company’s primary market area.  As the real estate market and general economic conditions waned throughout those years, the ability of borrowers to satisfy their obligations to the financial sector languished.  Although the Company’s primary market area has historically witnessed a more stable level of economic activity, the weakened state of the real estate market in conjunction with a decline in economic activity in the Company’s primary market negatively impacted the credit quality of our loan portfolio.

 

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Starting in 2012 and continuing through 2013, the business climate has shown steady signs of improvement including stabilizing real estate prices and a decline in the unemployment rates.  The labor market information published by the California Employment Development Department in December 2013 shows the unemployment rate within California to be approximately 8.3%, compared to over 12% at the peak of the recent economic crisis in 2010.  Within the Company’s primary market area, the labor market information also indicates the unemployment rate within San Luis Obispo and Santa Barbara major metropolitan areas may improve in 2014, as these areas exited 2013 with unemployment levels below 7%.

 

Management remains cautiously optimistic that there will be slow but steady improvement in economic conditions in 2014 in our primary markets.  Additionally, several local economists have recently reported that the improvements in unemployment, the tourism industry, housing and household income are all indicators of stabilization in our primary markets.  However, there have been growing concerns regarding both the global economy and our nation’s economy due primarily to excessive government debt as well as public perceptions of unsound fiscal policies.  There are also growing concerns that the prolonged drought, which has affected most of California, could have adverse impacts on the Central Coast of California’s critical agriculture market and therefore our loan portfolio in the future should drought conditions not ease.  Should either of these uncertainties materialize they could eventually affect our local economy, and ultimately negatively impact the financial condition of borrowers to whom the Company has extended credit.  In turn, the Company may suffer higher credit losses as a result.

 

Employees

 

At December 31, 2013, the Company employed 234 full-time equivalent employees. The Company’s employees are not represented by a union or covered by a collective bargaining agreement. Management believes that its employee relations are positive.

 

Economic Conditions and Legislative and Regulatory Developments

 

The Company’s profitability, like most financial institutions, is primarily dependent on interest rate differentials. These rates are highly sensitive to many factors that are beyond the Company’s control and cannot be predicted, such as inflation, recession and unemployment, and the impact that future changes in domestic and foreign economic conditions might have on the Company.  A more detailed discussion of the Company’s interest rate risks and the mitigation of those risks is included in Item 7A. Quantitative and Qualitative Disclosures About Market Risk, in this Annual Report on Form 10-K.

 

The Company’s business is also influenced by the monetary and fiscal policies of the Federal government and the policies of regulatory agencies.  The Federal Reserve Board implements national monetary policies (with objectives such as maintaining price stability, stimulating growth and reducing unemployment) through its open-market operations in U.S. Government securities, by adjusting the required level of reserves for depository institutions subject to its reserve requirements, and by varying the target Federal funds and discount rates applicable to borrowings by depository institutions. The actions of the Federal Reserve Board in these areas influence the growth of bank loans, investments, and deposits and also affect interest earned on interest-earning assets and interest paid on interest-bearing liabilities. The nature and impact of any future changes in monetary and fiscal policies on the Company cannot be predicted.

 

From time to time, federal and state legislation is enacted that may have the effect of materially increasing the cost of doing business, limiting or expanding permissible activities, or affecting the competitive balance between banks and other financial services providers. In response to the economic downturn and financial industry instability, legislative and regulatory initiatives were, and are expected to continue to be, introduced and implemented, which substantially intensify the regulation of the financial services industry.  Moreover, in light of the economic environment over the last three to five years, bank regulatory agencies have responded to concerns and trends identified in examinations.  While their response resulted in the increased issuance and continuation of enforcement actions to financial institutions towards the end of the last decade and into the beginning of this decade, the level of such actions has recently been on the decline.

 

Supervision and Regulation

 

General

The Company is a legal entity separate and distinct from the Bank.  As a bank holding company, the Company is regulated under the Bank Holding Company Act (“BHC Act”) and is subject to inspection, examination and supervision by the Federal Reserve. It is also subject to the California Financial Code, as well as limited oversight by the DBO and the FDIC.

 

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The Bank, as a California-chartered bank, is subject to primary supervision, examination and regulation by the DBO and the FDIC. If, as a result of an examination of a bank, the FDIC determines that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity or other aspects of its operations are unsatisfactory, or that it or its management is violating or has violated any law or regulation, various remedies are available to the FDIC. Such remedies include the power to: enjoin “unsafe or unsound” practices; require affirmative action to correct any conditions resulting from any violation or practice; issue an administrative order that can be judicially enforced; direct an increase in capital; restrict growth; assess civil monetary penalties; remove officers and directors; institute a receivership; and, ultimately terminate the bank’s deposit insurance, which would result in a revocation of its charter. The DBO separately holds many of the same remedial powers.

 

Regulatory Enforcement Actions

The federal and state bank regulatory agencies may respond to concerns and trends identified in examinations by issuing enforcement actions to, and entering into cease and desist orders, consent orders and memoranda of understanding with, financial institutions requiring action by management and boards of directors to address credit quality, liquidity, risk management and capital adequacy concerns, as well as other safety and soundness or compliance issues. Banks and bank holding companies are also subject to examination and potential enforcement actions by their state regulatory agencies.

 

While the Company and the Bank have operated under various levels of enhanced regulatory supervision beginning in March 2010, all enhanced forms of supervision were lifted for the Bank in April 2013 and for the Company in September 2013.

 

TARP Participation

In response to the financial crisis that affected the banking system and financial markets in recent years, the Emergency Economic Stabilization Act (“EESA”) was enacted in 2008 and established the Troubled Asset Relief Program (“TARP”).  As part of TARP, the United States Department of the Treasury (“Treasury”) established the Capital Purchase Program (“CPP”) to provide up to $700 billion of funding to eligible financial institutions through the purchase of capital stock and other financial instruments for the purpose of stabilizing and providing liquidity to the U.S. financial markets.  The Company participated in the CPP and on March 20, 2009 issued and sold 21,000 shares of its Series A Preferred Stock to Treasury and issued a warrant for the purchase of 611,650 shares of common stock, in exchange for $21.0 million.  Upon the Company’s participation in the CPP, it became subject to certain limitations in the EESA on executive compensation and the payment of dividends.  In 2009, the American Recovery and Reinvestment Act (“ARRA”) modified and expanded the executive compensation provisions in the EESA and expanded the class of employees to whom the limits and restrictions applied as long as TARP securities are held by Treasury.

 

On July 17, 2013, the Company repurchased all 21,000 outstanding shares of the Series A Preferred Stock that were held by the Treasury, plus accrued but unpaid dividends for an aggregate of $21.2 million.  Further, on July 30, 2013, the Company reached an agreement with the Treasury to repurchase the related warrant to purchase 611,650 shares of the Company’s common stock for $1.6 million.  The decision to repurchase the Preferred Stock and the outstanding warrant was made to mitigate the dilutive effect these instruments had on the common shareholders.  The funds for these repurchases were made available through a one-time dividend of $25 million from the Bank to the Company.  For further details on the Company’s participation in the CPP, please see Note 16. Preferred Stock, of the Consolidated Financial Statements, filed in this Form 10-K.

 

Bank Holding Company and Bank Regulation

Bank holding companies and their subsidiaries are subject to significant regulation and restrictions by Federal and State laws and regulatory agencies.  Federal and State laws, regulations and restrictions, which may affect the cost of doing business, limit permissible activities and expansion or impact the competitive balance between banks and other financial services providers, are intended primarily for the protection of depositors and the FDIC deposit insurance fund (“DIF”), and secondarily for the stability of the U.S. banking system. They are not intended for the benefit of shareholders of financial institutions. The following discussion of key statutes and regulations to which the Company and the Bank are subject is a summary and does not purport to be complete nor does it address all applicable statutes and regulations. This discussion is qualified in its entirety by reference to the statutes and regulations referred to in this discussion.

 

The wide range of requirements and restrictions contained in both Federal and State banking laws include:

 

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·          Requirements that bank holding companies serve as a source of strength for their banking subsidiaries. In addition, the regulatory agencies have “prompt corrective action” authority to limit activities and order an assessment of a bank holding company if the capital of a bank subsidiary falls below capital levels required by the regulators.

 

·          Limitations on dividends payable to shareholders. The Company’s ability to pay dividends on both its common and preferred stock are subject to legal and regulatory restrictions.  A substantial portion of the Company’s funds to pay dividends or to pay principal and interest on our debt obligations is derived from dividends paid by the Bank.

 

·          Limitations on dividends payable by bank subsidiaries.  These dividends are subject to various legal and regulatory restrictions.  The federal banking agencies have indicated that paying dividends that deplete a depositary institution’s capital base to an inadequate level would be an unsafe and unsound banking practice.  Moreover, the federal agencies have issued policy statements that provide that bank holding companies and insured banks should generally only pay dividends out of current operating earnings.

 

·          Safety and soundness requirements. Banks must be operated in a safe and sound manner and meet standards applicable to internal controls, information systems, internal audit, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation, as well as other operational and management standards. These safety and soundness requirements give bank regulatory agencies significant latitude in exercising their supervisory authority and their authority to initiate informal or formal enforcement action.

 

·          Requirements for approval of acquisitions and activities. Prior approval or non-objection of the applicable federal regulatory agencies is required for most acquisitions and mergers and in order to engage in certain non-banking activities and activities that have been determined by the Federal Reserve to be financial in nature, incidental to financial activities, or complementary to a financial activity.  Laws and regulations governing state-chartered banks contain similar provisions concerning acquisitions and activities.

 

·          The Community Reinvestment Act (the “CRA”).  The CRA requires that banks help meet the credit needs in their communities, including the availability of credit to low and moderate income individuals. If the Company or the Bank fails to adequately serve their communities, penalties may be imposed, including denials of applications for branches, to add subsidiaries and affiliates, or to merge with or purchase other financial institutions. In its last reported examination by the FDIC in November 2011, the Bank received a CRA rating of “Satisfactory.”

 

·          The Bank Secrecy Act, the USA Patriot Act, and other anti-money laundering laws. These laws and regulations require financial institutions to assist U.S. Government agencies in detecting and preventing money laundering and other illegal acts by maintaining policies, procedures and controls designed to detect and report money laundering, terrorist financing, and other suspicious activity.

 

·          Limitations on the amount of loans to one borrower and its affiliates and to executive officers and directors.

 

·          Limitations on transactions with affiliates.

 

·          Restrictions on the nature and amount of any investments in, and ability to underwrite certain securities.

 

·          Requirements for opening of branches intra- and interstate.

 

·          Fair lending and truth in lending laws to ensure equal access to credit and to protect consumers in credit transactions.

 

·          Provisions of the Gramm-Leach-Bliley Act of 1999 (“GLB Act”) and other federal and state laws dealing with privacy for nonpublic personal information of customers.

 

The Dodd-Frank Act

 

The events of the past several years have led to numerous new laws and regulatory pronouncements in the United States and internationally for financial institutions. The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), enacted in 2010, is one of the most far reaching legislative actions affecting the financial services industry in decades and significantly restructures the financial regulatory regime in the United States.

 

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The Dodd-Frank Act broadly affects the financial services industry by creating new resolution authorities, requiring ongoing stress testing of capital, mandating higher capital and liquidity requirements, increasing regulation of executive and incentive-based compensation and requiring numerous other provisions aimed at strengthening the sound operation of the financial services sector depending, in part, on the size of the financial institution. Among other things, the Dodd-Frank Act provides for:

 

·          capital standards applicable to bank holding companies may be no less stringent than those applied to insured depository institutions;

 

·          annual stress tests and early remediation or so-called living wills are required for larger banks with more than $50 billion of assets as well risk committees of their boards of directors that include a risk expert and such requirements may have the effect of establishing new best practices standards for smaller banks;

 

·          trust preferred securities must generally be deducted from Tier 1 capital over a three-year phase-in period ending in 2016, although depository institution holding companies with assets of less than $15 billion as of year-end 2009 are grandfathered with respect to such securities for purposes of calculating regulatory capital;

 

·          the assessment base for federal deposit insurance was changed to consolidated assets less tangible capital instead of the amount of insured deposits, which generally increased the insurance fees of larger banks, but had relatively less impact on smaller banks;

 

·          repeal of the federal prohibition on the payment of interest on demand deposits, including business checking accounts, and made permanent the $250,000 limit for federal deposit insurance;

 

·          the establishment of the Consumer Finance Protection Bureau (the “CFPB”) with responsibility for promulgating regulations designed to protect consumers’ financial interests and prohibit unfair, deceptive and abusive acts and practices by financial institutions, and with authority to directly examine those financial institutions with $10 billion or more in assets for compliance with the regulations promulgated by the CFPB;

 

·          limits, or places significant burdens and compliance and other costs, on activities traditionally conducted by banking organizations, such as originating and securitizing mortgage loans and other financial assets, arranging and participating in swap and derivative transactions, proprietary trading and investing in private equity and other funds; and

 

·          the establishment of new compensation restrictions and standards regarding the time, manner and form of compensation given to key executives and other personnel receiving incentive compensation, including documentation and governance, proxy access by stockholders, deferral and claw-back requirements.

 

As required by the Dodd-Frank Act, federal regulators have adopted regulations to (i) increase capital requirements on banks and bank holding companies pursuant to Basel III, and (ii) implement the so-called “Volcker Rule” of the Dodd-Frank Act, which significantly restricts certain activities by covered bank holding companies, including restrictions on proprietary trading and private equity investing.

 

Many of the regulations to implement the Dodd-Frank Act have not yet been published for comment or adopted in final form and/or will take effect over several years, making it difficult to anticipate the overall financial impact on the Company and the Bank, our customers or the financial industry more generally.  Individually and collectively, these proposed regulations resulting from the Dodd-Frank Act may materially and adversely affect the Company’s and the Bank’s business, financial condition, and results of operations.  Provisions in the legislation that require revisions to the capital requirements of the Company and the Bank could require the Company and the Bank to seek additional sources of capital in the future.

 

Capital Standards

 

Banks and bank holding companies are subject to various capital requirements administered by state and federal banking agencies.  Capital adequacy guidelines involve quantitative measures of assets, liabilities and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weighting and other factors.

 

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The regulatory agencies’ risk-based capital guidelines are based upon the 1988 capital accord (“Basel I”) of the internal Basel Committee on Bank Supervision (“Basel Committee”), a committee of central banks and bank supervisors/regulators from the major industrialized countries that develops broad policy guidelines, which each country’s supervisors can use to determine the supervisory policies they apply to their home jurisdiction.  In 2004, the Basel Committee proposed a new capital accord (“Basel II”) to replace Basel I that provided approaches for setting capital standards for credit risk and capital requirements for operational risk and refining the existing capital requirements for market risk exposures.  U.S. banking regulators published a final rule for Basel II implementation requiring banks with over $250 billion in consolidated total assets or on-balance sheet foreign exposure of $10 billion (“core banks”) to adopt the advanced approaches of Basel II while allowing other banks to elect to “opt in.”  The regulatory agencies later issued a proposed rule for larger banks that would give banking organizations that do not use the advanced approaches the option to implement a new risk-based capital framework that would adopt the standardized approach of Basel II for credit risk, the basic indicator approach of Basel II for operational risk and related disclosure requirements. A definitive rule was not issued.

 

In December 2010, the Basel Committee released its final framework for strengthening international capital and liquidity regulation, now officially identified as “Basel III.” Basel III, when fully  phased-in,  would require bank holding companies and their bank subsidiaries to maintain substantially more capital than currently required, with a greater emphasis on common equity. The Basel III capital framework, among other things:

 

·      introduces as a new capital measure, Common Equity Tier 1 (“CET1”), more commonly known in the United States as “Tier 1 Common,” and defines CET1 narrowly by requiring that most adjustments to regulatory capital measures be made to CET1 and not to the other components of capital, and expands the scope of the adjustments as compared to existing regulations;

 

·      when fully phased in, requires banks to maintain: (i) a newly adopted international standard, a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7%); (ii) an additional “SIFI buffer” for those large institutions deemed to be systemically important, ranging from 1.0% to 2.5%, and up to 3.5% under certain conditions; (iii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation); (iv) a minimum ratio of Total (that is, Tier 1 plus Tier 2) capital to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation); and (v) as a newly adopted international standard, a minimum leverage ratio of 3%, calculated as the ratio of Tier 1 capital to balance sheet exposures plus certain off-balance sheet exposures (as the average for each quarter of the month-end ratios for the quarter); and

 

·     an additional “countercyclical capital buffer,” generally to be imposed when national regulators determine that excess aggregate credit growth becomes associated with a buildup of systemic risk, that would be a CET1 add-on to the capital conservation buffer in the range of 0% to 2.5% when fully implemented.

 

In July 2013, the U.S. banking agencies approved the U.S. version of Basel III. The federal bank regulatory agencies adopted version of Basel III revises the risk-based and leverage capital requirements and the method for calculating risk-weighted assets to make them consistent with Basel III and to meet the requirements of the Dodd-Frank Act.   Although many of the rules contained in these final regulations are applicable only to large, internationally active banks, some of them will apply on a phased in basis to all banking organizations, including the Company and the Bank.  Among other things, the rules establish a new minimum common equity Tier 1 ratio (4.5% of risk-weighted assets), a higher minimum Tier 1 risk-based capital requirement (6.0% of risk-weighted assets) and a minimum non-risk-based leverage ratio (4.00% eliminating a 3.00% exception for higher rated banks). The new additional capital conservation buffer of 2.5% of risk weighted assets over each of the required capital ratios will be phased in from 2016 to 2019 and must be met to avoid limitations on the ability of the Bank to pay dividends, repurchase shares or pay discretionary bonuses.  The additional “countercyclical capital buffer” is also required for larger and more complex institutions.  The new rules assign higher risk weighting to exposures that are more than 90 days past due or are on nonaccrual status and certain commercial real estate facilities that finance the acquisition, development or construction of real property.  The rules also change the permitted composition of Tier 1 capital to exclude trust preferred securities, mortgage servicing rights and certain deferred tax assets and include unrealized gains and losses on available for sale debt and equity securities (with a one-time opt out option for Standardized Banks (banks with less than $250 billion of total consolidated assets and less than $10 billion of foreign exposures)).  The rules, including alternative requirements for smaller community financial institutions like the Company, would be phased in through 2019.  The implementation of the Basel III framework is to commence January 1, 2015.

 

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Volcker Rule

The final rules adopted on December 10, 2013, to implement a part of the Dodd-Frank Act commonly referred to as the “Volcker Rule”, would prohibit insured depository institutions and companies affiliated with insured depository institutions (“banking entities”) from engaging in short-term proprietary trading of certain securities, derivatives, commodity futures and options on these instruments, for their own account. The final rules also impose limits on banking entities’ investments in, and other relationships with, hedge funds or private equity funds. These rules will become effective on April 1, 2014.  Certain collateralized debt obligations (“CDOs”), securities backed by trust preferred securities which were initially defined as covered funds subject to the investment prohibitions, have been exempted to address the concern that many community banks holding such CDOs securities may have been required to recognize significant losses on those securities.

 

Like the Dodd-Frank Act, the final rules provide exemptions for certain activities, including market making, underwriting, hedging, trading in government obligations, insurance company activities, and organizing and offering hedge funds or private equity funds. The final rules also clarify that certain activities are not prohibited, including acting as agent, broker, or custodian.

 

The compliance requirements under the final rules vary based on the size of the banking entity and the scope of activities conducted. Banking entities with significant trading operations will be required to establish a detailed compliance program and their CEOs will be required to attest that the program is reasonably designed to achieve compliance with the final rule. Independent testing and analysis of an institution’s compliance program will also be required. The final rules reduce the burden on smaller, less-complex institutions by limiting their compliance and reporting requirements. Additionally, a banking entity that does not engage in covered trading activities will not need to establish a compliance program. The Company and the Bank held no investment positions at December 31, 2013 that were subject to the final rule.  Therefore, while these new rules may require us to conduct certain internal analysis and reporting, we believe that they will not require any material changes in our operations or business.

 

Deposit Insurance

 

Substantially all of the deposits of the Bank are insured up to applicable limits by the DIF of the FDIC and are subject to deposit insurance assessments to maintain the DIF.  All FDIC-insured institutions are also required to pay assessments to the FDIC to fund interest payments on bonds issued by the Financing Corporation (“FICO”), an agency of the Federal government established to recapitalize the predecessor to the DIF. These assessments will continue until the FICO bonds mature in 2017.

 

Securities Laws and Corporate Governance

 

The Company is subject to the disclosure and regulatory requirements of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, both as administered by the SEC. As a company listed on the NASDAQ Global Select Market, the Company is subject to NASDAQ listing standards for listed companies.

 

The Company is also subject to the Sarbanes-Oxley Act of 2002, provisions of the Dodd-Frank Act, and other federal and state laws and regulations which address, among other issues, required executive certification of financial presentations, corporate governance requirements for board audit committees and their members, and disclosure of controls and procedures and internal control over financial reporting, auditing and accounting, executive compensation, and enhanced and timely disclosure of corporate information. NASDAQ has also adopted corporate governance rules, which are intended to allow shareholders and investors to more easily and efficiently monitor the performance of companies and their directors.

 

Where You Can Find More Information

 

Under Section 13 of the Securities Exchange Act of 1934, as amended, periodic and current reports must be filed with or furnished to the U.S. Securities and Exchange Commission (the “SEC”). The Company electronically files or furnishes such reports with the SEC and any amendments thereto, including the following: Form 10-K (“Annual Report”), Form 10-Q (“Quarterly Report”), Form 8-K (“Current Report”) and Form DEF 14A (“Proxy Statement”).  The SEC maintains an Internet site, www.sec.gov, in which all forms filed and furnished electronically may be accessed. Additionally, all forms filed with or furnished to the SEC and additional shareholder information is available free of charge on the Company’s website: www.heritageoaksbancorp.com.  The Company posts these reports to its website as soon as reasonably practicable after filing them with the SEC.  The Company also posts its Committee Charters, Code of Ethics, Code of Conduct and Corporate Governance Guidelines on the Company website.  None of the information on or hyperlinked from the Company’s website is incorporated into this Annual Report on Form 10-K.

 

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ITEM  1A.         RISK FACTORS

 

In the course of conducting its business operations, the Company is exposed to a variety of risks, some of which are inherent in the financial services industry and others of which are more specific to its own business.  The following discussion addresses the most significant risks that could affect the Company’s business, financial condition, liquidity, results of operations, and capital position.  The risks identified below are not intended to be a comprehensive list of all risks faced by the Company.  Additional risks and uncertainties that the Company is not aware of or that the Company currently deems immaterial may also impair our business.

 

Risks Associated With Our Business

 

Difficult market conditions have adversely affected and may continue to have a material and adverse effect on our business.

 

Since late 2007, the United States generally and the State of California in particular have experienced difficult economic conditions.  Weak economic conditions are characterized by, among other indicators, deflation, increased levels of unemployment, fluctuations in debt and equity capital markets, increased delinquencies on mortgage, commercial and consumer loans, residential and commercial real estate price declines and lower home sales and commercial activity. All of those factors have been, and may continue to be, detrimental to the Company’s business.

 

In addition, the Company’s ability to assess the creditworthiness of customers and to estimate the losses inherent in its credit exposure is made more complex by these difficult market and economic conditions. Adverse economic conditions could reduce our growth rate, affect the ability of our customers to repay their loans and generally affect the Company’s financial condition and results of operations.

 

While some economic trends have shown signs of improvement, we cannot be certain that market and economic conditions will substantially improve in the near future.  Recent and ongoing events at the state, national and international levels continue to create uncertainty in the economy and financial markets and could adversely impact economic conditions in the Company’s market area.  A worsening of these conditions would likely exacerbate the adverse effects of the recent market and economic conditions on us and our customers.  As a result, the Company may experience additional increases in foreclosures, delinquencies and customer bankruptcies as well as more restricted access to funds.

 

Any such negative events may have an adverse effect on the Company’s business, financial condition, results of operations and stock price. Moreover, because of the Company’s geographic concentration, it is less able to diversify its credit risks across multiple markets to the same extent as regional or national financial institutions.

 

We are highly dependent on the real estate market on the Central Coast of California and a renewed downturn in the real estate market may have a material and adverse effect on our business.

 

A significant portion of our loan portfolio is collateralized by real estate.  Although we have seen what we believe are the signs of stabilization in the local economies in which we operate, a renewed decline in economic conditions, the local housing market or rising interest rates could have an adverse effect on the demand for new loans (as evidenced by the downturn in mortgage lending activities in the second half of 2013), the ability of borrowers to repay outstanding loans, the value of real estate and other collateral securing loans or the value of real estate owned by us, any combination of which could materially and adversely impact our financial condition and results of operations.

 

In addition, a large portion of the loan portfolio is collateralized by real estate that is subject to risks related to acts of nature, including drought, earthquakes, floods and fires. To the extent that these events occur, they may cause uninsured damage and other loss of value to real estate that secures these loans, which may also materially and adversely impact our financial condition and results of operations.

 

We have a concentration in commercial real estate loans.

 

We have a high concentration in commercial real estate (“CRE”) loans. CRE loans are defined as construction, land development, other land loans, loans secured by multi-family (5 or more units) residential properties and loans secured by non-farm, non-residential properties.  Following this definition, approximately 52% of our gross loans can be classified as CRE lending as of December 31, 2013.  CRE loans generally involve a higher degree of credit risk than certain other types of lending due to, among other things, the generally large amounts loaned to individual borrowers.  Losses incurred on loans to a small number of these borrowers could have a material and adverse impact on our operating results and financial condition.  In addition, commercial real estate loans generally depend on the cash flow from the property to service the debt.  Cash flow may be adversely affected by general economic conditions, which may result in non-performance by certain borrowers.

 

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The cost and other effects of the full implementation of the Dodd-Frank Act remain unknown and may have a material and adverse effect on our business.

 

The full compliance burden and impact on our operations and profitability with respect to the Dodd-Frank Act remain uncertain, as the Dodd-Frank Act delegates to various federal agencies the task of implementing its many provisions through regulation.  Although certain provisions of the Dodd-Frank Act have been implemented, federal rules and policies in this area and the effects of their implementation will be further developing for some time to come.  However, based on the provisions of the Dodd-Frank Act and the current and anticipated implementing regulations, it is highly likely that banks and their holding companies will be subject to significantly increased regulation and compliance obligations that expose us to higher costs as well as noncompliance risk and consequences.

 

Implementation of new Basel III capital rules adopted by the federal bank regulatory agencies will require increased capital levels that we may not be able to satisfy and could impede our growth and profitability.

 

The federal bank regulatory agencies adopted new Basel III capital rules in mid-2013 that would increase minimum capital ratios, add a new minimum common equity ratio, add a new capital conservation buffer, and would change the risk-weightings of certain assets. These changes, when implemented beginning in 2015, will be phased in through 2019. Management is currently assessing the effect of the proposed rules on the Company and the Bank’s capital positions. When the rules are implemented, they could have a material and adverse effect on our liquidity, capital resources and financial condition (See Item 1. Business — Supervision and Regulation, for a further discussion of Basel III).

 

Our business is subject to credit exposure and our allowance for loan losses may not be sufficient to cover actual loan losses.

 

We have been able to reduce our overall level of classified assets, including substandard loans, other real estate owned and non-investment grade securities.  However, the current levels remain elevated as compared to our historical experience prior to the global credit crisis beginning in the latter part of the last decade.  These higher levels of classified assets expose us to increased credit risk. While we believe that we are making progress in identifying and resolving classified assets, no assurance can be given that we will continue to make progress, particularly if the local economies in which we operate suffer renewed deterioration.  We believe that the Company’s allowance for loan losses is maintained at a level adequate to absorb probable, credit losses inherent in our loan portfolio as of the corresponding balance sheet date.  We make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the probability of such borrowers making payments, as well as the value of real estate and other assets serving as collateral for the repayment of many of our loans when considering the adequacy of the Company’s allowance. If our assumptions are incorrect, our allowance for loan and lease losses may be insufficient to cover losses inherent in our loan portfolio, which may adversely impact our operating results. Our regulators, as an integral part of their regular examination process, periodically review our allowance for loan losses and may require us to increase it by recognizing additional provisions for loan losses or to decrease our allowance for loan losses by recognizing loan charge-offs. Any additional provisions for loan losses or charge-offs, as required by these regulatory agencies, could have a material and adverse effect on our financial condition and results of operations.

 

The Company’s business is subject to interest rate risk and variations in interest rates may negatively affect its financial performance.

 

A substantial portion of the Company’s income is derived from the differential or “spread” between the interest earned on loans, securities and other interest earning assets, and the interest paid on deposits, borrowings and other interest bearing liabilities. Interest rates are highly sensitive to many factors that are beyond the Company’s control, including general economic conditions and the policies of various governmental and regulatory authorities. As interest rates change, net interest income is affected. With fixed rate assets (such as fixed rate loans and investment securities) and liabilities (such as certificates of deposit), the effect on net interest income depends on the cash flows associated with the maturity of the asset or liability. Asset/liability management policy may not be successfully implemented and from time to time the Company’s risk position may not be balanced. An unanticipated rapid decrease or increase in interest rates could have an adverse effect on the spreads between the interest rates earned on assets and the rates of interest paid on liabilities, and therefore on the level of net interest income. For instance, any rapid increase in interest rates in the future could result in interest expense increasing faster than interest income because of fixed rate loans and longer term investments. Further, substantially higher interest rates could reduce loan demand and may result in slower loan growth than previously experienced. Any one of these occurrences would have a material and adverse effect on the Company’s results of operation and financial condition.

 

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Competition from within and outside the financial services industry may materially and adversely affect our business.

 

The financial services business in our market area is highly competitive.  It is becoming increasingly competitive due to changes in regulation, technological advances and the accelerating pace of consolidation among financial services providers.  We face competition in attracting and retaining core business relationships.  Increasing levels of competition in the banking and financial services business may reduce our market share, decrease loan demand, cause the prices we charge for our services to fall, resulting in a decline in the rates we charge on loans and/or cause higher rates to be paid on deposits.  Therefore, our results may differ in future periods depending upon the nature and level of competition.

 

Additionally, technology and other changes are allowing parties to complete financial transactions, which historically have involved banks, through alternative methods.  For example, consumers can now maintain funds, which would have historically been held as bank deposits in brokerage accounts or mutual funds.  Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as “disintermediation,” could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits.  The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.

 

Liquidity risk could impair our ability to fund operations and negatively impact our financial condition.

 

Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a material and adverse effect on our liquidity. Our access to funding sources in amounts adequate to finance our activities could be impaired by factors that affect us specifically or the financial services industry in general. Factors that could detrimentally impact our access to liquidity sources include a decrease in the level of our business activity due to a market downturn or adverse regulatory action against us.

 

Declines in the market value of our investment portfolio may adversely affect our financial performance, liquidity and capital.

 

We maintain an investment portfolio that includes, but is not limited to, mortgage-backed securities, municipal securities and asset backed securities. The market value of investments in our portfolio has become increasingly volatile over the last few years, largely due to disruptions in the capital markets and fluctuations in long term interest rates. Due to increasing long term interest rates in 2013, we have seen a decline  in the overall market value of our investment portfolio in 2013.  The market value of investments may be affected by factors other than the underlying performance of the servicer of the securities, or the mortgages underlying the securities, such as changes in interest rates, credit ratings downgrades, adverse changes in the business climate, and a lack of liquidity in the secondary market for certain investment securities. Furthermore, problems at the federal and state government levels may trickle down to municipalities and adversely impact our investment in municipal bonds.

 

On a quarterly basis, we evaluate investments and other assets for impairment. We may be required to record impairment charges if our investments suffer a decline in value that is considered other-than-temporary. If we determine that a significant impairment has occurred, we would be required to charge the credit-related portion of the other-than-temporary impairment against earnings, which may have a material adverse effect on our results of operations in the periods in which the charges occur.

 

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Failure to successfully execute our strategic plan may adversely affect our performance.

 

Our financial performance and profitability depend on our ability to execute our corporate strategies.  Each year, our board of directors approves our long-term strategic plan and annual operating budget.  Our near-term business strategy includes expanding our market share within our geographic footprint through opening new branches and/or loan production offices or acquiring other financial institutions.  Any future mergers, including our pending merger with Mission Community Bank, will be accompanied by the risks commonly encountered in acquisitions.  These risks may include, among other things: our ability to realize anticipated cost savings; the difficulty of integrating operations and personnel; dilution of earnings due to the issuance of 7.5 million shares of common stock as part of the consideration to be paid in the pending merger; the loss of key employees; the potential disruption of our or the acquired company’s ongoing business in such a way that could result in decreased revenues; the inability of our management to maximize our financial and strategic position; the inability to maintain uniform standards, controls, procedures and policies; and the impairment of relationships with the acquired company’s employees and customers as a result of changes in ownership and management.  Furthermore, our growth strategy may present operating and other problems that could adversely affect our business, financial condition and results of operations.  Accordingly, there can be no assurance that we will be able to effectively execute this strategy or maintain the level of profitability that we have recently experienced.  Other factors that may adversely affect our ability to attain our long-term financial performance goals include an inability to control non-interest expense, including, but not limited to, rising employee compensation, regulatory compliance and  healthcare costs, limitations imposed on us through regulatory actions, and our inability to increase net-interest income due to continued downward pressure on interest rates.

 

The treatment of Mission Community Bank’s largest shareholder, Carpenter, and its affiliates by the Federal Reserve Board as a bank holding company, which will control the Company and indirectly Heritage Oaks Bank after the merger could adversely impact the operations of the Company or restrict its growth.

 

The Carpenter Community BancFunds and Carpenter Fund Manager GP, LLC, currently Mission Community Bank’s largest shareholder, will become our largest shareholder following the merger and will be considered to control the Company and indirectly Heritage Oaks Bank under the Bank Holding Company Act.  Carpenter is a bank holding company, which controls other depository institutions, is subject to minimum capital requirements and supervision and regulation by the Federal Reserve Board, and is required to serve as a source of financial and managerial strength and commit resources as may be necessary to support each bank it controls.  Were Carpenter to fail to meet these obligations, the operations and expansion of the Company could be restricted by the Federal Reserve Board and therefore materially and adversely impacted.

 

We may not be able to attract and retain skilled people.

 

Our success depends, in large part, on our ability to attract and retain key people.  Competition for the best people can be intense and we may not be able to hire people or to retain them without offering very high compensation.  The unexpected loss of the services of one or more of our key personnel could have a material and adverse impact on our business because of the loss  of their skills, knowledge of our market and  years of industry experience and the difficulty of promptly finding qualified replacement personnel.

 

The bank regulatory agencies have published guidance and regulations which limit the manner and amount of compensation that banking organizations provide to employees. These regulations and guidance may materially and adversely affect our ability to retain key personnel. Due to these restrictions, we may not be able to successfully compete with other larger financial institutions to attract, retain and appropriately incentivize high performing employees. If we were to suffer such adverse effects with respect to our employees, our business, financial condition and results of operations could be materially and adversely affected.

 

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The Company faces operational risks that may result in unexpected losses.

 

We are subject to certain operational risks, including, but not limited to, data processing system failures and errors, customer or employee fraud and catastrophic failures resulting from terrorist acts or natural disasters.  We maintain a system of internal controls to mitigate against such occurrences and maintain insurance coverage for such risks that are insurable, but should such an event occur that is not prevented or detected by our internal controls, uninsured or in excess of applicable insurance limits, it could have a material and adverse impact on our business, financial condition and results of operations.

 

The Company’s information systems may experience an interruption or security breach that may result in unexpected losses.

 

We rely heavily on communications and information systems to conduct our business.  Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems.  In recent months, groups of foreign ‘hacktivists’ have targeted banks with distributed denial of service (DDos) attacks aimed at disrupting the bank’s websites and e-baking capabilities.  These attacks may increase or spread to smaller banks, such as ours.  While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed.  The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material and adverse effect on our financial condition and results of operations.

 

Necessary changes in technology could be costly.

 

The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services.  The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs.  Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations.  Many of our competitors have substantially greater resources to invest in technological improvements.

 

We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers.  Failure to successfully keep pace with technological change affecting the financial services industry could have a material and adverse impact on our business, financial condition and results of operations.

 

The Company relies on third party service providers for key systems, placing us and our customers at risk if the vendor has service outages, work stoppages or is subjected to attacks on their IT systems that expose information relating to us and our customers.

 

The Company uses a third party software service provider to perform all of its transaction data processing.  The Company also outsources other customer service applications, such as on-line banking, ACH and wire transfers, to third party vendors.   If these service providers were to experience technical difficulties or incur any extended outages in services, it could have a material and  adverse impact on the Company and its customers.  Because such service providers service us and other banks, their systems could be affected by DDoS attacks directed at their other bank customers.  In addition, third parties may seek to penetrate our vendors’ IT systems, obtain information about us or our customers or access to our customers’ accounts, and exploit that information to wrongfully withdraw or transfer our customers’ funds, which could have material and adverse impacts on our customers and the Company.  Further, if the Company was required to switch service providers due to deterioration in service quality or other factors, there is no guarantee that it could obtain comparable services for a comparable price.

 

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Our operations face severe weather, natural disasters, acts of war or terrorism and other external risks.

 

Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on our ability to conduct business.  Such events could affect the stability of our deposit base; impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause us to incur additional expenses.  The Central Coast of California is subject to earthquakes, fires and landslides.  Operations in our market could be disrupted by both the evacuation of large portions of the population as well as damage and or lack of access to our banking and operation facilities.  The local market that the Company serves is also currently facing drought conditions which could not only impact the largest industry in our market footprint, agriculture, but could have rippling effects on other industries, including hospitality.  Although management has established disaster recovery policies and procedures, the occurrence of any such event could have a material and adverse effect on our business, financial condition and results of operations.

 

Maintaining our reputation as a community bank is critical to our success and the failure to do so may materially and adversely affect our performance.

 

We are a community bank and our reputation is one of the most valuable components of our business.  As such, we strive to conduct our business in a manner that enhances our reputation.  This is done, in part, by recruiting, hiring and retaining employees who share our core values of being an integral part of the communities we serve, delivering superior service to our customers and caring about our customers and associates.  If our reputation is negatively affected by the actions of our employees, or otherwise, our business, operating results and financial condition may be materially and adversely affected.

 

Risks Associated With Our Stock

 

We depend on cash dividends from the Bank to meet our cash obligations.

 

As a holding company, dividends from our subsidiary bank provide a substantial portion of our cash flow used to service the interest payments on our trust preferred securities and any cash dividends to our preferred and common stockholders. Various statutory provisions restrict the amount of dividends our subsidiary bank can pay to us without regulatory approval. If the Bank is unable to generate the profits necessary to service the interest payments, or we are unable to obtain regulatory approval to make dividends from the Bank to the Company, our business, operating results and financial condition may be materially and adversely affected.

 

Our outstanding preferred stock impacts net income available to our common stockholders.

 

Our Series C Preferred Stock may be dilutive to common stockholders to the extent the Company is profitable and must consider the dilutive nature of these securities in its calculation of earnings per common share.  Also, the Company’s preferred stock will receive preferential treatment in the event of the Company’s liquidation, dissolution or winding-down, which could have a material and adverse effect on common stockholders in the event of such liquidation.

 

Our stock trades less frequently than others.

 

Although our common stock is listed for trading on the NASDAQ Capital Market, the trading volume in our common stock is less than that of other larger financial service companies.  A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of our common stock at any given time.  This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control.  Given the lower trading volume of our common stock, significant sales of our common stock, or the expectation of these sales, could cause our stock price to fall, which could in turn have a material and adverse effect on our business, financial condition and results of operations.

 

Our stock price is affected by a variety of factors.

 

Stock price volatility may make it more difficult for investors to resell their common stock when they want and at prices they find attractive.  Our stock price can fluctuate significantly in response to a variety of factors, including among other things: actual or anticipated variations in quarterly results of operations; recommendations by securities analysts; operating and stock price performance of other companies that investors deem comparable to our company; news reports relating to trends, concerns and other issues in the financial services industry; and perceptions in the marketplace regarding our company and/or its competitors and the industry in which we operate.

 

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These factors may adversely affect the trading price of our common stock, regardless of our actual operating performance, and could prevent shareholders from selling their common stock at or above the price they paid.  In addition, the stock markets, from time to time, experience extreme price and volume fluctuations that may be unrelated or disproportionate to the operating performance of companies.  These broad fluctuations may adversely affect the market price of our common stock, regardless of our trading performance, which could in turn have a material and adverse effect on our business, financial condition and results of operations.

 

Any future issuance of preferred or common stock may adversely affect the market price of our common stock.

 

We are not restricted from issuing additional shares of common stock or securities that are convertible into or exchangeable for, or that represent the right to receive, common stock.  We frequently evaluate opportunities to access the capital markets, taking into account our regulatory capital ratios, financial condition and other relevant considerations.    Any future issuances of equity may result in additional common shares outstanding and/or reduce the amount of income available to common shareholders.

 

In addition, we face significant regulatory and other governmental risk as a financial institution and it is possible that capital requirements and directives may, in the future, require us to change the amount or composition of our current capital including common equity.  As a result we may determine we need, or our regulators may require us to raise additional capital.  Should we need to raise capital in the future, it may have an adverse effect on the price of our common stock, which could in turn have a material and adverse effect on our business, financial condition and results of operations.

 

Holders of our junior subordinated debentures have rights that are senior to those of our common shareholders.

 

We have previously raised capital through two issuances of trust preferred securities from two separate special purpose trusts, one of which was dissolved in 2010.  At December 31, 2013, we had $8.3 million of trust preferred securities outstanding.  Payments of the principal and interest on the trust preferred securities of the remaining special purpose trust are fully and unconditionally guaranteed by us.  Further, the accompanying junior subordinated debentures we issued to the special purpose trust are senior to our shares of common stock.  As a result, we must make payments on the junior subordinated debentures before any dividends can be paid on our common stock and, in the event of our bankruptcy, dissolution or liquidation, the repayment obligation to holders of the junior subordinated debentures must be satisfied before any distributions can be made on our common stock.  We have the right to defer distributions on our junior subordinated debentures and the related trust preferred securities for up to five years during which time no cash dividends may be paid on our common stock.

 

Our common stock is not an FDIC insured deposit.

 

Our common stock is not a bank deposit and is not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity.  Investment in our common stock is inherently risky and is subject to market forces that affect the price of common stock in any company.  As a result, if you acquire our common stock, you may lose some or all of your investment.

 

Our articles of incorporation and bylaws, as well as certain banking laws, may have an anti-takeover effect.

 

Provisions of our articles of incorporation, bylaws and federal banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire us, even if doing so would be perceived to be beneficial to our shareholders.  The combination of these provisions may hinder a non-negotiated merger or other business combination, which, in turn, could materially and adversely affect the market price of our common stock.

 

ITEM  1B.         UNRESOLVED STAFF COMMENTS

 

None.

 

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ITEM  2.                                                       PROPERTIES

 

The Company’s headquarters are located at 1222 Vine Street in Paso Robles, California.  As of December 31, 2013, the Bank operates 12 branches within the Counties of San Luis Obispo and Santa Barbara.  The Bank currently owns its headquarters and seven of its branches and leases the remaining branches from various parties.  The Bank also leases two locations in Ventura and Santa Barbara Counties where it operates loan production offices.

 

The Company believes its facilities are adequate for its present needs.  The Company believes that the insurance coverage on all properties is adequate.  Most of the leases contain multiple renewal options and provisions for rental increases, principally for changes in the cost of living index, property taxes and maintenance.

 

ITEM  3.                                                       LEGAL PROCEEDINGS

 

The Bank is party to the following litigation:

 

Corona Fruits & Veggies, Inc., et al v. Heritage Oaks Bank, et al, Santa Barbara County Sup. Ct. case no. 1390870, filed 2/8/2012. Corona Fruits & Veggies, Inc. and related entities are seeking in excess of $2,000,000 in damages for a variety of claims including breach of contract, misrepresentation, interference with contractual relations and promissory estoppel.  The alleged factual basis underlying the claims is that the Bank promised to extend agricultural and equipment financing to the plaintiffs and ultimately failed to do so, causing the plaintiffs’ damages. The Bank denies that it acted improperly in any respect toward plaintiffs or that it breached a loan commitment to the plaintiffs and is vigorously defending the matter.   The case has been consolidated for trial with a related action by Robert Mann Packing, a supplier to and creditor of the plaintiffs, which alleges that the Bank breached an inter-creditor agreement between the Bank and Robert Mann Packing while collecting proceeds from Corona’s crop sales.  The case is in the discovery phase and trial is set in May 2014.  However, the Bank does not expect the litigation to have a material impact on the Bank.

 

Sandra Keller v. Heritage Oaks Bank, et al, U.S. District Court, Central District of California case no. CV-13-2049 CAS, filed 3/21/13. Sandra Keller, as guardian ad litem for Mary Mastagni, filed suit in federal court against the Bank and numerous other parties alleging damages from a conspiracy to commit elder financial abuse. The complaint was unclear as to the basis for the alleged damages against the Bank, and the Bank believes the complaint lacked any merit whatsoever. The federal court has dismissed the case.

 

Sandra Keller, et al vs. Heritage Oaks Bank,  et al, Superior Court of San Luis Obispo County, case no CV- 138124, filed 5/29/13. This is the identical complaint that was dismissed by the federal court.  The Bank was served with process in September 2013 and has demurred. The Bank does not expect the litigation to have a material impact on the Bank.

 

Except as indicated above, neither the Company nor the Bank is involved in any legal proceedings other than routine litigation incidental to the business of the Company or the Bank.

 

 

ITEM  4.                                                       MINE SAFETY DISCLOSURES

 

Not applicable.

 

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PART II

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

Market Information

The Company’s common stock trades on the NASDAQ Capital Market under the symbol “HEOP.”  As of February 24, 2014, there were approximately 2,350 holders of record of the Company’s common stock.  The following table summarizes those trades of the Company’s Common Stock on NASDAQ, setting forth the high and low sales prices for each quarterly period ended since January 1, 2012:

 

Stock Price

Quarters Ended

 

High

 

Low

 

December 31, 2013

 

$

8.10

 

$

5.95

 

September 30, 2013

 

7.00

 

6.00

 

June 30, 2013

 

6.34

 

5.35

 

March 31, 2013

 

5.90

 

5.43

 

 

 

 

 

 

 

December 31, 2012

 

$

5.90

 

$

5.15

 

September 30, 2012

 

5.95

 

5.05

 

June 30, 2012

 

6.00

 

4.70

 

March 31, 2012

 

5.22

 

3.25

 

Dividends

The Company’s Board of Directors has responsibility for the oversight and approval of the declaration of dividends.  The timing and amount of any future dividends will depend on the Company’s near and long term earnings capacity, current and future capital position, investment opportunities, statutory and regulatory limitations, general economic conditions and other factors deemed relevant by the Company’s Board of Directors.  No assurances can be given that any dividends will be paid in the future or, if payment is made, will continue to be paid.

 

Dividends the Company declares are subject to the restrictions set forth in the California General Corporation Law (the “Corporation Law”).  The Corporation Law provides that a corporation may make a distribution to its shareholders if the corporation’s retained earnings equal at least the amount of the proposed distribution.  The Corporation Law also provides that, in the event that sufficient retained earnings are not available for the proposed distribution, a corporation may nevertheless make a distribution to its shareholders if it meets two conditions, which generally stated are as follows: (i) the corporation’s assets equal at least 1 and 1/4 times its liabilities, and (ii) the corporation’s current assets equal at least its current liabilities or, if the average of the corporation’s earnings before taxes on income and before interest expenses for the two preceding fiscal years was less than the average of the corporation’s interest expenses for such fiscal years, then the corporation’s current assets must equal at least 1 and 1/4 times its current liabilities.  See also Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, for limitations on dividends resulting from the issuance of junior subordinated debentures. Additionally, the Federal Reserve Board has authority to limit the payment of dividends by bank holding companies, such as the Company, in certain circumstances, requiring, among other things, a holding company to consult with the Federal Reserve Board prior to payment of a dividend if the company does not have sufficient recent earnings in excess of the proposed dividend.

The principal source of funds from which the Company may pay dividends is the receipt of dividends from the Bank. The availability of dividends from the Bank is limited by various statutes and regulations.  The Bank is subject first to corporate restrictions on its ability to pay dividends.  Further, the Bank may not pay a dividend if it would be undercapitalized after the dividend payment is made.  The payment of cash dividends by the Bank 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) bank’s retained earnings; or (b) 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 DBO, make a distribution to its shareholders in an amount not exceeding the greatest 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 DBO determines that the shareholders’ equity of a bank is inadequate or that the making of a distribution by the bank would be unsafe or unsound, the DBO may order the bank to refrain from making a proposed distribution.  The FDIC may also restrict the payment of dividends 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 federal law.

 

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While the Federal Reserve Board has no general restriction with respect to the payment of cash dividends by an adequately capitalized bank to its parent holding company, the Federal Reserve Board might, under certain circumstances, place restrictions on the ability of a particular bank to pay dividends based upon peer group averages and the performance and maturity of the particular bank, or object to management fees to be paid by a subsidiary bank to its holding company on the basis that such fees cannot be supported by the value of the services rendered or are not the result of an arm’s length transaction.

No dividends have been paid to holders of the Company’s common stock during each of the preceding two years.

During the second quarter of 2012, the Company’s request to the FRB to allow it to pay all dividends in arrears on the Series A Preferred Stock which was approved and the Company brought the dividends on its Series A Preferred Stock current. The Company continued to receive approval from the FRB to pay dividends on the Series A Preferred Stock through the third quarter of 2013, at which time the Company repurchased the Series A Preferred Stock and ended the related dividend requirements.

Repurchase of Common Stock

The Company is not currently authorized to make repurchases of its common stock, nor did it make repurchases of its common stock during 2013, 2012, 2011, or 2010.

Securities Authorized for Issuance Under Equity Compensation Plans

The following table provides information at December 31, 2013, with respect to shares of Company common stock that may be issued under the Company’s existing equity compensation plans:

 

 

 

 

Number of

 

 

 

 

 

 

 

Securities To Be

 

Weighted Average

 

Number of Securities

 

 

 

Issued Upon Exercise

 

Exercise Price of

 

Remaining Available

 

Plan Category

 

of Outstanding Options

 

Outstanding Options

 

For Future Issuance

 

Equity compensation plans

 

 

 

 

 

 

 

approved by security holders:

 

562,257  

(1)

$

6.34

 

1,593,616  

(2)

Equity compensation plans not

 

 

 

 

 

 

 

approved by security holders:

 

N/A 

 

N/A

 

N/A 

 

 

(1) Under the 2005 Equity Based Compensation Plan, the Company is authorized to issue restricted stock awards.  Restricted stock awards are not included in the table above.  At December 31, 2013, there were 195,048  shares of restricted stock issued and outstanding.  See also Note 14. Share Based Compensation Plans, of the Consolidated Financial Statements on this Form 10-K for more information on the Company’s equity compensation plans.

 

(2) Includes securities available for issuance stock options and restricted stock.

 

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Item 6.  Selected Financial Data

 

The following table compares selected financial data for the past five years.  Explanations for the year-to-year changes may be found in Management’s Discussion & Analysis in Item 7. and in the Company’s Consolidated Financial Statements and the accompanying notes that are presented in Item 8. of this Form 10-K.  The following data has been derived from the Consolidated Financial Statements of the Company and should be read in conjunction with those statements and the notes thereto, which are included in this report.

 

 

 

At or For The Years Ended December 31,

 

 (dollar amounts in thousands, except per share data)

 

 

2013

 

2012

 

2011

 

2010

 

2009

 

 Consolidated Income Data:

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

 

$

45,393

 

$

46,321

 

$

48,227

 

$

50,794

 

$

49,559

 

Interest expense

 

 

3,867

 

3,818

 

5,023

 

8,047

 

10,049

 

Net interest income

 

 

41,526

 

42,503

 

43,204

 

42,747

 

39,510

 

Provision for loan losses

 

 

-   

 

7,681

 

6,063

 

31,531

 

24,066

 

Net interest income after provision for loan losses

 

 

41,526

 

34,822

 

37,141

 

11,216

 

15,444

 

Non-interest income

 

 

12,875

 

12,548

 

9,730

 

10,747

 

7,415

 

Non-interest expense

 

 

36,563

 

36,131

 

37,318

 

41,283

 

35,733

 

Income / (loss) before income tax expense / (benefit)

 

 

17,838

 

11,239

 

9,553

 

(19,320

)

(12,874

)

Income tax expense / (benefit)

 

 

6,997

 

(1,798

)

1,828

 

(1,760

)

(5,825

)

Net income / (loss)

 

 

$

10,841

 

$

13,037

 

$

7,725

 

$

(17,560

)

$

(7,049

)

 Dividends and accretion on preferred stock

 

 

898

 

1,470

 

1,358

 

5,008

 

964

 

 Net income / (loss) available to common shareholders

 

 

$

9,943

 

$

11,567

 

$

6,367

 

$

(22,568

)

$

(8,013

)

 Share Data:

 

 

 

 

 

 

 

 

 

 

 

 

Earnings / (loss) per common share - basic

 

 

$

0.40

 

$

0.46

 

$

0.25

 

$

(1.30

)

$

(1.04

)

Earnings / (loss) per common share - diluted

 

 

$

0.37

 

$

0.44

 

$

0.24

 

$

(1.30

)

$

(1.04

)

Dividend payout ratio (1)

 

 

0.00%

 

0.00%

 

0.00%

 

0.00%

 

0.00%

 

Common book value per share

 

 

$

4.84

 

$

4.78

 

$

4.17

 

$

3.85

 

$

8.07

 

Tangible common book value per share

 

 

$

4.34

 

$

4.27

 

$

3.67

 

$

3.33

 

$

6.31

 

Actual shares outstanding at end of period (2)

 

 

25,397,780

 

25,307,110

 

25,145,717

 

25,082,344

 

7,771,952

 

Weighted average shares outstanding - basic

 

 

25,152,054

 

25,081,462

 

25,048,477

 

17,312,306

 

7,697,234

 

Weighted average shares outstanding - diluted

 

 

26,542,689

 

26,401,870

 

26,254,745

 

17,312,306

 

7,697,234

 

 Consolidated Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

 

Total cash and cash equivalents

 

 

$

26,238

 

$

34,116

 

$

34,892

 

$

22,951

 

$

40,738

 

Total investments and other securities

 

 

$

276,795

 

$

287,682

 

$

236,982

 

$

223,857

 

$

121,180

 

Total gross loans

 

 

$

827,484

 

$

689,608

 

$

646,286

 

$

677,303

 

$

728,679

 

Allowance for loan losses

 

 

$

(17,859

)

$

(18,118

)

$

(19,314

)

$

(24,940

)

$

(14,372

)

Total assets

 

 

$

1,203,651

 

$

1,097,532

 

$

987,138

 

$

982,612

 

$

945,177

 

Total deposits

 

 

$

973,895

 

$

870,870

 

$

786,208

 

$

798,206

 

$

775,465

 

Federal Home Loan Bank borrowings

 

 

$

88,500

 

$

66,500

 

$

51,500

 

$

45,000

 

$

65,000

 

Junior subordinated debt

 

 

$

8,248

 

$

8,248

 

$

8,248

 

$

8,248

 

$

13,403

 

Total stockholders’ equity

 

 

$

126,427

 

$

145,529

 

$

129,554

 

$

121,256

 

$

83,751

 

 Selected Other Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

 

Average assets

 

 

$

1,119,334

 

$

1,024,961

 

$

976,988

 

$

995,223

 

$

887,628

 

Average earning assets

 

 

$

1,031,578

 

$

953,815

 

$

916,356

 

$

935,991

 

$

829,329

 

Average stockholders’ equity

 

 

$

137,807

 

$

137,392

 

$

124,824

 

$

121,865

 

$

86,949

 

 Selected Financial Ratios:

 

 

 

 

 

 

 

 

 

 

 

 

Return on average assets

 

 

0.97%

 

1.27%

 

0.79%

 

-1.76%

 

-0.79%

 

Return on average equity

 

 

7.87%

 

9.49%

 

6.19%

 

-14.41%

 

-8.11%

 

Return on average tangible common equity

 

 

9.04%

 

11.55%

 

7.29%

 

-30.86%

 

-10.00%

 

Net interest margin (3)

 

 

4.03%

 

4.46%

 

4.71%

 

4.57%

 

4.76%

 

Efficiency ratio (4)

 

 

71.29%

 

67.88%

 

67.98%

 

69.08%

 

69.86%

 

Non-interest expense to average assets

 

 

3.27%

 

3.53%

 

3.82%

 

4.15%

 

4.03%

 

 Capital Ratios:

 

 

 

 

 

 

 

 

 

 

 

 

Average equity to average assets

 

 

12.31%

 

13.40%

 

12.78%

 

12.24%

 

9.80%

 

Leverage Ratio

 

 

10.20%

 

12.32%

 

12.06%

 

10.83%

 

8.24%

 

Tier 1 Risk-Based Capital ratio

 

 

12.91%

 

15.55%

 

14.81%

 

13.94%

 

9.59%

 

Total Risk-Based Capital ratio

 

 

14.17%

 

16.81%

 

16.07%

 

15.21%

 

10.85%

 

 Selected Asset Quality Ratios:

 

 

 

 

 

 

 

 

 

 

 

 

Non-performing loans to total gross loans (5)

 

 

1.22%

 

2.51%

 

1.91%

 

4.85%

 

5.26%

 

Non-performing assets to total assets (6)

 

 

0.84%

 

1.58%

 

1.35%

 

4.02%

 

4.15%

 

Allowance for loan losses to total gross loans

 

 

2.16%

 

2.63%

 

2.99%

 

3.68%

 

1.97%

 

Net charge-offs (recoveries) to average loans

 

 

0.03%

 

1.32%

 

1.75%

 

2.96%

 

2.83%

 

 

(1) No cash dividends were paid during the periods presented.

(2) Actual shares have been adjusted to fully reflect stock dividends and stock splits.

(3) Net interest margin represents net interest income as a percentage of average interest-earning assets.

(4) The efficiency ratio is defined as total non-interest expense as a percent of the combined net interest income plus non-interest income, exclusive of gains and losses on security sales, other than temporary impairment losses, gains and losses on sale of OREO and other OREO related costs and gains and losses on sale of fixed assets.

(5) Non-performing loans are defined as loans that are past due 90 days or more as well as loans placed in non-accrual status.

(6) Non-performing assets are defined as assets that are past due 90 days or more and loans placed in non-accrual status plus other real estate owned.

 

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Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operation

 

The following discussion and analysis should be read in conjunction with the Heritage Oaks Bancorp’s (“Company”, “we”, or “our”) Consolidated Financial Statements and notes filed in this Form 10-K, herein referred to as “the Consolidated Financial Statements” included and incorporated by reference herein.  “Bancorp” will be used in this discussion when referring only to the holding company as distinct from the consolidated company.  “Bank” will be used when referring to Heritage Oaks Bank.

Overview

 

Financial Highlights

Net income for the twelve months ended December 31, 2013 was $10.8 million, or $0.37 per diluted common share as compared with $13.0 million, or $0.44 per diluted common share for the twelve months ended December 31, 2012 and $7.7 million, or $0.24 per diluted common share, for the twelve months ended December 31, 2011.  The significant factors impacting the Company’s net income for the twelve months ended December 31, 2013 were:

·                  Net interest income declined for the twelve months ended December 31, 2013 as compared to the same period in 2012 largely due to the continued impact of net interest margin compression.  This compression reflects the decline in yields on our investments and loan portfolios attributable to the historically low interest rate environment and increasing competition in our lending market.  Net interest income was $41.5 million, or 4.03% of average interest earning assets (“net interest margin”), for 2013 compared with $42.5 million, or a 4.46% net interest margin for 2012.

·                  No provision for loan losses was recorded for the twelve months ended December 31, 2013, compared with $7.7 million for 2012. The lack of provisioning in 2013 was due to continued improvements in the overall credit quality for the loan portfolio, an improvement in historical loan charge-off experience and a change in the mix of loans to products with lower credit risk.

·                  Non-interest income increased $0.3 million to $12.8 million in 2013 from $12.5 million for 2012.  Higher non-interest income during 2013 compared with 2012 is primarily the result of $3.9 million of gains on the sale of investment securities, which gains were largely due to the sale of $89.3 million of securities in the first quarter of 2013.  These securities were sold to reduce the overall duration of the investment securities portfolio to limit interest rate risk and to provide a funding source for our growing loan demand.  The increase in the gain on sale of investment securities was partially offset by a reduction in gains on mortgage sales of $1.3 million due to a decline in the level of refinancing activity attributable to the increase in the long-term mortgage rates over the last three quarters.

·                  A $0.4 million increase in non-interest expense, which totaled $36.6 million in 2013, largely due to $1.1 million in merger and integration costs related to the pending Mission Community Bank merger, as well as increases in employee compensation costs due to the reintroduction of incentive compensation plans in the second half of 2012, merit increases and higher variable compensation.  Additionally, there was an increase in other expense due to increased lending costs to support the growth in the loan portfolio and settlement costs attributable to resolution of legal matters.  These increases were partially offset by decreases in regulatory assessment costs, mortgage repurchase provisions and professional services costs.

·                  Income taxes increased $8.8 million due to taxes for 2012 including the reversal of our remaining $5.6 million of deferred tax valuation allowance, as compared to an income tax expense of $7.0 million in 2013.  The remaining $3.2 million of the increase in taxes was largely due to improvement in pretax income from $11.2 million in 2012 to $17.8 million in 2013.

Critical Accounting Policies and Estimates

 

Our accounting policies are integral to understanding the Company’s financial condition and results of operations.  Accounting policies management considers to be significant, including newly issued standards to be adopted in future periods, are disclosed in Note 1. Summary of Significant Accounting Policies, of the Consolidated Financial Statements filed in this Form 10-K. The following discussions should be read in conjunction with the Consolidated Financial Statements appearing in Item 8. of this Form 10-K.

 

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Table of Contents

 

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ materially from those estimates.

 

Estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses, the valuation of real estate acquired through foreclosure, the carrying value of the Company’s deferred tax assets and estimates used in the determination of the fair value of certain financial instruments.

 

Allowance for Loan Losses and Valuation of Foreclosed Real Estate

 

In connection with the determination of the specific credit component of the allowance for loan losses for non-performing loans in the loan portfolio and the value of foreclosed real estate, management obtains independent appraisals at least once a year for significant properties.  While management uses available information to recognize losses on non-performing loans and foreclosed real estate, future additions to the allowance for loan losses may be necessary based on changes in local economic conditions or other factors outside our control.

 

The general portfolio component of the allowance is determined by pooling performing loans by collateral type and purpose.  These loans are then further segmented by an internal loan grading system that classifies loans as: pass, special mention, substandard and doubtful.  Estimated loss rates are then applied to each segment according to loan grade to determine the amount of the general portfolio allocation.  Estimated loss rates are determined through an analysis of historical loss rates for each segment of the loan portfolio, based on the Company’s prior experience with such loans.  In addition, qualitatively determined adjustments are made to the historical loss history to give effect to certain internal and external factors that may have either a positive or negative impact on the overall credit quality of the loan portfolio.

 

Because of all the variables that go into the determination of both the specific and general allocation components of the allowance for loan losses, as well as the valuation of foreclosed real estate, it is reasonably possible that the allowance for loan losses and foreclosed real estate values may change in future periods and those changes could be material and have an adverse effect on our financial condition and results of operations.  See also Note 5. Allowance for Loan Losses, of the Consolidated Financial Statements, filed in this Form 10-K.

 

Realizability of Deferred Tax Assets

 

The Company uses an estimate of its future earnings in determining if it is more likely than not that the carrying value of its deferred tax assets will be realized over the period they are expected to reverse.  If based on all available evidence, the Company believes that a portion or all of its deferred tax assets will not be realized; a valuation allowance must be established.  During 2010, the Company established a valuation allowance against a portion of its deferred tax assets. Based on the Company’s ongoing assessment of the realizability of its deferred tax assets, management reduced the level of the valuation allowance in 2011 and ultimately reversed the remaining valuation allowance during 2012, based upon management’s determination that it was more likely than not that the entire balance of the deferred tax assets will ultimately be realized.  See also Note 7. Deferred Tax Assets and Income Taxes, of the Consolidated Financial Statements, filed in this Form 10-K.

 

Fair Value of Financial Instruments

 

The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of pricing observability.  Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of observable pricing and a lesser degree of judgment utilized in measuring fair value.  Conversely, financial instruments rarely traded or not quoted will generally have little or no observable pricing and a higher degree of judgment is utilized in measuring the fair value of such instruments.  Observable pricing is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and the characteristics specific to the transaction.  See also Note 2. Fair Value of Assets and Liabilities, of the Consolidated Financial Statements, filed in this Form 10-K.

 

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Table of Contents

 

Results of Operations

 

Net Interest Income and Margin

 

Net interest income, the primary component of the net earnings of a financial institution, refers to the difference between the interest earned on loans, investments and other interest earning assets, and the interest paid on deposits and borrowings.  The net interest margin is the amount of net interest income expressed as a percentage of average earning assets.  Factors considered in the analysis of net interest income are the composition and volume of interest-earning assets and interest-bearing liabilities, the amount of non-interest-bearing liabilities, non-accruing loans, and changes in market interest rates.

 

The table below sets forth average balance sheet information, interest income and expense, average yields and rates and net interest income and margin for the years ended December 31, 2013, 2012 and 2011.  The average balance of non-accruing loans has been included in loan totals.

 

 

 

For The Year Ended,

 

For The Year Ended,

 

For The Year Ended,

 

 

 

December 31, 2013

 

December 31, 2012

 

December 31, 2011

 

 

 

 

 

Yield/

 

Income/

 

 

 

Yield/

 

Income/

 

 

 

Yield/

 

Income/

 

(dollar amounts in thousands)

 

Balance

 

Rate

 

Expense

 

Balance

 

Rate

 

Expense

 

Balance

 

Rate

 

Expense

 

Interest Earning Assets

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investments with other banks

 

$

-   

 

0.00

%

 $

-   

 

$

-   

 

0.00

%

 $

-   

 

$

58

 

1.72

%

 $

1

 

Interest bearing due from banks

 

15,466

 

0.21

%

33

 

15,193

 

0.17

%

26

 

16,343

 

0.18

%

30

 

Investment securities taxable

 

217,270

 

1.83

%

3,981

 

202,109

 

2.45

%

4,944

 

188,285

 

2.82

%

5,304

 

Investment securities non taxable

 

45,234

 

3.31

%

1,495

 

57,065

 

3.42

%

1,952

 

36,888

 

4.04

%

1,490

 

Other investments

 

6,590

 

4.16

%

274

 

6,519

 

1.86

%

121

 

7,176

 

0.79

%

57

 

Loans (1) (2)

 

747,018

 

5.30

%

39,610

 

672,929

 

5.84

%

39,278

 

667,606

 

6.19

%

41,345

 

Total interest earning assets

 

1,031,578

 

4.40

%

45,393

 

953,815

 

4.86

%

46,321

 

916,356

 

5.26

%

48,227

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Allowance for loan losses

 

(17,937

)

 

 

 

 

(19,169

)

 

 

 

 

(22,895

)

 

 

 

 

Other assets

 

105,693

 

 

 

 

 

90,315

 

 

 

 

 

83,527

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

1,119,334

 

 

 

 

 

$

1,024,961

 

 

 

 

 

$

976,988

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest Bearing Liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest bearing demand

 

$

78,055

 

0.10

%

 $

81

 

$

67,986

 

0.11

%

 $

77

 

$

64,187

 

0.15

%

 $

95

 

Savings

 

40,548

 

0.10

%

40

 

35,769

 

0.10

%

36

 

32,153

 

0.14

%

46

 

Money market

 

302,998

 

0.33

%

1,000

 

289,079

 

0.36

%

1,034

 

275,278

 

0.50

%

1,367

 

Time deposits

 

200,249

 

0.87

%

1,739

 

183,803

 

1.00

%

1,841

 

214,677

 

1.39

%

2,974

 

Total interest bearing deposits

 

621,850

 

0.46

%

2,860

 

576,637

 

0.52

%

2,988

 

586,295

 

0.76

%

4,482

 

Federal Home Loan Bank borrowing

 

59,063

 

1.42

%

840

 

50,153

 

1.27

%

638

 

38,527

 

0.97

%

372

 

Junior subordinated debentures

 

8,248

 

2.02

%

167

 

8,248

 

2.33

%

192

 

8,248

 

2.05

%

169

 

Other secured borrowing

 

-   

 

0.00

%

-   

 

-   

 

0.00

%

-   

 

3

 

0.00

%

-   

 

Total borrowed funds

 

67,311

 

1.50

%

1,007

 

58,401

 

1.42

%

830

 

46,778

 

1.16

%

541

 

Total interest bearing liabilities

 

689,161

 

0.56

%

3,867

 

635,038

 

0.60

%

3,818

 

633,073

 

0.79

%

5,023

 

Non interest bearing demand

 

282,060

 

 

 

 

 

243,304

 

 

 

 

 

208,646

 

 

 

 

 

Total funding

 

971,221

 

0.40

%

3,867

 

878,342

 

0.43

%

3,818

 

841,719

 

0.60

%

5,023

 

Other liabilities

 

10,306

 

 

 

 

 

9,227

 

 

 

 

 

10,445

 

 

 

 

 

Total liabilities

 

981,527

 

 

 

 

 

887,569

 

 

 

 

 

852,164

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ Equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total stockholders’ equity

 

137,807

 

 

 

 

 

137,392

 

 

 

 

 

124,824

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

1,119,334

 

 

 

 

 

$

1,024,961

 

 

 

 

 

$

976,988

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest margin (3)

 

 

 

4.03

%

 

 

 

 

4.46

%

 

 

 

 

4.71

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate spread

 

 

 

3.84

%

 $

41,526

 

 

 

 

4.26

%

 $

42,503

 

 

 

 

4.47

%

 $

43,204

 

 

(1) Non-accruing loans have been included in total loans.

(2) Loan fees have been included in interest income computation.

(3) Net interest margin has been calculated by dividing the net interest income by total average earning assets.

 

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Table of Contents

 

The volume and rate variances table below sets forth the dollar difference in interest earned and paid for each major category of interest-earning assets and interest-bearing liabilities for each of the years ended December 31, 2013 and 2012 and the amount of such change attributable to changes in average balances (volume) or changes in average yields and rates:

 

 

 

For The Year Ended,

 

For The Year Ended,

 

 

 

December 31, 2013

 

December 31, 2012

 

(dollar amounts in thousands)

 

Volume

 

Rate

 

Rate/Volume

 

Total

 

Volume

 

Rate

 

Rate/Volume

 

Total

 

Interest income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investments with other banks

 

$

-    

 

$

-    

 

$

-    

 

$

-    

 

$

(1

)

$

(1

)

$

1

 

$

(1

)

Interest bearing due from banks

 

-    

 

7

 

-    

 

7

 

(2

)

(2

)

-    

 

(4

)

Investment securities taxable

 

371

 

(1,241

)

(93

)

(963

)

389

 

(698

)

(51

)

(360

)

Investment securities non-taxable (1)

 

(614

)

(100

)

21

 

(693

)

1,235

 

(345

)

(189

)

701

 

Taxable equivalent adjustment (1)

 

209

 

34

 

(7

)

236

 

(420

)

117

 

64

 

(239

)

Other investments

 

1

 

150

 

2

 

153

 

(5

)

76

 

(7

)

64

 

Loans

 

4,324

 

(3,596

)

(396

)

332

 

330

 

(2,378

)

(19

)

(2,067

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net increase / (decrease)

 

4,291

 

(4,746

)

(473

)

(928

)

1,526

 

(3,231

)

(201

)

(1,906

)

Interest expense:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Savings, NOW, money market

 

84

 

(102

)

(8

)

(26

)

86

 

(423

)

(24

)

(361

)

Time deposits

 

165

 

(246

)

(21

)

(102

)

(428

)

(824

)

119

 

(1,133

)

Federal Home Loan Bank borrowing

 

113

 

75

 

14

 

202

 

112

 

118

 

36

 

266

 

Long term borrowings

 

-    

 

(25

)

-    

 

(25

)

-    

 

23

 

-    

 

23

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net increase / (decrease)

 

362

 

(298

)

(15

)

49

 

(230

)

(1,106

)

131

 

(1,205

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total net increase / (decrease)

 

$

3,929

 

$

(4,448

)

$

(458

)

$

(977

)

$

1,756

 

$

(2,125

)

$

(332

)

$

(701

)

 

(1) Adjusted to a fully taxable equivalent basis using a tax rate of 34%.

 

Discussion of 2013 Compared to 2012

 

For the years ended December 31, 2013 and 2012, net interest income was $41.5 million and $42.5 million, respectively, and net interest margin was 4.03% and 4.46%, respectively. During 2013, the impact of the continued current low interest rate environment has had an adverse impact on yields on new and renewing loans. In addition, the low interest rate environment and relative flatness of interest yield curves have had a two-fold impact on securities’ yields as new investments are typically providing lower yields, and existing investments in mortgage backed securities realized increased levels of refinancing of the underlying mortgages, which led to increased prepayment activity during most of 2013, which resulted in acceleration of the amortization of premiums paid on these securities.  These factors have combined to reduce the yield on earning assets for the year ended December 31, 2013 by 46 basis points. This improvement in the mix of earning assets, with a higher percentage of such assets invested in higher yielding loans, helped mitigate some of the downward pressures on net interest margin.   The declines in the yield on earning assets was marginally offset by improvements in the cost of funds that were largely due to shifts in the composition of deposits from interest bearing accounts to more liquid non-interest bearing deposit accounts, coupled with reductions in the rates of interest paid on interest bearing deposits, largely due to new and renewing certificates of deposit bearing lower interest rates.

 

Forgone interest on non-accrual loans continued to adversely impact interest income for the year ended December 31, 2013, but to a lesser degree than during 2012. Total forgone interest related to non-accrual loans, which includes (1) the initial accrued interest reversal when a loan is transferred to non-accrual status, (2) interest lost prospectively for the period of time a loan is on non-accrual status and (3) lost interest due to restructuring terms below original note terms or below current market-rate terms, was approximately $1.0 million and $1.4 million for the years ended December 31, 2013 and 2012, respectively.

 

Our earnings are directly influenced by changes in interest rates.  The nature of our balance sheet can be summarily described as consisting of short duration assets and liabilities and slightly net asset sensitive, meaning that changes in interest rates have a slightly more immediate impact on asset yields than they do on liability rates. A large percentage of our interest sensitive assets and liabilities re-price immediately with changes in the Prime Rate and other capital markets interest rates.  Declines in interest rates have resulted in a significant portion of the loan portfolio reaching floor rates.  To the extent that overall interest rates rise, the Company will not experience the benefit of rising interest rates until such rates rise above such interest rate floors. However, modifications in the loan floor rates over the last twelve to eighteen months, primarily as part of loan renewals, have further contributed to the decline in current yields on our loan portfolio but have effectively reduced the level of upward interest rate movement required to see future improvement in yields on impacted loans.  See Item 7A. Qualitative and Quantitative Disclosures About Market Risk, included in this Form 10-K for further discussion of the Company’s sensitivity to interest rate movements based on our current net asset sensitive profile, as well as the impacts of interest rate floors on the variable rate component of our loan portfolio.

 

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Table of Contents

 

For the year ended December 31, 2013, average interest-earning assets were $77.8 million, or 8.2%, higher than that reported for the year ended December 31, 2012.  Growth in average earning assets for 2013 was largely driven by growth in the average loan balances of $74.1 million, or 11.0% as compared to 2012.  The Company’s average investment in its securities portfolio increased by $3.3 million in 2013, as compared to 2012.  The relative increase in higher yielding loans as compared to investment securities served to mitigate the impacts in declines in net interest margin.

 

The decline in the yield on interest-earning assets for the year ended December 31, 2013 can be attributed to two key factors: declines in the average returns on the loan portfolio due to continued downward rate pressure on new loans and renewals;  and declines in the yields on the investment securities purchased over the last year due to continued market pressures on interest rates and the repositioning of the investment portfolio in the first quarter of 2013.  The adverse impacts of the declines in investment security and loan yields during 2013 were partially offset by the declines in the level of interest reversals and forgone interest on non-accruing loans and lost interest due to troubled debt restructuring (“TDR”) rate concessions.

 

For the year ended December 31, 2013, the yield on the loan portfolio declined 54 basis points to 5.30% from the year ended December 31, 2012. This decline was largely attributable to declines in interest rates on new loans issued and loans renewed, which were driven by increased competition in the Company’s primary market area and the historically low capital market interest rates aimed at fostering the economic recovery.  In addition, interest income for 2013 included $0.3 million of interest recoveries on the pay-off of non-accrual loans, as well as prepayment penalties and related accelerations of unearned fees on loan payoffs, which represented $0.1 million less than was realized in 2012. This decline in prepayment income in 2013 represented less than 1 basis point of the decline in yield in 2013 as compared to 2012. These downward pressures on loan yields were partially offset by a decline in the level of forgone interest on non-accrual loans from $1.4 million to $1.0 million for the years ended December 31, 2012 and 2013, respectively. Total forgone interest on non-accrual loans reduced the yield on the loan portfolio by 13 basis points for the year ended December 31, 2013, as compared to 15 basis points for the year ended December 31, 2012.

 

The Company invests excess liquidity primarily in agency mortgage backed securities and municipal securities, in an effort to maximize the yield on interest earning assets pending investment in new loan originations. Purchases made during the latter part of 2012, along with the impacts of recent efforts to shorten the duration of the securities portfolio by selling some of our longer-duration investments and replacing them with shorter duration instruments has contributed to the decline in the overall yield on investment securities as the recently acquired investment securities currently yield considerably less than other investments in the portfolio. Assuming that the loan growth experienced over the past eighteen months continues over the next year, we should realize further improvement in the mix of interest earning assets, which should help mitigate further compression on our net interest margin, but no assurances can be given with respect to any of the foregoing.

 

The average balance of interest bearing liabilities was $54.1 million higher for the year ended December 31, 2013, than that reported for the year ended December 31, 2012.  The year to date increase in the average balance of interest bearing liabilities can be attributed to $45.2 million increase in average interest bearing deposits to $621.9 million for the year ended December 31, 2013.  Growth in interest bearing deposits has been primarily the result of the ongoing efforts to gather deposits across the Bank’s service territory, as well as the impacts of the Morro Bay branch acquisition completed in December 2012.  Much of the growth in interest bearing deposits has been in lower cost deposit types, which has helped to control our overall cost of funds.  In addition to the growth in interest bearing deposits, the level of average FHLB borrowings at December 31, 2013 increased $8.9 million, compared to the corresponding period in 2012 to support the growth in the loan portfolio in 2013.

 

The rate paid on interest bearing deposits declined by 6 basis points, to 0.46% for the year ended December 31, 2013 as compared to the year ended December 31, 2012.  This decline is in part due to the historically low interest rate environment that has existed for the last few years, but is also due to our efforts to systematically lower our cost of deposits over this same time period.    In addition to the favorable effects realized from these changes in our interest bearing deposits, our average non-interest bearing demand deposit balances have increased by $38.8 million, to $282.1 million for the year ended December 31, 2013.  These increases in non-interest bearing demand deposit balances have served to reduce our total funding cost by 3 basis points to 0.40% for the year ended December 31, 2013.  Management believes that the increase in non-interest bearing demand deposits is indicative of money being held in highly liquid accounts pending the customer’s determination of how best to invest the funds in light of today’s low returns on traditional investments.  As such, it is difficult to determine how long the increased levels of non-interest bearing demand deposits will remain at or near the current levels and therefore how long we will benefit from this low cost source of funds.

 

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Table of Contents

 

For the year ended December 31, 2013, the average rate paid on interest bearing liabilities was 0.56% as compared to 0.60% for the year ended December 31, 2012.  The year over year decline can be attributed in large part to the deposit portfolio rate reductions previously discussed. This decline was partially offset by an increase in funding costs for the Federal Home Loan Bank (“FHLB”) borrowings due to a strategy designed to lock in historically low fixed rates on longer term borrowings to match fund longer term fixed rate loans.

 

Discussion of 2012 Compared to 2011

 

For the years ended December 31, 2012 and 2011, net interest income was $42.5 million and $43.2 million, respectively, and net interest margin was 4.46% and 4.71%, respectively. During 2012 increased competition, coupled with the impact of a slow economy and low interest rate environment, had an adverse impact on yields on new and renewing loans. In addition, the low interest rate environment had a two-fold impact on securities’ yields as new investments are typically providing lower yields and existing investments in mortgage backed securities experienced increased levels of refinancing of the underlying mortgages, which results in acceleration of the amortization of premiums paid on these securities.  All of these factors combined to reduce the yield on earning assets for the year ended December 31, 2012 by 40 basis points. The mix of average earning assets for the year ended December 31, 2012 also contributed to the decline in the yield on earning assets, as a larger percentage of earning assets was invested in lower yielding securities as opposed to higher yielding loans.  However, the loan portfolio grew late in the second half of 2012, which contributed to a more favorable earning asset mix.  This growth helped mitigate some of the downward pressures on net interest margin.  The declines in the yield on earning assets was partially offset by improvements in the cost of funds that were largely due to shifts in the composition of deposits from interest bearing accounts to more liquid and fully insured non-interest bearing deposit accounts, coupled  with reductions in the rates of interest paid on interest bearing deposits.

 

Forgone interest on non-accrual loans continued to adversely impact interest income for the year ended December 31, 2012. Total forgone interest related to non-accrual loans, which includes (1) the initial accrued interest reversal when a loan is transferred to non-accrual status, (2) interest lost prospectively for the period of time a loan is on non-accrual status and (3) lost interest due to restructuring terms below original note terms or below current market-rate terms, was approximately $1.4 million and $1.7 million for the years ended December 31, 2012 and 2011, respectively.

 

For the year ended December 31, 2012, average interest-earning assets were $37.4 million, or 4.1%, higher than that reported for the year ended December 31, 2011.  The Company’s average investment in its securities portfolio increased by $34.0 million in 2012, as compared to 2011.  Increases in the relative percentage of the securities portfolio during 2012 as compared to higher yielding loans negatively impacted net interest margin.

 

The decline in the yield on interest-earning assets for the year ended December 31, 2012 can be attributed to three key factors: declines in the average returns on the loan portfolio due to continued downward rate pressure on new loans and renewals;  the change of the mix of interest-earning assets away from higher yielding loans to lower yielding investment securities, discussed above; and declines in the yields on the investment securities purchased over the last year due to continued market pressures on interest rates.  The adverse impacts of the shift in interest-earning assets and declines in investment security and loan yields during 2012 were partially offset by the declines in the level of interest reversals and forgone interest on non-accruing loans and lost interest due to troubled debt restructuring (“TDR”) rate concessions.

 

For the year ended December 31, 2012, the yield on the loan portfolio declined 35 basis points to 5.84% from the year ended December 31, 2011. This decline was largely attributable to declines in interest rates on new loans issued and loans renewed, which were driven by increased competition in the Company’s primary market area and the historically low interest rates set by the government to improve the economic recovery.  In addition, interest income for 2011 included $0.4 million of interest recoveries on the pay-off of non-accrual loans, as well as prepayment penalties and related accelerations of unearned fees on loan payoffs, which represented $0.1 million more than was realized in 2012. This decline in prepayment income in 2012 represented 1 basis point of the decline in yield in 2012 as compared to 2011. These downward pressures on loan yields were partially offset by a decline in the level of forgone interest on non-accrual loans from $1.7 million to $1.4 million for the years ended December 31, 2011 and 2012, respectively. Total forgone interest on non-accrual loans reduced the yield on the loan portfolio by 15 basis points for the year ended December 31, 2012, as compared to 19 basis points for the year ended December 31, 2011.

 

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Beginning in 2009 and continuing through the first quarter of 2012, new loan originations slowed due in part to a decline in loan demand and in part due to the impact of tighter underwriting standards resulting in fewer loans that met our underwriting criteria in the current economic environment.  As a result, in an effort to maximize the yield on interest earning assets in the absence of significant new loan originations, we invested excess liquidity primarily in agency mortgage backed securities and municipal securities.  These purchases account for the majority of the year over year increase in the average balance of the investment portfolio and the decline in the overall yield of taxable investment securities as these recently acquired investment securities currently yield considerably less than other investments in the portfolio.

 

The average balance of interest bearing liabilities was $1.9 million higher for the year ended December 31, 2012, than that reported for the year ended December 31, 2011.  The year to date increase in the average balance of interest bearing liabilities can be attributed to $11.6 million increase in Federal Home Loan Bank (“FHLB”) borrowings as the Company chose to draw down additional long-term advances in 2012 to lock in historically low, long-term fixed rate funds.  This increase in borrowings was partially offset by declines in interest bearing deposits, most notably time deposits.  We attribute the decrease in time deposits in part to the migration to other interest bearing account categories, such as savings, and non-interest bearing deposits as customers weighed their investment alternatives in the current low interest rate environment and were reluctant to commit funds to time deposits given low market yields.

 

The rate paid on interest bearing deposits declined by 24 basis points, to 0.52% for the year ended December 31, 2012 as compared to the year ended December 31, 2011.  These declines are in part due to the historically low interest rate environment that has existed for the last few years, but are also due to our efforts to systematically lower our cost of deposits over this same time period.  Although such efforts have contributed to a moderate decline in time deposits, the overall deposit mix and cost of our deposit portfolio has improved as a result of these factors.

 

While we have experienced a decline in average interest bearing deposits during 2012 as compared with 2011, our average non-interest bearing demand deposit balances have increased on a comparative basis by $34.7 million to $243.3 million during 2012.  This increase in non-interest bearing demand balances has served to reduce our total funding cost by 17 basis points for the year ended December 31, 2012, as compared to the 0.60% cost of our interest bearing liabilities. Our total cost of funds for the year ended December 31, 2012, was 0.43%, a decrease of 17 basis points as compared to 2011.

 

For the year ended December 31, 2012, the average rate paid on interest bearing liabilities was 0.60% as compared to 0.79% for the year ended December 31, 2011.  The year over year decline can be attributed in large part to the deposit portfolio rate reductions previously discussed. This decline was partially offset by an increase in funding costs for the Federal Home Loan Bank borrowings due to a strategy designed to lock in historically low fixed rates on longer term borrowings as compared to the Company’s traditional reliance on a heavier mix of lower cost, variable rate short-term borrowings.

 

Provision for Loan Losses

 

As more fully discussed in Note 5. Allowance for Loan Losses, of the Consolidated Financial Statements, filed in this Form 10-K, the allowance for loan losses has been established for probable credit losses inherent in the loan portfolio.  The allowance is maintained at a level considered by management to be adequate to provide for probable credit losses inherent in the loan portfolio as of the balance sheet date and is based on methodologies applied on a consistent basis with the prior year.  Management’s review of the adequacy of the allowance includes, among other things, an analysis of past loan loss experience and management’s evaluation of the loan portfolio under current economic conditions.

 

The allowance for loan losses is based on estimates, and actual losses may vary from current estimates, which variances could be material and could have an adverse effect on the Company’s performance.  The Company recognizes that the risk of loss will vary with, among other things: general economic conditions; the type of loan being made; the creditworthiness of the borrower over the term of the loan and in the case of a collateralized loan, the value of the collateral for such loans.  The allowance for loan losses represents the Company’s best estimate of the allowance necessary to provide for probable incurred credit losses inherent in the loan portfolio as of the balance sheet date.  For additional information see the “Allowance for Loan Losses” discussion in the Financial Condition section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

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Discussion of 2013 Compared to 2012

 

A provision for loan losses was not recorded for year ended December 31, 2013 as compared to a provision for loan losses of $7.7 million for the year ended December 31, 2012; representing a decrease of $7.7 million as compared to the amount reported in 2012.  The lack of a loan loss provision in 2013 is reflective of the continuing improvements in the overall credit quality of the loan portfolio, the overall improvement in the charge-off history over the last year, the improvement in property values that serve as collateral for a large portion of our loans, as well as the limited amount of new loans moving into non-accrual status and therefore requiring specific reserves.  As of December 31, 2013, the Company’s allowance for loan losses represented 2.16% of total gross loans. Specifically, the Company experienced the level of provisions for loan losses in 2012 were primarily attributable to increased reserve requirements associated with specific reserve calculations and related charge-offs for a few large loans in the first half of 2012. For additional information see the “Allowance for Loan Losses” discussion in the Financial Condition section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

Discussion of 2012 Compared to 2011

 

The Company’s provision for loan losses was $7.7 million for the year ended December 31, 2012. This represents an increase of $1.6 million as compared to the amount reported in 2011. In 2012, the Company migrated to a more granular loan risk grading scale after completing a risk grade recertification and full review of all loan relationships equal to or greater than $500 thousand, which represented 74% of gross loans at the time the review was performed. While this review was primarily focused on ensuring existing loans were properly graded based on the new methodology, it provided additional insights on the overall credit quality of this portion of the portfolio.  The increase in the provision for loan losses in 2012 as compared to the corresponding period in 2011 was primarily attributable to increased reserve requirements associated with specific reserve calculations and related charge-offs for a few large loans in the first half of 2012. The incremental provision requirements for these increases in specific reserves during 2012 were partially offset by reduced provision requirements on the majority of the remaining loan portfolio due to: continued improvement in our historical loss data as older higher loss level periods roll out of the loss history window and are replaced by more recent losses at lower loss rates; and improvements in the qualitative portfolio factors which resulted from improvements in both the national and local economic indicators. Both of these factors form the principal basis for the general reserve portion of the allowance for loan losses.  As of December 31, 2012, the Company’s allowance for loan losses represented 2.63% of total gross loans.  For additional information see the “Allowance for Loan Losses” discussion in the Financial Condition section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

Non-Interest Income

 

The table below sets forth changes for 2013, 2012, and 2011 in non-interest income:

 

 

 

For The Years Ended

 

Variances

 

 

 

December 31,

 

2012

 

2011

 

(dollar amounts in thousands)

 

2013

 

2012

 

2011

 

dollar

 

percentage

 

dollar

 

percentage

 

Fees and service charges

 

$

4,529

 

$

4,350

 

$

4,085

 

$

179

 

4.1%

 

$

265

 

6.5%

 

Mortgage gain on sale and origination fees

 

2,924

 

4,263

 

2,645

 

(1,339

)

-31.4%

 

1,618

 

61.2%

 

Gain on sale of investment securities

 

3,926

 

2,619

 

1,983

 

1,307

 

49.9%

 

636

 

32.1%

 

Gain / (loss) on sale of other real estate owned

 

-    

 

199

 

(543

)

(199

)

-100.0%

 

742

 

-136.6%

 

Other income

 

1,496

 

1,117

 

1,560

 

379

 

33.9%

 

(443

)

-28.4%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

12,875

 

$

12,548

 

$

9,730

 

$

327

 

2.6%

 

$

2,818

 

29.0%

 

 

Discussion of 2013 Compared to 2012

 

Non-interest income increased by $0.3 million, or 2.6%, for the year ended December 31, 2013 compared with the amount reported for 2012.  The primary drivers for the higher non-interest income was a $1.3 million increase in the gains realized on sale of investment securities and a $0.4 million increase in the gain realized on the sale of SBA loans, which is reflected in other income.  Gains on sales of investment securities during the 2013 were driven by increased sales activity in the first quarter of 2013, as the Company repositioned portions of its investment portfolio to shorten their effective duration, to reduce exposure to future unfavorable movement in interest rates, and to reduce further exposure to interest rate volatility due to unexpected changes in prepayment speeds on certain mortgage backed securities.  Specifically, during the first quarter of 2013, the Company sold securities with a carrying value of $89.3 million that resulted in gains of $3.6 million.  The gain on sale of SBA loans reflects the first SBA loan sales the Company has undertaken since 2010.  These increases in non-interest income were largely offset by a $1.3 million reduction in mortgage gain on sale, largely due to a decline in refinance activity during the second half of 2013, and a $0.2 million reduction in gain on sale of other real estate owned (“OREO”) due to the limited OREO sales activity in 2013 not yielding any gains.  The pipeline for potential mortgages as of December 31, 2013 remains lower than it was at the end of 2012 due primarily to increases in long term mortgage rates. While we would not expect modest increases in mortgage rates to have a further material impact on near-term mortgage volumes, a large upward move in rates could have a further adverse impact on the refinance market, the effects of which we believe could be partially mitigated by purchase mortgage originations increasing, as buyers have historically tended to accelerate purchase decisions in the face of a rising rate environment.

 

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Discussion of 2012 Compared to 2011

 

Non-interest income increased by $2.8 million, or 29.0%, for the year ended December 31, 2012 compared with the amount reported for 2011.  The primary drivers for the increases were increases in mortgage gain on sale and origination fees, improvements in the gain/(loss) on sale of OREO and improved gains on sale of investment securities.  The increase in the mortgage related income was driven by investments we have made over the past year in the infrastructure and staffing levels of our mortgage banking business, which when combined with the current favorable interest rate environment led to increased refinancing and new home purchase loan activity and correspondingly to increased mortgage gain on sale and fee income as compared to the prior year.

 

The improvement in the gain/(loss) on sale of OREO is attributable to a more stable real estate market, the reduced level of OREO holdings in 2012 and reduced risk of loss in value due to the passage of time, as average OREO assets turned over more quickly in 2012 than in 2011. The increase in gain on sale of investment securities was primarily driven by the narrowing of credit spreads, which improved the fair market value of the securities portfolio during 2012 which translated into greater gain on sale of such securities. Specifically, during 2012, the Company sold $140.2 million of securities that resulted in gains of $2.6 million, compared with $147.2 million of securities sold in 2011 that resulted in gains of $2.0 million.  Much of the gain realized on the sale of investment securities in 2012 was in conjunction with management repositioning elements of the investment portfolio in an attempt to reduce the impacts of accelerating prepayment speeds on certain mortgage back securities and to eliminate the investment in corporate debt securities.

 

Non-Interest Expenses

 

The table below sets forth changes in non-interest expense for 2013, 2012 and 2011:

 

 

 

For the Years Ended

 

Variances

 

 

 

December 31,

 

2012

 

2011

 

(dollar amounts in thousands)

 

2013

 

2012

 

2011

 

dollar

 

percentage

 

dollar

 

percentage

 

Salaries and employee benefits

 

$

18,977

 

$

18,304

 

$

17,630

 

$

673

 

3.7%

 

$

674

 

3.8%

 

Occupancy

 

3,215

 

3,287

 

3,771

 

(72

)

-2.2%

 

(484

)

-12.8%

 

Information technology

 

2,582

 

2,553

 

2,975

 

29

 

1.1%

 

(422

)

-14.2%

 

Professional services

 

2,833

 

3,546

 

2,786

 

(713

)

-20.1%

 

760

 

27.3%

 

Regulatory

 

1,007

 

1,596

 

2,360

 

(589

)

-36.9%

 

(764

)

-32.4%

 

Equipment

 

1,676

 

1,613

 

1,739

 

63

 

3.9%

 

(126

)

-7.2%

 

Sales and marketing

 

584

 

690

 

668

 

(106

)

-15.4%

 

22

 

3.3%

 

Foreclosed asset costs and write-downs

 

180

 

334

 

1,868

 

(154

)

-46.1%

 

(1,534

)

-82.1%

 

Provision for potential mortgage repurchases

 

570

 

1,192

 

169

 

(622

)

-52.2%

 

1,023

 

605.3%

 

Amortization of intangible assets

 

400

 

342

 

445

 

58

 

17.0%

 

(103

)

-23.1%

 

Merger and integration

 

1,051

 

-    

 

-    

 

1,051

 

100.0%

 

-    

 

0.0%

 

Other expense

 

3,488

 

2,674

 

2,907

 

814

 

30.4%

 

(233

)

-8.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

36,563

 

$

36,131

 

$

37,318

 

$

432

 

1.2%

 

$

(1,187

)

-3.2%

 

 

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Table of Contents

 

Discussion of 2013 Compared to 2012

 

Total non-interest expense increased by approximately $0.4 million in 2013 as compared with 2012, and was primarily driven by a $1.1 million increase in merger and integration costs related to the pending merger with Mission Community Bank, a $0.7 million increase in salaries and employee benefit costs, and $0.8 million increase in other expenses.   The increase in merger and integration costs reflect the costs of due diligence, regulatory and SEC related filing costs, as well as initial integration planning costs associated with the Mission Community Bank merger, for which there were no comparable costs in 2012.  The increased salary and benefit costs were associated with increased costs related to variable bonus plans in 2013, as 2013 included a full year of such bonus plans whereas 2012 only included such plans for the second half of the year.  Salaries and employee benefit costs were also impacted by merit increases across the organization in 2013.  The increase in other expenses  were due to increases in other loan costs due to increased loan production in 2013, as compared to 2012, and settlement costs attributable to resolution of legal matters.  Off-setting these non-interest expense increases were decreases in provisions for mortgage repurchases, professional services and regulatory costs totaling $1.9 million.  The decrease in the provision for potential mortgage repurchases in 2013 was largely driven by 2012 including increased provisioning for estimated losses related to a step up in claims activity in the second quarter of 2012 associated with a group of related mortgages funded and sold in 2007.  The Company provided for the remaining three loans in the group of related mortgages in the first quarter of 2013 and management does not expect there to be any further material provisions required for this group of related loans.  Repurchase requests like these are relatively rare for the Bank.  Total cash paid in settlement for mortgage repurchases has been $1.6 million in the prior 8 years.  We do not believe the requests are in any way indicative of systemic problems with the Bank’s underwriting or origination process of mortgage loans held for sale or that there is significant exposure to repurchase requests other than those arising from the group of related loans to the borrowers in question, which totaled $2.8 million inclusive of the approximately $0.6 million of mortgage repurchases provided for in the first quarter of 2013.  The decline in professional services costs in 2013 as compared to the corresponding period in 2012 is primarily related the Company hiring consultants in 2012 to aid in identifying and implementing operating efficiency initiatives across the organization, which effort was largely completed in the second half of 2012.  The decline in the level of regulatory costs is reflective of the favorable impacts on FDIC assessment costs due to the termination of the Consent Order and the Written Agreement in the second and third quarters of 2012, respectively, and the termination of the MOUs with the FDIC, DBO and FRB in the second and third quarters of 2013.

 

Discussion of 2012 Compared to 2011

 

The decline in non-interest expense for 2012 compared with 2011 was largely caused by a $1.5 million reduction in the level write-downs of foreclosed assets and OREO related expenses as a result of the OREO balance being significantly reduced in 2012 as compared to 2011.  In addition regulatory costs, occupancy costs and data processing costs declined $0.8 million, $0.5 million and $0.4 million, respectively in 2012 as compared to 2011. The decline in regulatory costs was directly related to the terminations of the Consent Order and Written Agreement in 2012 and the corresponding impacts on our FDIC assessments.  The decline in occupancy costs was largely attributable to the savings generated from our consolidation of three branches into other nearby Bank branches and the repurchase of four leased facilities, including our administrative headquarters.  The decline in data processing costs primarily reflects 2011 including one-time costs related to new vendors and data processing services that were added in 2011 that did not recur in 2012.

 

These declines in the non-interest expense categories for 2012 were partially offset by increases in the provision for potential mortgage repurchases, outside service provider expense and salaries and employee benefits. The provision for potential mortgage repurchases increased by $1.0 million.  This increase was largely driven by estimated losses primarily related to claims received in the second and fourth quarters of 2012, as previously discussed.  Repurchase requests are relatively rare for the Bank. In addition, our outside service provider expense increased by $0.9 million in 2012 as compared with 2011 largely due to our filing of registration statements related to our Series A Preferred Stock and related warrants and our Series C Preferred Stock and consulting services related to identifying operating efficiencies within the Bank.  Salaries and employee benefits increased by $0.7 million compared with 2011, largely due to increased commissions due to higher mortgage loan originations and the re-establishment in 2012 of an employee incentive compensation plan in the second half of 2012.

 

Provision for Income Taxes

 

For the year ended December 31, 2013, the Company recorded an income tax expense of approximately $7.0 million.  This compares to $1.8 million of income tax benefit in 2012.  The change in the provision for income taxes for 2013 as compared to 2012 can be attributed to the Company’s reversal of $5.6 million of deferred tax asset valuation allowance in 2012, for which there was no corresponding valuation allowance reversal in 2013, as the valuation allowance was fully reversed in the third quarter of 2012.  In addition, income tax expense increased in 2013 due to the overall increase in earnings before taxes.  The Company’s effective tax rate was 39.2% and (16.0)% for 2013 and 2012, respectively.  The Company’s effective tax rate, exclusive of the impacts of the changes in the deferred tax asset valuation allowance, was 33.9% for 2012, which rate reflects a disproportionately larger benefit of tax free municipal bond income due to the lower pre-tax income levels in 2012 as compared to 2013.

 

The determination as to whether a valuation allowance should be established against deferred tax assets is based on the consideration of all available evidence using a “more likely than not” standard.  Management evaluates the realizability of the deferred tax assets on a quarterly basis.  As a result of this evaluation in 2012, it was determined that 100% of the Company’s deferred tax assets were now more likely than not recognizable as future tax benefits, resulting in the reversal of a previously established valuation allowance of $5.6 million.  The reversal of the allowance in 2012 reflected the impacts of numerous factors, such as continued quarterly earnings and improvements in credit quality that provided adequate positive evidence as to the incremental recoverability of these deferred tax assets.  Please see Note 7. Deferred Tax Assets and Income Taxes, of the Consolidated Financial Statements, filed in this Form 10-K, for additional information concerning the Company’s deferred tax assets.

 

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Table of Contents

 

Financial Condition

 

The Company saw continued growth in the balance sheet in 2013.  At December 31, 2013, total assets were approximately $1.2 billion.  This represents an increase of approximately $106.1 million or 9.7% over that reported at December 31, 2012.  The increase in total assets is primarily attributable to the growth in the loan portfolio, partially offset by a decline in the investment portfolio and cash and cash equivalents.

 

At December 31, 2013, total deposits were approximately $973.9 million or approximately $103.0 million higher than that reported at December 31, 2012.  The increase in the level of deposits is reflective of the Bank’s continuing focus to bring new deposit relationships into the Bank and expand our existing customer relationships.  A more detailed discussion about loans and deposits, as well as the other key elements of our financial condition follows.

 

Total Cash and Cash Equivalents

 

Total cash and cash equivalents were $26.2 million and $34.1 million at December 31, 2013 and December 31, 2012, respectively. This line item will vary depending on daily cash settlement activities, the amount of highly liquid assets needed based on known events such as the repayment of borrowings or loans expected to be funded in the near future, and actual cash on hand in the branches.  The year to date decline is attributable to elevated balances at December 2012 due to the time lag between receipt of proceeds from investment security sales and maturities near the end of the month and redeployment of such funds into the investment portfolio.

 

Investment Securities and Other Earning Assets

 

Other earning assets are comprised of Interest Bearing Due from Federal Reserve, Federal Funds Sold (funds the Company lends on a short-term basis to other banks), investments in securities and short-term interest bearing deposits at other financial institutions.  These assets are maintained for liquidity needs of the Company, collateralization of public deposits, and diversification of the earning asset mix.

 

Securities Available for Sale

 

The Company manages its securities portfolio to provide a source of both liquidity and earnings.  The Company has invested in a mix of securities including obligations of U.S. government agencies, mortgage backed securities and state and municipal securities. The Company has an Asset/Liability Committee that develops investment policies based upon the Company’s operating needs and market circumstances.  The Company’s investment policy is formally reviewed and approved annually by the Board of Directors.  The Asset/Liability Committee is responsible for reporting and monitoring compliance with the investment policy.  Reports are provided to the Company’s  Board of Directors on a regular basis.

 

The following table provides a summary of investment securities by securities type as of December 31, 2013, 2012 and 2011 is as follows:

 

 

As of December 31,

 

 

 

2013

 

 

2012

 

 

2011

 

 

 

 

Amortized

 

 

 

 

 

Amortized

 

 

 

 

 

Amortized

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(dollar amounts in thousands)

 

 

Cost

 

 

Fair Value

 

 

Cost

 

 

Fair Value

 

 

Cost

 

 

Fair Value

 

Obligations of U.S. government agencies

 

$

6,243

 

$

6,208

 

$

7,307

 

$

7,567

 

$

4,209

 

$

4,326

 

Mortgage backed securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. government sponsored entities and agencies

 

 

186,981

 

 

182,931

 

 

145,430

 

 

145,768

 

 

116,732

 

 

117,325

 

Non-agency

 

 

10,924

 

 

11,032

 

 

43,402

 

 

44,795

 

 

34,667

 

 

34,532

 

State and municipal securities

 

 

51,532

 

 

50,030

 

 

64,824

 

 

68,968

 

 

49,661

 

 

51,923

 

Corporate debt securities

 

 

 

 

 

 

 

 

 

 

28,909

 

 

26,856

 

Asset backed securities

 

 

26,935

 

 

26,594

 

 

20,049

 

 

20,584

 

 

2,059

 

 

2,020

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

282,615

 

$

276,795

 

$

281,012

 

$

287,682

 

$

236,237

 

$

236,982

 

 

At December 31, 2013, the fair value of the investment portfolio was approximately $276.8 million or $10.9 million lower than that reported at December 31, 2012.  The change in the balance of the portfolio can be attributed to a decline in market value in 2013, due to rising long term interest rates.

 

Securities available for sale are carried at fair value, with related unrealized net gains or losses, net of deferred income taxes, recorded as an adjustment to equity capital.  At December 31, 2013, the securities portfolio had net unrealized losses, net of taxes, of approximately $3.4 million, a decrease of approximately $7.4 million from the unrealized gain position reported at December 31, 2012.  Fluctuations in the fair value of the investment portfolio in the last three years can be attributed to market turbulence and volatility in overall interest rates, stemming in part from continued economic conditions and uncertainty.  All fixed and adjustable rate mortgage pools contain a certain amount of risk related to the uncertainty of prepayments of the underlying mortgages, which prepayments are directly impacted by interest rate changes.  The Company uses computer simulation models to test the average life, duration, market volatility and yield volatility of adjustable rate mortgage pools under various interest rate assumptions to monitor volatility.

 

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The majority of the Company’s mortgage securities were issued by: The Government National Mortgage Association (“Ginnie Mae”), The Federal National Mortgage Association (“Fannie Mae”), and The Federal Home Loan Mortgage Corporation (“Freddie Mac”).  These securities carry the full faith and guarantee of the issuing agencies and the U.S. Federal Government.  At December 31, 2013, approximately $182.9 million or 66.1% of the Company’s mortgage related securities were issued by government agencies and government sponsored entities, such as those listed above.

 

All fixed and adjustable rate mortgage pools contain a certain amount of risk related to the uncertainty of prepayments of the underlying mortgages.  Interest rate changes have a direct impact upon prepayment rates.  The Company uses computer simulation models to test the average life, duration, market volatility and yield volatility of adjustable rate mortgage pools under various interest rate assumptions to monitor volatility.  In general, in a rising rate environment, as we are currently in, prepayment speeds tend to slow down, which extends the effective duration of this type of security and therefore makes it more susceptible to declines in fair value due solely to rising interest rates.

 

The following table sets forth the maturity distribution of available for sale securities in the investment portfolio and the weighted average yield for each category at December 31, 2013:

 

(dollar amounts in thousands)

 

One Year Or
Less

 

Over 1
Through 5
Years

 

Over 5 Years
Through 10
Years

 

Over 10 Years

 

Total

 

 

Obligations of U.S. government agencies

 

$

92

 

$

408

 

$

3,345

 

$

2,363

 

$

6,208

 

 

Mortgage backed securities

 

 

 

 

 

 

 

 

 

 

 

 

U.S. government sponsored entities and agencies

 

24,524

 

74,556

 

40,224

 

43,627

 

182,931

 

 

Non-agency

 

4,383

 

5,118

 

1,531

 

 

11,032

 

 

State and municipal securities

 

 

8,678

 

37,872

 

3,480

 

50,030

 

 

Asset backed securities

 

 

 

14,780

 

11,814

 

26,594

 

 

Total available for sale securities

 

$

28,999

 

$

88,760

 

$

97,752

 

$

61,284

 

$

276,795

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amortized cost

 

$

29,282

 

$

90,023

 

$

100,191

 

$

63,119

 

$

282,615

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average yield

 

2.20%

 

2.35%

 

2.47%

 

2.61%

 

2.43%

 

 

Federal Home Loan Bank Stock (“FHLB”)

 

As a member of FHLB of San Francisco, the Company is required to hold a specified amount of FHLB capital stock based on the level of borrowings the Company has obtained from the FHLB.  As such, the amount of FHLB stock the Company carries can vary from one period to another based on, among other things, the current liquidity needs of the Company.  At December 31, 2013, the Company held approximately $4.7 million in FHLB stock, an increase of $0.1 million from that reported at December 31, 2012, due to required incremental investments in the stock by FHLB.

 

Loans

 

Summary of Market Conditions

 

The local economies in which the Company operates have been showing steady signs of improvement since the second quarter of 2012, after two plus years of tepid demand.  With the addition of our new sales team who are focused on our region’s largest industry, agriculture, as well as the commercial and small business segments of the market, and single-family mortgages, the Bank has been able to capitalize on the markets’ slow but steady recovery to generate quarter over quarter net loan growth in each quarter since the second quarter of 2012.

 

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We continue to see improving borrower activity and we anticipate that this increased activity in our existing markets, coupled with new sales team, our expansion into Ventura County, with the opening of new loan production office in Oxnard in the middle of 2012, and the opening of the Goleta loan production office in the first quarter of 2013, should contribute to continued growth in our loan portfolio. We also believe that the merger with Mission Community Bank will provide expanded opportunities in markets, for which the Company has had limited focus, which should also enhance our opportunities for loan production growth.  Although the Company believes that it is seeing continued signs of stabilization in the local economies in which it operates, the Company realizes that the economic recovery is still very fragile and a renewed decline in the global, national, state and local economies may further impact local borrowers, as well as negatively impact values of real estate within our market footprint used to secure certain loans. As such, management continues to closely monitor credit trends and leading indicators for renewed signs of deterioration. The Bank employs stringent lending standards and remains very selective with regard to loan originations, including commercial real estate, real estate construction, land and commercial loans that it chooses to originate, in an effort to effectively manage risk in this difficult credit environment. The Company is focused on monitoring credit in order to take proactive steps when and if necessary, to mitigate any material adverse impacts on the Company.

 

Credit Quality

 

The Company’s primary business is the extension of credit to individuals and businesses and safekeeping of customers’ deposits. The Company’s policies concerning the extension of credit require risk analysis including an extensive evaluation of the purpose for the loan request and the borrower’s ability and willingness to repay the Bank as agreed. The Company also considers other factors when evaluating whether or not to extend new credit to a potential borrower. These factors include the current level of diversification in the loan portfolio and the impact that funding a new loan will have on that diversification, legal lending limit constraints and any regulatory limitations concerning the extension of certain types of credit.

 

The credit quality of the loan portfolio is impacted by numerous factors including the economic environment in the markets in which the Company operates, which can have a direct impact on the value of real estate securing collateral dependent loans. Weak economic conditions in recent years have also impacted certain borrowers the Company has extended credit to, making it difficult for those borrowers to continue to make timely repayment on their loans. An inability of certain borrowers to continue to perform under the original terms of their respective loan agreements in conjunction with declines in real estate collateral values may result in increases in provisions for loan losses that have an adverse impact on the Company’s operating results.

 

See also Note 4. Loans, of the Consolidated Financial Statements, filed in this Form 10-K, for a more detailed discussion concerning credit quality, including the Company’s related policy.

 

Loans Held for Sale

 

Loans held for sale primarily consist of mortgage originations that have already been specifically designated for sale pursuant to correspondent mortgage loan investor agreements. There is minimal interest rate risk associated with these loans as purchase commitments are entered into with investors at the time the Company funds the loans. Settlement from the correspondents is typically within 30 to 60 days of funding the mortgage.  At December 31, 2013, mortgage correspondent loans (loans held for sale) totaled approximately $2.4 million, $20.1 million less than that reported at December 31, 2012. The decrease in mortgage correspondent loans in 2013 is reflective of a reduction in funding levels in the second half of the year due to higher mortgage interest rates as well as the timing of mortgage originations at the end of 2012, which resulted in a larger than normal volume of loans pending purchase by the investors at December 31, 2012.

 

Summary of Loan Portfolio

 

At December 31, 2013, total gross loan balances were $827.5 million.  This represents an increase of approximately $137.9 million or 20.0% from the $689.6 million reported at December 31, 2012.  The current year growth in total gross loans was primarily due to new loan originations driven by improving market conditions and increasing loan demand over the last year, together with the expansion of our sales team and opening of new loan production offices.

 

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The table below sets forth the composition of the loan portfolio as of December 31, 2013, 2012, 2011, 2010, and 2009:

 

 

 

2013

 

2012

 

2011

 

2010

 

2009

 

(dollar amounts in thousands)

 

Amount

 

Percent

 

Amount

 

Percent

 

Amount

 

Percent

 

Amount

 

Percent

 

Amount

 

Percent

 

Real Estate Secured

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Multi-family residential

 

$

31,140

 

3.8%

 

$

21,467

 

3.1%

 

$

15,915

 

2.5%

 

$

17,637

 

2.6%

 

$

20,631

 

2.8%

 

Residential 1 to 4 family

 

88,904

 

10.7%

 

41,444

 

6.0%

 

20,839

 

3.2%

 

21,804

 

3.2%

 

25,483

 

3.5%

 

Home equity line of credit

 

31,178

 

3.8%

 

31,863

 

4.6%

 

31,047

 

4.8%

 

30,801

 

4.5%

 

29,780

 

4.1%

 

Commercial