10-Q 1 d10q.htm FORM 10-Q Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-Q

 


Quarterly report pursuant to section 13 or 15(d) of the Securities

Exchange Act of 1934

For the quarterly period ended September 30, 2007

Commission file number: 000-29105

 


1st CENTENNIAL BANCORP

(Exact Name of Registrant as specified in its charter)

 


 

California

(State or other jurisdiction of

incorporation or organization)

 

91-1995265

(I.R.S. Employer

Identification Number)

218 East State Street

Redlands, California

(Address of principal executive offices)

 

92373

(Zip Code)

Registrant’s telephone number, including area code: (909) 798-3611

 


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 is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ¨         Accelerated filer x         Non-accelerated filer ¨

Indicate by check mark whether the registrant is a shell Company (as defined in Rule 12b-2 of the Exchange Act).    Yes ¨     No x

The number of shares of Common Stock of the registrant outstanding as of November 6, 2007 was 4,881,791.

 



Table of Contents

TABLE OF CONTENTS

 

ITEM

      PAGE
PART I – Financial Statements   

ITEM 1

   Unaudited Consolidated Financial Statements    2
  

Consolidated statements of condition

   2
  

Consolidated statements of earnings

   3
  

Consolidated statements of shareholders’ equity

   4
  

Consolidated statements of cash flows

   5
  

Notes to unaudited consolidated financial statements

   7

ITEM 2

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    10

ITEM 3

   Quantitative and Qualitative Disclosures about Market Risk    36

ITEM 4

   Controls and Procedures    36
PART II – Other Information   

ITEM 1

   Legal Proceedings    36

ITEM 1A

   Risk Factors    36

ITEM 2

   Unregistered Sales of Equity Securities and Use of Proceeds    37

ITEM 3

   Defaults Upon Senior Securities    37

ITEM 4

   Submission of Matters to a Vote of Security Holders    37

ITEM 5

   Other Information    37

ITEM 6

   Exhibits    38
   Signatures    40

 


Table of Contents

PART I – FINANCIAL INFORMATION

 

ITEM 1. UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

1ST CENTENNIAL BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CONDITION

September 30, 2007 and December 31, 2006

 

Dollar amounts in thousands

   2007    2006
     (unaudited)     
ASSETS      

Cash and due from banks

   $ 12,271    $ 18,385

Federal funds sold

     —        2,900
             

Total cash and cash equivalents

     12,271      21,285

Interest-bearing deposits in financial institutions

     1,963      2,922

Investment securities, available for sale

     126,198      72,649

Stock investments restricted, at cost

     1,990      1,681

Loans, net of allowance for loan losses of $6,197 and $5,741

     487,572      426,200

Accrued interest receivable

     3,668      3,469

Premises and equipment, net

     3,045      3,152

Goodwill

     4,180      4,180

Cash surrender value of life insurance

     14,408      11,639

Other assets

     5,047      3,950
             

Total assets

   $ 660,342    $ 551,127
             
LIABILITIES      

Deposits:

     

Noninterest-bearing demand deposits

   $ 108,610    $ 111,154

Interest-bearing deposits

     379,275      345,309
             

Total deposits

     487,885      456,463

Accrued interest payable

     948      432

Federal funds purchased

     5,610      —  

Borrowings from federal home loan bank

     25,000      —  

Repurchase agreements

     75,113      30,000

Other liabilities

     4,111      3,729

Subordinated notes payable to subsidiary trusts

     12,300      18,306
             

Total liabilities

     610,967      508,930
             
SHAREHOLDERS’ EQUITY      

Common stock, no par value; authorized 10,000,000 shares, issued and outstanding 4,881,791 and 3,212,215 shares at September 30, 2007 and December 31, 2006, respectively

     28,985      27,998

Retained earnings

     20,279      14,038

Accumulated other comprehensive income

     111      161
             

Total shareholders’ equity

     49,375      42,197
             

Total liabilities and shareholders’ equity

   $ 660,342    $ 551,127
             

The accompanying notes are an integral part of these consolidated statements.

 

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1ST CENTENNIAL BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF EARNINGS

Three and Nine Months Ended September 30, 2007 and 2006 (unaudited)

 

    

Three Months Ended

September 30,

  

Nine Months Ended

September 30,

Dollar amounts in thousands, except per share amounts

   2007    2006    2007    2006

Interest income:

           

Loans, including fees

   $ 11,117    $ 9,696    $ 32,293    $ 27,570

Deposits in financial institutions

     26      29      92      88

Federal funds sold

     99      224      315      776

Investments

           

Taxable

     1,248      279      2,620      475

Tax-exempt

     259      110      753      220
                           

Total interest income

     12,749      10,338      36,073      29,129
                           

Interest expense:

           

Interest bearing demand and savings deposits

     1,896      1,575      5,109      4,164

Time deposits $100,000 or greater

     1,170      692      3,149      1,631

Other time deposits

     937      571      2,806      1,495

Interest on borrowed funds

     1,270      470      2,933      1,165
                           

Total interest expense

     5,273      3,308      13,997      8,455
                           

Net interest income

     7,476      7,030      22,076      20,674

Provision for loan losses

     300      200      700      820
                           

Net interest income after provision for loan losses

     7,176      6,830      21,376      19,854
                           

Noninterest income:

           

Customer service fees

     444      411      1,276      1,241

Gains from sale of loans

     134      2      407      319

Conduit loan referral income

     118      80      755      638

Other income

     168      204      587      458
                           

Total noninterest income

     864      697      3,025      2,656
                           

Noninterest expense:

           

Salaries and employee benefits

     2,544      2,302      7,906      7,254

Net occupancy expense

     581      551      1,729      1,673

Other operating expense

     1,512      1,504      4,750      4,616
                           

Total noninterest expense

     4,637      4,357      14,385      13,543
                           

Income before provision for income taxes

     3,403      3,170      10,016      8,967

Provision for income taxes

     1,277      1,321      3,769      3,555
                           

Net income

   $ 2,126    $ 1,849    $ 6,247    $ 5,412
                           

Basic earnings per share1

   $ 0.44    $ 0.39    $ 1.29    $ 1.13
                           

Diluted earnings per share1

   $ 0.40    $ 0.35    $ 1.18    $ 1.03
                           

The accompanying notes are an integral part of these consolidated statements.

 


1

Adjusted for the 50% stock distribution declared for shareholders of record as of May 1, 2007, and distributed May 15, 2007.

 

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1ST CENTENNIAL BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

Nine Months Ended September 30, 2007 and 2006 (unaudited)

Dollar amounts in thousands, except share amounts

 

     Shares     Common
Stock
   Retained
Earnings
    Accumulated
Other
Comprehensive
Income (Loss)
    Total  

BALANCE, DECEMBER 31, 2005

   2,100,075     $ 26,803    $ 6,617     $ 1     $ 33,421  
                 

Comprehensive income:

           

Net income

   —         —        5,412       —         5,412  

Change in net unrealized gain on investment securities available for sale, after tax effects

   —         —        —         155       155  
                 

Total comprehensive income

              5,567  
                 

Stock Distribution

   1,062,656       —        —         —         —    

Cash paid in lieu of fractional shares

   —         —        (6 )     —         (6 )

Compensation expense on incentive stock options

   —         398      —         —         398  

Retirement of unvested restricted stock awards

   (578 )     —        —         —         —    

Exercise of stock options, including tax benefit

   41,066       511      —         —         511  
                                     

BALANCE, SEPTEMBER 30, 2006

   3,203,219     $ 27,712    $ 12,023     $ 156     $ 39,891  
                                     

BALANCE, DECEMBER 31, 2006

   3,212,215     $ 27,998    $ 14,038     $ 161     $ 42,197  

Comprehensive income:

           

Net income

   —         —        6,247       —         6,247  

Change in net unrealized gain on investment securities available for sale, after tax effects

   —         —        —         (50 )     (50 )
                 

Total comprehensive income

              6,197  
                 

Stock Distribution

   1,614,406       —        —         —         —    

Cash paid in lieu of fractional shares

   —         —        (6 )     —         (6 )

Compensation expense on incentive stock options

   —         461      —         —         461  

Exercise of stock options, including tax benefit

   55,170       526      —         —         526  
                                     

BALANCE, SEPTEMBER 30, 2007

   4,881,791     $ 28,985    $ 20,279     $ 111     $ 49,375  
                                     

The accompanying notes are an integral part of these consolidated statements.

 

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1ST CENTENNIAL BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

Nine Months Ended September 30, 2007 and 2006 (unaudited)

 

Dollar amounts in thousands

   2007     2006  

CASH FLOWS FROM OPERATING ACTIVITIES

    

Net income

   $ 6,247     $ 5,412  

Adjustments to reconcile net income to net cash provided by operating activities:

    

Depreciation and amortization

     482       517  

Gain on sale of fixed assets

     (3 )     (7 )

Gain from sale of investments

     (34 )     —    

Provision for loan losses

     700       820  

Amortization of deferred loan fees

     (953 )     (1,334 )

Amortization of excess purchase value of deposits

     —         9  

Fair value of stock options and restricted stock awards in noninterest expense

     488       425  

Deferred income tax benefit

     (90 )     (44 )

Net amortization of premiums (discounts) on investments and interest-bearing deposits

     (102 )     82  

Increase in cash surrender value of life insurance

     (352 )     (291 )

Change in:

    

Accrued interest receivable

     (199 )     (429 )

Other assets

     (1,059 )     (144 )

Accrued interest payable

     516       185  

Other liabilities

     355       292  
                

Net cash provided by operating activities

     5,996       5,493  
                

CASH FLOWS FROM INVESTING ACTIVITIES

    

Net decrease (increase) in interest-bearing deposits in financial institutions

     1,027       (654 )

Activity in available for sale securities:

    

Purchases of securities

     (60,035 )     (49,266 )

Proceeds from sales, maturities and principal repayments of securities

     6,556       2,689  

Purchases of Federal Home Loan Bank stock

     (309 )     (45 )

Net increase in loans

     (60,342 )     (44,059 )

Acquisition of other real estate owned

     (777 )     —    

Additions to bank premises and equipment

     (372 )     (149 )

Purchases of life insurance

     (2,417 )     (4,500 )
                

Net cash used in investing activities

     (116,669 )     (95,984 )
                

The accompanying notes are an integral part of these consolidated statements.

 

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1ST CENTENNIAL BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)

Nine Months Ended September 30, 2007 and 2006 (unaudited)

 

Dollar amounts in thousands

   2007     2006  

CASH FLOWS FROM FINANCING ACTIVITIES

    

Net increase (decrease) in noninterest-bearing demand deposits

     (2,544 )     6,693  

Net increase in interest-bearing deposits

     33,966       39,853  

Proceeds from federal funds purchased

     5,610       —    

Proceeds from federal home loan bank borrowings

     25,000       —    

Proceeds from repurchase agreements

     45,113       30,000  

Redemption of trust preferred securities

     (6,006 )     —    

Cash paid in lieu of fractional shares

     (6 )     (6 )

Proceeds from exercise of stock options

     526       511  
                

Net cash provided by financing activities

     101,659       77,051  
                

Net decrease in cash and cash equivalents

     (9,014 )     (13,440 )

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD

     21,285       38,367  
                

CASH AND CASH EQUIVALENTS, END OF PERIOD

   $ 12,271     $ 24,927  
                

SUPPLEMENTAL INFORMATION:

    

Interest paid

   $ 13,481     $ 8,261  
                

Income taxes paid

   $ 3,498     $ 3,987  
                

SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES:

    

Transfer of loans to other real estate owned, after charge-off of $446

   $ 310     $ —    
                

The accompanying notes are an integral part of these consolidated statements.

 

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1ST CENTENNIAL BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2007

Note 1. NATURE OF BUSINESS AND BASIS OF PRESENTATION

Nature of Business

1st Centennial Bancorp (“the Company”) is a California corporation registered as a bank holding company under the Bank Holding Company Act of 1956, as amended and is headquartered in Redlands, California. The Company was incorporated in August 1999 and acquired 100% of the outstanding shares of 1st Centennial Bank (“the Bank”) in December 1999. The Bank operates six branches and three loan production offices, which provide commercial and consumer banking services and also a broad array of products and services throughout its operating areas in Southern California.

Basis of Presentation

The unaudited financial information included herein has been prepared in conformity with the accounting principles and practices disclosed in the consolidated financial statements, Note 1, included in the Company’s Annual Report on Form 10-K, for the year ended December 31, 2006, filed with the Securities and Exchange Commission (“SEC”). The accompanying interim consolidated financial statements contained herein are unaudited. However, in the opinion of the Company, all adjustments, consisting of normal recurring items necessary for a fair presentation of the operating results for the periods shown, have been made. The results of operations for the three and nine months ended September 30, 2007 may not be indicative of operating results for the full year ending December 31, 2007. Certain prior year and prior quarter amounts have been reclassified to conform to current classifications, including the reclassification of brokered certificates of deposits from greater than $100,000 to other time deposits that are in groups of large master certificates but are made up of individual time deposits of $1,000 each. As of September 30, 2007 and December 31, 2006, $19.2 million and $34.4 million respectively, represented such brokered time deposits and were reclassified with no effect on net income and shareholders’ equity.

Note 2. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS No. 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement and, therefore, should be determined based on the assumptions that market participants would use in pricing that asset or liability. SFAS No. 157 also establishes a fair value hierarchy that distinguishes between market participant assumptions developed based on market data obtained from independent sources and the Company’s own assumptions about market participant assumptions based on the best information available. SFAS No. 157 is effective for the Company on January 1, 2008 with earlier adoption permitted. The Company does not expect adoption to have a significant impact on the consolidated financial statements, results of operations or liquidity of the Company.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — including an amendment of FASB Statement No. 115” which is effective for the Company as of the beginning of the first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the fiscal year that begins on or after November 15, 2006, provided that the Company also elects to apply the provisions of FASB Statement No. 157, “Fair Value Measurements”. The Company has evaluated this Statement and has decided to not elect the fair value option for eligible items at the date of adoption.

 

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Note 3. EARNINGS PER SHARE2

Basic earnings per share represents income available to common shareholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding, if potential dilutive common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options and are determined using the treasury stock method.

The weighted average number of shares used in computing basic and diluted earnings per share is as follows:

Earnings per share calculation

For the three months ended September 30,

(In thousands, except per share amounts)

 

     2007     2006  
     Net
Income
   Weighted
average
shares
   Per share
amount
    Net
Income
   Weighted
average
shares
   Per share
amount
 

Basic earnings per share

   $ 2,126    4,865    $ 0.44     $ 1,849    4,791    $ 0.39  

Effect of dilutive shares:

                

assumed exercise of

outstanding options

     —      453      (0.04 )     —      503      (0.04 )

Diluted earnings per share

   $ 2,126    5,318    $ 0.40     $ 1,849    5,294    $ 0.35  

Earnings per share calculation

For the nine months ended September 30,

(In thousands, except per share amounts)

 

     2007     2006  
     Net
Income
   Weighted
average
shares
   Per share
amount
    Net
Income
   Weighted
average
shares
   Per share
amount
 

Basic earnings per share

   $ 6,247    4,842    $ 1.29     $ 5,412    4,775    $ 1.13  

Effect of dilutive shares:

                

assumed exercise of

outstanding options

     —      453      (0.11 )     —      503      (0.10 )

Diluted earnings per share

   $ 6,247    5,295    $ 1.18     $ 5,412    5,278    $ 1.03  

 


2

Adjusted for the 50% stock distribution declared for shareholders of record as of May 1, 2007, and distributed May 15, 2007.

 

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Note 4. OFF-BALANCE SHEET COMMITMENTS

Commitments to extend credit are agreements to lend to customers, provided there is no violation of any conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Commitments generally have variable rates, and many of these commitments are expected to expire without being drawn upon. As such, the total commitment amounts do not necessarily represent future cash requirements. The Company’s exposure to credit losses is represented by the contractual amount of these commitments. The Company uses the same credit underwriting policies in granting or accepting such commitments as it does for on-balance-sheet instruments, which consist of evaluating customers’ creditworthiness individually.

Standby letters of credit are conditional commitments issued by the Company to guarantee the financial performance of a customer to a third party. Those guarantees are primarily issued to support private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. When deemed necessary, the Company holds appropriate collateral supporting those commitments. Management does not anticipate any material losses as a result of these transactions.

The following table shows the amounts of total off-balance sheet commitments by category as of the dates indicated:

Off-Balance sheet commitments

 

    

September 30,

2007

   December 31,
2006
     (Dollars in Thousands)

Standby letters of credit

   $ 4,572    $ 3,231

Undisbursed loans and lines of credit

     194,467      223,201

Available credit card lines

     3,469      3,060
             

Total off-balance sheet commitments

   $ 202,508    $ 229,492
             

Note 5. STOCK REPURCHASE PROGRAM

On September 21, 2007 the Board of Directors of the Company approved a plan to incrementally repurchase up to an aggregate of $3.0 million of the Company’s common stock. The repurchase program commenced on October 17, 2007 and will continue for a period of twelve months thereafter, subject to earlier termination at the Company’s discretion. The shares would be repurchased at the prevailing market prices from time to time in open market transactions during the repurchase period. The timing of the purchases and the number of shares to be repurchased at any given time will depend on market conditions and SEC regulations. The Company has engaged Western Financial Corporation in connection with the stock repurchases.

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This discussion focuses primarily on the results of operations of the Company and its subsidiary on a consolidated basis for the three and nine months ended September 30, 2007 and 2006, and the financial condition of the Company as of September 30, 2007 and December 31, 2006.

Management’s discussion and analysis is written to provide greater insight into the results of operations and the financial condition of the Company and its subsidiary. For a more complete understanding of the Company and its operations, reference should be made to the consolidated financial statements included in this report and in the Company’s 2006 Annual Report on Form 10-K.

Certain statements in this Report on Form 10-Q constitute “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”), which involve risks and uncertainties. The Company’s actual results may differ significantly from the results discussed in such forward-looking statements. Factors that might cause such a difference include, but are not limited to, possible future deteriorating economic conditions in the Company’s areas of operation; interest rate risk associated with volatile interest rates and related asset-liability matching risk; liquidity risks; risk of significant non-earning assets, and net credit losses that could occur, particularly in times of weak economic conditions or times of rising interest rates; risks of available-for-sale securities declining significantly in value as interest rates rise or issuer’s of such securities suffering financial losses; and regulatory risks associated with the variety of current and future regulations to which the Company is subject. All of these risks could have a material adverse impact on the Company’s consolidated financial condition, results of operations or prospects, and these risks should be considered in evaluating the Company. Segment reporting is not presented since the Company’s revenue is attributed to a single reportable segment. For additional information concerning these factors, refer to the Company’s Form 10-K for the year ended December 31, 2006.

CRITICAL ACCOUNTING POLICIES

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The financial information contained within these statements is, to a significant extent, based on approximate measures of the financial effects of transactions and events that have already occurred. Based on its consideration of accounting policies that involve the most complex and subjective decisions and assessments, Management has identified its most critical accounting policy to be that related to the allowance for loan losses. The Company’s allowance for loan loss methodologies incorporate a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan losses that Management believes is appropriate at each reporting date.

Quantitative factors include our historical loss experience, delinquency and charge-off trends, collateral values, changes in nonperforming loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers’ sensitivity to interest rate movements and borrowers’ sensitivity to quantifiable external factors including commodity and finished goods prices as well as acts of nature (earthquakes, floods, fires, etc.) that occur in a particular period.

Qualitative factors include the general economic environment in our markets, including economic conditions in Southern California, and in particular, the state of certain industries, the size and complexity of individual credits in relation to lending officers’ background and experience levels, loan structure, extent and nature of waivers of existing loan policies and pace of portfolio growth are other qualitative factors that are considered in our methodologies.

As the Company adds new products and expands its geographic coverage, it increases the complexity of its loan portfolio. The Company will enhance its methodologies to keep pace with the size and complexity of the loan portfolio. Management might report a materially different amount for the provision for loan losses if its assessment of the above factors were different. This discussion and analysis should be read in conjunction with the Company’s financial statements and the accompanying notes presented elsewhere herein, as well as the portion of this Management’s Discussion and Analysis section entitled “Financial Condition—Allowance for Loan Losses.” Although Management believes the level of the allowance as of September 30, 2007 was adequate to absorb losses inherent in the loan portfolio, a decline in the local economy may result in increasing losses that cannot reasonably be predicted at this time.

 

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SUMMARY OF PERFORMANCE

Results of operations summary

Third quarter analysis. Net income for the quarter ended September 30, 2007 was $2.1 million, which is $277,000 or 15% higher than net income of $1.8 million for the same period in 2006. Basic and diluted earnings per share were $0.44 and $0.40 respectively, for the three months ended September 30, 2007, as compared to $0.39 and $0.35 respectively, for the same period in 2006. Earnings per share calculations were adjusted to give retroactive effect to stock dividends and distributions, including the 50% stock distribution paid on May 15, 2007 to shareholders of record as of May 1, 2007. Return on average assets and return on average equity for the three months ended September 30, 2007 were 1.33% and 17.73% respectively, as compared to 1.46% and 18.82% respectively, for the same period in 2006 due to faster growth in average assets and average equity than in income.

The primary drivers behind the variance in net income for the quarter ended September 30, 2007 relative to the same period in 2006 are as follows:

 

   

Net interest income before provision for loan losses increased by $446,000 or 6%, primarily due to the increase in average total loans.

 

   

Gains from the sale of loans increased by $132,000, which resulted from more loans sold during the third quarter of 2007, when compared to 2006.

 

   

Salaries and employee benefits increased by $242,000 or 11%, as a result of the Company’s growth, coupled with salary increases.

Nine-month analysis. Net income for the nine months ended September 30, 2007 was $6.2 million, which is $835,000 or 15% higher than net income of $5.4 million for the same period in 2006. Basic and diluted earnings per share were $1.29 and $1.18 respectively, for the nine months ended September 30, 2007, as compared to $1.13 and $1.03 respectively, for the same period in 2006. Earnings per share calculations were adjusted to give retroactive effect to stock dividends and distributions, including the 50% stock distribution paid on May 15, 2007 to shareholders of record as of May 1, 2007. Return on average assets and return on average equity for the nine months ended September 30, 2007 were 1.41% and 18.33% respectively, as compared to 1.51% and 19.60% respectively, for the same period in 2006 due to faster growth in average assets and average equity than in income.

The primary drivers behind the variance in net income for the nine months ended September 30, 2007 relative to the same period in 2006 are as follows:

 

   

Net interest income before the provision for loan losses increased by $1.4 million or 7%, primarily due to the increase in average total loans.

 

   

Conduit loan referral income increased by $117,000, as a result of more referrals during the first nine months of 2007 as compared to the same period in 2006.

 

   

Salaries and employee benefits increased $652,000 or 9% as a result of the Company’s growth, coupled with salary increases.

Financial Condition Summary

The Company’s total assets were $660.3 million at September 30, 2007, an increase of $109.2 million, or 20%, compared to total assets of $551.1 million at December 31, 2006. The most significant changes in the Company’s balance sheet during the first nine months of 2007 are outlined below:

 

   

The Company’s investment portfolio increased $53.5 million or 74% from December 31, 2006. During the third quarter of 2007, the Company entered into a $45.1 million repurchase agreement that included an interest rate floor to mitigate interest rate risk in a declining rate environment. The repurchase agreement was collateralized by the purchase of three federal agency mortgage-backed securities totaling $48.6 million.

 

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Net loans increased $61.4 million or 14% from December 31, 2006. Strong loan demand in the Company’s market areas contributed to the increase in net loans.

 

   

Interest-bearing deposits increased $34.0 million or 10% from December 31, 2006. The increase in interest-bearing deposits was primarily the result of the Company’s continued emphasis to attract new customers.

 

   

At September 30, 2007 the Company had borrowings from the Federal Home Loan Bank (“FHLB”) totaling $25.0 million compared to no borrowings at December 31, 2006. The Company allowed brokered certificates of deposit to run off and replaced with less expensive Federal Home Loan Bank borrowings.

 

   

Stock Repurchase Program. On September 21, 2007 the Board of Directors of the Company approved a plan to incrementally repurchase up to an aggregate of $3.0 million of the Company’s common stock. See note 5 above “Stock Repurchase Program”.

 

   

Nonperforming assets increased $5.4 million or 139% from December 31, 2006. The increase was primarily attributable to the addition of two construction and development loans totaling $5.2 million that were placed on non-accrual status during the third quarter of 2007, partially offset by the payoff of one commercial loan totaling $2.5 million. Of the $5.2 million addition in construction and development loans, $4.0 million represents a 29 single family tract which is 95% complete; a notice of default has been filed on the project. $1.2 million represents a 22 raw land lot tract, which subsequently has become Other Real Estate Owned in October 2007 and is anticipated to be disposed of in the coming months. Loans 90 days past due increased $2.6 million and is attributed to one construction and development loan. In addition, $1.1 million was transferred to other real estate owned.

RESULTS OF OPERATIONS

The Company earns income from two primary sources. The first is net interest income, which is interest income generated by interest-earning assets less, interest expense on interest-bearing liabilities. The second is noninterest income, which primarily consists of customer service fees but also comes from non-customer sources such as loan sales, bank-owned life insurance, and other income. The majority of the Company’s noninterest expenses are operating costs that relate to providing a full range of banking services to our customers.

NET INTEREST INCOME/NET INTEREST MARGIN

The principal component of the Company’s earnings is net interest income, which is the difference between the interest and fees earned on loans and investments, and the interest paid on deposits and borrowed funds. When net interest income is expressed as a percentage of average earning assets, the result is the net interest margin. The net interest spread is the yield on average earning assets minus the average cost of interest-bearing deposits and borrowed funds. The Company’s net interest income, net interest margin and interest spread are sensitive to general business and economic conditions. These conditions include short-term and long-term interest rates, inflation, monetary supply, and the strength of the economy, and the local economies in which the Company conducts business.

The net interest margin can be affected by changes in the yield on earning assets and the cost of interest-bearing liabilities, as well as changes in the level of interest-bearing liabilities in proportion to earning assets. The net interest margin can also be affected by changes in the mix of earning assets as well as the mix of interest-bearing liabilities.

Third quarter analysis. The Company’s net interest margin as of the quarter ended September 30, 2007 was 4.97%, compared to 5.93% for the same period in 2006. The increase in rates paid for money market deposits and time deposits, coupled with the increase in the average balance on these liabilities were the major contributors toward compression of the net interest margin. The percentage of total average interest bearing deposits represented by time deposits increased to 45% from 36% from September 30, 2006 to September 30, 2007. The shift in this average deposit mix also contributed to the reduction of the net interest margin as of the three months ended September 30, 2007 compared to the same period in 2006.

For the quarter ended September 30, 2007, total interest-earning assets averaged $597.3 million, which represented an increase of $126.7 million or 27%, as compared to $470.6 million for the same period in 2006. This increase is primarily attributable to the increase in loans as a result of the strong business climate and loan demand, coupled with the purchase of a $30 million FNMA U.S. agency security that settled during September of 2006 and the purchase of three federal agency mortgage-backed securities totaling $48.6 million that settled during July of 2007. Total interest-bearing deposits and other interest-bearing liabilities averaged $472.3 million, which represented an increase of $121.6 million or 35%, as compared to $350.7 million for the same period in 2006. This increase is primarily attributable to the increase in money market and time deposits, coupled with the increase of $55.8 million in the average balance of repurchase agreements.

 

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The Company reported total interest income of $12.7 million for the three months ended September 30, 2007, which represented an increase of $2.4 million or 23%, over total interest income of $10.3 million for the same period in 2006. The increase is primarily the result of increases in interest and fees on loans of approximately $1.4 million and increases in interest on taxable investments of $969,000 that resulted from an increase of $55.9 million and $66.9 million in average loans and average taxable investments, respectively for the three months ended September 30, 2007, as compared to the same period in 2006,

The Company reported total interest expense of $5.3 million for the three months ended September 30, 2007, which represented an increase of $2.0 million or 59%, over total interest expense of $3.3 million for the same period in 2006. The increase is primarily attributable to an increase in the average balance of money market and time deposits, coupled with the increase of the average balance of repurchase agreements.

For the three months ended September 30, 2007, net interest income before provision for loan losses was $7.5 million, which represented an increase of $446,000 or 6%, over net interest income before provision for loan losses of $7.0 million for the same period in 2006. The increase in net interest income for the three months ended September 30, 2007 as compared to 2006 was primarily due to the increase in average total loans.

Nine-month analysis. The Company’s year-to-date net interest margin as of September 30, 2007 was 5.29% compared to 6.16% for the same period in 2006. The increase in rates paid for money market deposits and time deposits, coupled with the increase in the average balance on these liabilities were the major contributors toward compressing our net interest margin. The percentage of total average interest-bearing deposits represented by time deposits increased to 45% from 34% from September 30, 2006 to September 30, 2007. The shift in this average deposit mix also contributed to the reduction of the net interest margin in the first nine months of 2007 versus 2006.

For the first nine months of 2007, total interest-earning assets averaged $557.5 million, which represented an increase of $108.7 million or 24%, as compared to $448.8 million for the same period in 2006. This increase is primarily attributable to the increase in loans as a result of the strong business climate and loan demand, coupled with the purchase of a $30 million FNMA U.S. agency security that settled during September of 2006 and the purchase of three federal agency mortgage-backed securities totaling $48.6 million that settled during July of 2007. Total interest-bearing deposits and other interest-bearing liabilities averaged $434.2 million, which represented an increase of $101.1 million or 30%, as compared to $333.1 million for the same period in 2006. This increase is primarily attributable to the increase in money market and time deposits, coupled with the increase of $38.7 million in the average balance of repurchase agreements.

The Company reported total interest income of $36.1 million for the nine months ended September 30, 2007, which represented an increase of $7.0 million or 24%, over total interest income of $29.1 million for the same period in 2006. The increase for the nine months ended September 30, 2007, when compared to the same period in 2006 is primarily the result of increases in interest and fees on loans of approximately $4.7 million that resulted from an increase of $55.0 million in average loans, coupled with the increase of $2.1 million in interest income on taxable investments that resulted in part from the addition of the $45.1 million in federal agency mortgage backed securities that settled during the third quarter of 2007.

The Company reported total interest expense of $14.0 million for the nine months ended September 30, 2007, which represented an increase of $5.5 million or 66%, over total interest expense of $8.5 million for the same period in 2006. The increase is primarily attributable to an increase in the average balance of time deposits, coupled with the increase in the average balance of repurchase agreements.

For the nine months ended September 30, 2007, net interest income before provision for loan losses was $22.1 million, which represented an increase of $1.4 million or 7%, over net interest income before provision for loan losses of $20.7 million for the same period in 2006. The increase in net interest income for the first nine months of 2007 as compared to 2006 was primarily due to the increase in average total loans.

 

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The following tables show the average interest-earning assets and interest-bearing liabilities; the amount of interest income or interest expense; and the average yield or rate for each category of interest-earning assets and interest- bearing liabilities and the net interest margin (net interest income divided by average earning assets) for the periods indicated.

Distribution, Yield and Rate3 Analysis of Net Interest Income

 

     For the Three Months Ended September 30,  
     2007     2006  
    

Average

Balance

  

Interest

Income/

Expense

  

Average

Rate/Yield

   

Average

Balance

  

Interest

Income/

Expense

  

Average

Rate/Yield

 
     (Dollars in Thousands)  

Interest-earning Assets:

                

Federal funds sold

   $ 7,831    $ 99    5.02 %   $ 17,030    $ 224    5.22 %

Interest-bearing deposits in financial institutions

     1,951      26    5.29 %     2,614      29    4.40 %

Investment securities:4

                

Taxable

     88,309      1,248    5.61 %     21,376      279    5.18 %

Non-taxable

     24,002      259    4.28 %     10,351      110    4.22 %
                                

Total investments

     122,093      1,632    5.30 %     51,371      642    4.96 %

Loans5

     475,186      11,117    9.28 %     419,268      9,696    9.17 %
                                

Total interest-earning assets

   $ 597,279      12,749    8.47 %   $ 470,639      10,338    8.71 %
                                

Interest-bearing Liabilities:

                

Interest-bearing deposits

                

Interest-bearing demand deposits

   $ 17,267      12    0.28 %   $ 24,617      24    0.39 %

Money market deposits

     184,593      1,858    3.99 %     164,114      1,498    3.62 %

Savings deposits

     12,338      26    0.84 %     18,566      53    1.13 %

Time deposits $100,000 or greater

     95,872      1,170    4.84 %     61,549      692    4.46 %

Other time deposits

     79,503      937    4.68 %     57,015      571    3.97 %
                                

Total interest-bearing deposits

     389,573      4,003    4.08 %     325,861      2,838    3.46 %
                                

FHLB borrowings

     6,993      88    4.99 %     —        —      0.00 %

Federal funds purchased

     589      9    6.06 %     —        —      0.00 %

Repurchase agreement

     62,364      934    5.94 %     6,522      94    5.72 %

Subordinated notes payable to subsidiary trusts

     12,822      239    7.40 %     18,306      376    8.15 %
                                

Total borrowings

     82,768      1,270    6.09 %     24,828      470    7.51 %
                                

Total interest-bearing liabilities

   $ 472,341      5,273    4.43 %   $ 350,689      3,308    3.74 %
                                

Net interest income

      $ 7,476         $ 7,030   
                        

Net interest margin6

         4.97 %         5.93 %

 


3

Average rates/yields for these periods have been annualized using actual days.

4

Yields on securities have not been adjusted to a tax equivalent basis because the impact is not material.

5

Loans are gross, which excludes the allowance for loan losses, and net of deferred fees. Nonaccrual loans are included in the table for computation purposes, but the foregone interest on such loans is excluded.

6

Net interest income as a percentage of average interest-earning assets.

 

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Distribution, Yield and Rate7 Analysis of Net Interest Income

 

     For the Nine Months Ended September 30,  
     2007     2006  
    

Average

Balance

  

Interest

Income/

Expense

  

Average

Rate/Yield

   

Average

Balance

  

Interest

Income/

Expense

  

Average

Rate/Yield

 
     (Dollars in Thousands)  

Interest-earning Assets:

                

Federal funds sold

   $ 8,165    $ 315    5.16 %   $ 21,501    $ 776    4.83 %

Interest-bearing deposits

in financial institutions

     2,392      92    5.14 %     2,462      88    4.78 %

Investment securities:8

                

Taxable

     63,193      2,620    5.54 %     12,953      475    4.90 %

Non-taxable

     23,770      753    4.24 %     6,898      220    4.26 %
                                

Total investments

     97,520      3,780    5.18 %     43,814      1,559    4.76 %

Loans9

     460,013      32,293    9.39 %     405,009      27,570    9.10 %
                                

Total interest-earning assets

   $ 557,533      36,073    8.65 %   $ 448,823      29,129    8.68 %
                                

Interest-bearing Liabilities:

                

Interest-bearing deposits

                

Interest-bearing demand deposits

   $ 20,552      52    0.34 %   $ 26,364      69    0.35 %

Money market deposits

     171,539      4,975    3.88 %     157,411      3,926    3.33 %

Savings deposits

     13,067      82    0.84 %     21,842      169    1.03 %

Time deposits $100,000 or greater

     87,427      3,149    4.82 %     54,117      1,631    4.03 %

Other time deposits

     80,582      2,806    4.66 %     52,878      1,495    3.78 %
                                

Total interest-bearing deposits

     373,167      11,064    3.96 %     312,612      7,290    3.12 %
                                

FHLB borrowings

     2,924      111    5.08 %     —        —      0.00 %

Federal funds purchased

     744      31    5.57 %     —        —      0.00 %

Repurchase agreement

     40,906      1,817    5.94 %     2,198      94    5.72 %

Subordinated notes payable to subsidiary trusts

     16,458      974    7.91 %     18,306      1,071    7.82 %
                                

Total borrowings

     61,032      2,933    6.43 %     20,504      1,165    7.60 %
                                

Total interest-bearing liabilities

   $ 434,199      13,997    4.31 %   $ 333,116      8,455    3.39 %
                                

Net interest income

      $ 22,076         $ 20,674   
                        

Net interest margin10

         5.29 %         6.16 %

 


7

Average rates/yields for these periods have been annualized using actual days.

8

Yields on securities have not been adjusted to a tax equivalent basis because the impact is not material.

9

Loans are gross, which excludes the allowance for loan losses, and net of deferred fees. Nonaccrual loans are included in the table for computation purposes, but the foregone interest on such loans is excluded.

10

Net interest income as a percentage of average interest-earning assets.

 

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The following table shows a rate and volume analysis for changes in interest income, interest expense, and net interest income for the periods indicated.

Rate11/Volume Analysis of Net Interest Income

 

    

Three Months Ended

September 30, 2007 vs. 2006

    

Nine Months Ended

September 30, 2007 vs. 2006

 
     Increases (Decreases) Due to      Increases (Decreases) Due to  
     Volume     Rate     Total      Volume     Rate     Total  
     (Dollars in Thousands)  

Increase (Decrease) in Interest Income:

             

Federal funds sold

   $ (121 )   $ (4 )   $ (125 )    $ (481 )   $ 20     $ (461 )

Interest-bearing deposits in financial institutions

     (7 )     4       (3 )      (3 )     7       4  

Investment securities:12

             

Taxable

     874       95       969        1,842       303       2,145  

Non-taxable

     145       4       149        538       (5 )     533  

Loans13

     1,293       128       1,421        3,744       979       4,723  
                                                 

Total

   $ 2,184     $ 227     $ 2,411      $ 5,640     $ 1,304     $ 6,944  
                                                 

Increase (Decrease) in Interest Expense:

             

Interest-bearing demand deposits

   $ (7 )   $ (5 )   $ (12 )    $ (15 )   $ (2 )   $ (17 )

Money market deposits

     187       173       360        352       697       1,049  

Savings deposits

     (18 )     (9 )     (27 )      (68 )     (19 )     (87 )

Time deposits $100,000 or greater

     386       92       478        1,004       514       1,518  

Other time deposits

     225       141       366        783       528       1,311  

FHLB borrowings

     —         88       88        —         111       111  

Federal funds purchased

     —         9       9        —         31       31  

Repurchase agreement

     805       35       840        1,655       68       1,723  

Subordinated notes payable to subsidiary trusts

     (113 )     (24 )     (137 )      (108 )     11       (97 )
                                                 

Total

   $ 1,465     $ 500     $ 1,965      $ 3,603     $ 1,939     $ 5,542  
                                                 

Total change in net interest income

   $ 719     $ (273 )   $ 446      $ 2,037     $ (635 )   $ 1,402  
                                                 

PROVISION FOR LOAN LOSSES

Credit risk is inherent in the business of making loans. The Company sets aside an allowance or reserve for loan losses through charges to earnings, which are shown in the statement of earnings as the provision for loan losses. Specifically identifiable and quantifiable losses are immediately charged off against the allowance. The loan loss provision is determined by conducting a monthly evaluation of the adequacy of the Company’s allowance for loan losses, and charging the shortfall, if any, to the current month’s expense. This has the effect of creating variability in the amount and frequency of charges to the Company’s earnings.

The provision for loan losses totaled $700,000 for the nine months ended September 30, 2007. This represented a decrease of $120,000 or 15% when compared to $820,000 for the same period in 2006. The decrease was due to the decrease in net charge-offs during the first nine months of 2007, when compared to the same period in 2006 and in spite of an increase in the level of nonperforming loans. For the nine months ended September 30, 2007 and 2006, the Company had net charge-offs of $244,000 and $359,000, respectively. The process for monitoring the adequacy of the allowance for loan losses, as well as supporting documentation, regarding the allowance for loan losses is analyzed below. See “Allowance for Loan Losses”.

 


11

Rates for these periods on which calculations are based have been annualized using actual days.

12

Yields on securities have not been adjusted to a tax equivalent basis because the impact is not material.

13

Loans are gross, which excludes the allowance for loan losses, and net of deferred fees. Nonaccrual loans are included in the table for computation purposes, but the foregone interest on such loans is excluded.

 

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Table of Contents

NONINTEREST INCOME

Noninterest income for the Company includes customer service fees, gains from sale of loans, increases in the cash surrender value of life insurance policies, broker fee income, conduit loan referral income and other miscellaneous income. Conduit loan referral income consists of referral fees or brokerage fees from loans that are packaged and referred to other lenders. The loans are never recorded on the Company’s books; therefore, the recognized income is not recorded as gain on the sale of loans. The Company recognizes noninterest income as a result of the referral.

Third quarter analysis. Noninterest income totaled $864,000 for the quarter ended September 30, 2007. This represented an increase of $167,000 or 24% when compared to $697,000 for the same period in 2006.

The increase in noninterest income was primarily attributable to the increase in gains from the sale of Small Business Administration (“SBA”) loans of $132,000 which resulted from more loans sold during the third quarter of 2007, when compared to 2006.

For the three months ended September 30, 2007 as compared to 2006, noninterest income as an annualized percentage of average earning assets decreased to 0.57% from 0.59%.

Nine-month analysis. Noninterest income totaled $3.0 million for the nine months ended September 30, 2007. This represented an increase of $369,000 or 14% when compared to $2.7 million for the same period in 2006.

The increase in noninterest income was primarily attributable to the increase in conduit loan referral income of $117,000 or 18% as a result of more referrals during the first nine months of 2007 as compared to the same period in 2006. Gains from the sale of SBA loans increased $88,000 or 28% which resulted from more loans sold during the first nine months of 2007, when compared to 2006. Also as a result of the Company’s growth, other miscellaneous income increased by $81,000 or 140% during the first nine months of 2007, when compared to the same period in 2006.

For the nine months ended September 30, 2007 as compared to 2006, noninterest income as an annualized percentage of average earning decreased to 0.73% from 0.79%.

 

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The following tables set forth components of the Company’s noninterest income for the periods indicated and expresses the amounts as a percentage of total noninterest income:

Noninterest Income

 

     For the Three Months Ended September 30,  
     2007     2006  
     Amount   

Percent

of Total

    Amount   

Percent

of Total

 
     (Dollars in Thousands)  

Customer service fees

   $ 444    51.38 %   $ 411    58.96 %

Gains from sale of loans

     134    15.51 %     2    0.29 %

Increase in cash surrender value of life insurance

     127    14.70 %     140    20.09 %

Broker fee income

     15    1.74 %     18    2.58 %

Conduit loan referral income

     118    13.66 %     80    11.48 %

Other miscellaneous income

     26    3.01 %     46    6.60 %
                          

Total noninterest income

   $ 864    100.00 %   $ 697    100.00 %
                          

As a percentage of average earning assets (annualized)

      0.57 %      0.59 %
                  

Noninterest Income

 

     For the Nine Months Ended September 30,  
     2007     2006  
     Amount   

Percent

of Total

    Amount   

Percent

of Total

 
     (Dollars in Thousands)  

Customer service fees

   $ 1,276    42.18 %   $ 1,241    46.73 %

Gains from sale of loans

     407    13.45 %     319    12.01 %

Increase in cash surrender value of life insurance

     352    11.64 %     321    12.09 %

Broker fee income

     96    3.17 %     79    2.97 %

Conduit loan referral income

     755    24.96 %     638    24.02 %

Other miscellaneous income

     139    4.60 %     58    2.18 %
                          

Total noninterest income

   $ 3,025    100.00 %   $ 2,656    100.00 %
                          

As a percentage of average earning assets (annualized)

      0.73 %      0.79 %
                  

 

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Table of Contents

NONINTEREST EXPENSE

Noninterest expense for the Company includes salaries and employee benefits, net occupancy and equipment expense, marketing expense, data processing and professional fees, and other operating expenses.

Third quarter analysis. Noninterest expense totaled $4.6 million for the quarter ended September 30, 2007. This represented an increase of $280,000 or 6% when compared to $4.3 million for the same period in 2006.

Due to the Company’s growth, coupled with salary increases, salaries and employee benefits increased $242,000 or 11%. Other operating expense decreased $137,000 or 23% as a result of a non-recurring reversal of $200,000 in reserve for loan losses on undisbursed balances due to a decline of off-balance sheet commitments. See note 4 above “Off-Balance Sheet Commitments”.

For the three months ended September 30, 2007 as compared to 2006, noninterest expense as an annualized percentage of average earning assets decreased to 3.08% from 3.67%.

Nine-month analysis. Noninterest expense totaled $14.4 million for the nine months ended September 30, 2007. This represented an increase of $842,000 or 6% when compared to $13.5 million for the same period in 2006. The increase in noninterest expense was primarily due to increases of $652,000 or 9% and $181,000 or 30% in salaries and employee benefits and data processing expense, respectively, due to the Company’s growth.

For the nine months ended September 30, 2007 as compared to 2006, noninterest expense as an annualized percentage of average earning assets decreased to 3.45% from 4.03%. This decrease is reflective of Management’s continuing efforts to control overhead expenses and improve operating efficiency.

 

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Table of Contents

The following tables set forth components of the Company’s noninterest expense for the periods indicated and express the amounts as a percentage of total noninterest expense:

Noninterest Expense

 

     For the Three Months Ended September 30,  
     2007     2006  
     Amount    Percent
of Total
    Amount    Percent
of Total
 
     (Dollars in Thousands)  

Salaries and employee benefits

   $ 2,544    54.85 %   $ 2,302    52.83 %

Net occupancy expense

     581    12.53 %     551    12.65 %

Marketing

     340    7.33 %     286    6.56 %

Data processing fees

     263    5.67 %     223    5.12 %

Professional fees

     246    5.31 %     217    4.98 %

Postage, telephone, supplies

     131    2.83 %     129    2.96 %

Directors’ fees

     74    1.60 %     54    1.24 %

Other operating expense

     458    9.88 %     595    13.66 %
                          

Total noninterest expense

   $ 4,637    100.00 %   $ 4,357    100.00 %
                          

As a percentage of average earning assets (annualized)

      3.08 %      3.67 %
                  

Noninterest Expense

 

     For the Nine Months Ended September 30,  
     2007     2006  
     Amount    Percent
of Total
    Amount    Percent
of Total
 
     (Dollars in Thousands)  

Salaries and employee benefits

   $ 7,906    54.96 %   $ 7,254    53.57 %

Net occupancy expense

     1,729    12.02 %     1,673    12.35 %

Marketing

     1,008    7.01 %     1,057    7.80 %

Data processing fees

     792    5.51 %     611    4.51 %

Professional fees

     737    5.12 %     706    5.21 %

Postage, telephone, supplies

     410    2.85 %     413    3.05 %

Directors’ fees

     215    1.49 %     165    1.22 %

Other operating expense

     1,588    11.04 %     1,664    12.29 %
                          

Total noninterest expense

   $ 14,385    100.00 %   $ 13,543    100.00 %
                          

As a percentage of average earning assets (annualized)

      3.45 %      4.03 %
                  

INCOME TAXES

The tax provision was $3.8 million for the first nine months of 2007 and $3.6 million for the first nine months of 2006, representing 37.6% and 39.6%, respectively, of pre-tax income for those periods. The amount of the tax provision is determined by applying the Company’s statutory income tax rates to pre-tax book income, adjusted for permanent differences between pre-tax book income and actual taxable income. Such permanent differences include but are not limited to tax-exempt interest income, increases in the cash surrender value of bank-owned life insurance, compensation expense associated with stock options and certain other expenses that are not allowed as tax deductions, and tax credits.

 

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Table of Contents

FINANCIAL CONDITION

GENERAL

The Company’s total assets were $660.3 million at September 30, 2007, an increase of $109.2 million, or 20%, compared to total assets of $551.1 million at December 31, 2006. Total net loans increased $61.4 million, or 14%, to $487.6 million at September 30, 2007 as compared to $426.2 million at December 31, 2006. The Company’s investment portfolio increased $53.6 million or 74% to $126.2 million at September 30, 2007 as compared to $72.6 million at December 31, 2006. Total deposits at September 30, 2007 were $487.9 million, which represented an increase of $31.4 million, or 7% from total deposits of $456.5 million at December 31, 2006. The increase was primarily in interest-bearing deposits, which increased $34.0 million or 10% to $379.3 million at September 30, 2007 compared to $345.3 million at December 31, 2006. Noninterest bearing demand deposits decreased $2.6 million or 2% to $108.6 million at September 30, 2007 compared to $111.2 million at December 31, 2006. The major components of the Company’s statement of condition are individually analyzed below, along with off-balance sheet information.

LOANS

Total gross loans were $494.9 million at September 30, 2007 as compared to $433.3 million at December 31, 2006. Total gross loans increased by $61.6 million, or 14% for the first nine months of 2007. Total gross loans represented 75% of total assets at September 30, 2007 and 78% of total assets at December 31, 2006. Real estate loans, which include construction and development loans, increased $45.3 million or 18% during the first nine months of 2007 and represented approximately 74% of the total loan growth of $61.6 million. This was due to the continuing strong demand for affordable housing in our market areas. Commercial loans increased $13.8 million or 8% during the first nine months of 2007 due to the continued success of our business development efforts in and around the marketplaces the Company serves.

LOANS HELD FOR SALE

The Company actively generates SBA loans as part of its primary operating activity of making loans. The guaranteed portion of each individual loan is sold on the secondary market simultaneously with the booking of the loan, and therefore the Company has no inventory “held-for-sale,” unlike some institutions that warehouse loans to sell as “pools.” The Company retains the unguaranteed portion of the SBA loans. The total gain on sale of loans was $407,000 or 1.04% of total interest and noninterest income as of September 30, 2007 and $319,000 or 1.00% of total interest and noninterest income as of September 30, 2006.

 

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The following table shows the amounts of total loans outstanding by category as of the dates indicated:

Loan Portfolio Composition

 

     September 30, 2007     December 31, 2006  
     Amount     Percent
of Total
    Amount     Percent
of Total
 
     (Dollars in Thousands)  

Real estate loans:

        

Construction and development

   $ 221,111     44.68 %   $ 174,040     40.16 %

Residential loans

     2,572     0.52 %     3,063     0.71 %

Commercial and multi-family

     75,985     15.35 %     77,245     17.83 %

Commercial loans

     179,571     36.28 %     165,765     38.26 %

Consumer loans

     7,271     1.47 %     4,764     1.10 %

Equity lines of credit

     7,293     1.47 %     6,762     1.56 %

Credit card and other loans

     1,124     0.23 %     1,652     0.38 %
                            

Total gross loans

     494,927     100.00 %     433,291     100.00 %
                

Less:

        

Unearned income

     (1,158 )       (1,350 )  

Allowance for loan losses

     (6,197 )       (5,741 )  
                    

Total net loans

   $ 487,572       $ 426,200    
                    

NONPERFORMING ASSETS

Nonperforming assets include loans for which interest is no longer accruing, loans 90 or more days past due and still accruing, restructured loans and other real estate owned.

The Company’s policy is to recognize interest income on an accrual basis unless the full collectibility of principal and interest is uncertain. Loans that are delinquent 90 days or more, unless well secured and in the process of collection, are placed on nonaccrual status and on a cash basis, and previously accrued but uncollected interest is reversed against current income. Thereafter, income is recognized only as it is collected in cash. Collectibility is determined by considering the borrower’s financial condition, cash flow, quality of management, the existence of collateral or guarantees and the state of the local economy. The Company establishes a plan with each borrower that falls into nonaccrual status that is based on receiving payments, however, it is uncertain whether such a plan will prove to be successful.

December 31, 2006 to September 30, 2007 analysis. Nonperforming assets at September 30, 2007 increased $5.3 million to $9.2 million, from $3.9 million at December 31, 2006, and represented 1.87% and 0.89% of total gross loans and other real estate owned, respectively. The increase was primarily attributable to the addition of two construction and development loans totaling $5.2 million that were placed on non-accrual status during the third quarter of 2007, partially offset by the payoff of one commercial loan totaling $2.5 million.

Of the $5.2 million addition in construction and development loans, $4.0 million represents a 29 single family tract which is 95% complete; a notice of default has been filed on the project. $1.2 million represents a 22 raw land lot tract, which subsequently has become Other Real Estate Owned in October 2007 and is anticipated to be disposed of in the coming months.

Loans 90 days past due increased $2.6 million and is attributed to one construction and development loan. In addition, $1.1 million was transferred to other real estate owned (See below).

Other real estate owned is recorded at the fair value of the property at the time of acquisition. Fair value is based on current appraisals less estimated selling costs. The excess of the recorded loan balance over the estimated fair value of the property at the time of acquisition is charged to the allowance for loan losses. Any subsequent write downs are charged to noninterest expense and recognized as a valuation allowance. Subsequent increases in the fair value of the asset less selling costs reduce the valuation allowance, but not below zero, and are credited to noninterest expense. Operating expenses of such properties and gains and losses on their disposition are included in noninterest income and expense.

 

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In February 2007, the Company acquired through foreclosure the underlying real property collateralizing a commercial loan of $617,000. To acquire the property, the Company assumed senior debt of approximately $769,000. The transaction resulted in the Company charging off $446,000 against the allowance for loan losses that represented the difference between the total debt outstanding on the property less its fair value net of selling cost.

In August 2007, the Company acquired through foreclosure the underlying real property collateralizing a construction and development loan of $139,000. To acquire the property, the Company capitalized $8,000 in costs associated with the acquisition, however, there was no charge against the allowance for loan losses.

September 30, 2006 to September 30, 2007 analysis. Nonperforming assets at September 30, 2007 increased $4.4 million to $9.2 million, from $4.8 million at September 30, 2006, and represented 1.87% and 1.12% of total gross loans and other real estate owned, respectively. The increase was primarily attributable to the addition of two construction and development loans totaling $5.2 million that were placed in non-accrual status during the third quarter of 2007, partially offset by the payoff of one commercial loan totaling $2.5 million. Loans 90 days past due increased $1.6 million and is attributed to one construction and development loan.

 

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The following table provides information with respect to the components of the Company’s nonperforming assets as of the dates indicated:

Nonperforming Assets

 

    

September 30,

2007

    December 31,
2006
   

September 30,

2006

 
     (Dollars in Thousands)  

Nonaccrual loans:14

      

Real estate loans:

      

Construction and development

   $ 5,166     $ —       $ —    

Residential loans

     —         18       —    

Commercial and multi-family

     —         —         375  

Commercial loans

     345       3,840       3,352  

Consumer loans

     —         —         —    

Equity lines of credit

     —         —         —    

Credit card and other loans

     —         —         —    
                        

Total nonaccrual loans

     5,511       3,858       3,727  
                        

Loans 90 days or more past due (as to principal or interest) and still accruing:

      

Real estate loans:

      

Construction and development

     2,639       —         —    

Residential loans

     —         —         18  

Commercial and multi-family

     —         —         237  

Commercial loans

     —         —         831  

Consumer loans

     —         —         —    

Equity lines of credit

     —         —         —    

Credit card and other loans

     —         —         —    
                        

Total loans 90 days or more past due and still accruing

     2,639       —         1,086  
                        

Restructured loans15

     —         —         —    
                        

Total nonperforming loans

     8,150       3,858       4,813  

Other real estate owned

     1,082       —         —    
                        

Total nonperforming assets

   $ 9,232     $ 3,858     $ 4,813  
                        

Nonperforming loans as a percentage of total loans16

     1.65 %     0.89 %     1.12 %

Nonperforming assets as a percentage of total loans and other real estate owned

     1.87 %     0.89 %     1.12 %

Allowance for loan losses to nonperforming loans

     76.04 %     148.81 %     121.28 %

Allowance for loan losses

   $ 6,197     $ 5,741     $ 5,837  
                        

 


14

Additional interest income of approximately $259,000 would have been recorded for the nine months ended September 30, 2007 if these loans had been paid or accrued in accordance with their original terms and had been outstanding throughout the applicable period then ended.

15

Restructured loans are loans where the terms are renegotiated to provide a reduction or deferral of interest or principal due to deterioration in the financial position of the borrower.

16

Total loans are gross loans, which excludes the allowance for loan losses, and net of deferred fees.

 

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Table of Contents

ALLOWANCE FOR LOAN LOSSES

Arriving at an appropriate level of an allowance for loan losses involves a high degree of judgment. Our allowance for loan losses provides for probable losses based upon an evaluation of known and inherent risks in the loan portfolio. The determination of the balance in the allowance for loan losses is based on an analysis of the loans receivable portfolio using a systematic methodology that reflects an amount that, in our judgment, is adequate to provide for probable loan losses inherent in the portfolio.

The allowance for loan losses totaled $6.2 million at September 30, 2007 compared to $5.7 million at December 31, 2006 and as a percentage of total loans outstanding was 1.26% and 1.33%, respectively. The process for monitoring the adequacy of the allowance, as well as supporting documentation regarding the allowance follows.

In originating loans, the Company recognizes that credit losses will be experienced and that the risk of loss will vary with the type of loan being made and a number of other factors, including collateral and the creditworthiness of the borrower over the term of the loan. It is Management’s policy to maintain an adequate allowance for loan losses based on a number of factors, including the Company’s loan loss experience, economic conditions, and regular reviews of delinquencies and loan portfolio quality.

The Company establishes an Allowance for Loan Losses (“ALL”) through charges to earnings based on Management’s evaluation of the loan portfolio and a number of other criteria. If warranted, the allowance may be increased by regular provisions in order to maintain a proper relationship to the aggregate funded and unfunded loan portfolio. The provision may be influenced by the amount of charge-offs and/or recoveries. The adequacy of the ALL is determined by a number of factors that are included in the Company’s ALL methodology.

Two primary forms of analysis are used as tools to determine the adequacy of the ALL. The Portfolio Risk Analysis takes into consideration key components of the aggregate loan portfolio and selected risk weight factors are used based on the perceived risk associated with each loan category. Heavier weight factors are assigned to delinquent loans and adversely risk rated loans. Adversely classified loans (loans rated special mention, substandard and doubtful) are assessed for the proper amount to be used in determining the adequacy of the ALL. The other categories have formulae used to determine the needed allowance amount. Special circumstances are identified and a selected risk factor prescribed to allocate an appropriate portion of the reserve to mitigate that specific risk. For example, because of the high concentration of construction loans, a construction concentration risk has been established as one of the components of the ALL methodology.

Another analytical tool used is a Migration Analysis. This tool tracks loan losses and recoveries over reasonable time horizons to determine a level of ALL based on historical loss history by loan category. This methodology is structured such that the amount allocated to the reserve is based on analysis of historical losses or other risk weight factors consistent with those utilized in the Portfolio Risk Analysis. This approach attempts to prevent an unreasonably low reserve level in the event actual loan loss history is low.

Other factors considered in the ALL methodology include the following: quality and scope of lending policies and procedures, national and local economic conditions, peer bank data, concentration or other special circumstances, and overall quality of the loan portfolio, determined by quality of underwriting, level of loan delinquencies, non-accrual loans, and non-performing loans. An important indicator is the risk rating quality of the aggregate loan portfolio. The Company conducts semi-annual risk rating certifications in order to maintain the integrity of the risk rating process. The risk ratings are stratified by loan type and according to risk rating.

The aggregate loan portfolio risk ratings were stratified as follows for the period indicated:

 

    

Pass/

Homogeneous:

    Special
Mention:
    Substandard:     Doubtful:     Loss:     Total:  

September 30, 2007

   92.83 %   6.86 %   0.30 %   0.01 %   0.00 %   100.00 %
                                    

 

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Table of Contents

For the nine months ended September 30, 2007 and 2006, the Company had net charge-offs of $244,000 and $359,000, respectively. Implicit in lending activity is the risk that losses will occur and that the amount of such loss will vary over time. In many cases Management exercises considerable judgment in determining the timing of the recognition of inherent losses with the objective to present a realistic presentation of the quality of the loan portfolio.

Except for nonperforming assets and impaired loans, Management is not aware of any loans as of September 30, 2007 for which known credit problems of the borrower would cause serious doubt as to the ability of such borrowers to comply with their present loan repayment terms. Management cannot, however, predict the extent to which the deterioration in general economic conditions, real estate values, increase in general rates of interest, changing financial conditions or business of a borrower may adversely affect a borrower’s ability to repay. The ratio of the allowance for loan losses to total loans was determined by Management to be adequate at September 30, 2007 and December 31, 2006.

 

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The following table summarizes the activity in the Company’s allowance for loan losses for the periods indicated:

Allowance for Loan Losses

 

     September 30,
2007
    December 31,
2006
    September 30,
2006
 
     (Dollars in Thousands)  

Balances:

      

Average total loans outstanding during period

   $ 460,013     $ 411,415     $ 405,009  
                        

Total loans outstanding at end of period, net of unearned income

   $ 493,769     $ 431,941     $ 431,563  
                        

Allowance for Loan Losses:

      

Balance at beginning of period

   $ 5,741     $ 5,376     $ 5,376  

Charge-offs:

      

Real estate loans:

      

Construction and development

     —         —         —    

Residential loans

     —         —         —    

Commercial and multi-family

     —         375       —    

Commercial loans

     654 17     688       443  

Consumer loans

     2       —         —    

Equity lines of credit

     —         55       55  

Credit card and other loans

     —         5       4  
                        

Total charge-offs

     656       1,123       502  
                        

Recoveries:

      

Real estate loans:

      

Construction and development

     —         —         —    

Residential loans

     2       2       2  

Commercial and multi-family

     —         —         —    

Commercial loans

     410       163       138  

Consumer loans

     —         3       3  

Equity lines of credit

     —         —         —    

Credit card and other loans

     —         —         —    
                        

Total recoveries

     412       168       143  
                        

Net (charge-offs) recoveries

     (244 )     (955 )     (359 )
                        

Provision charged to operations

     700       1,320       820  
                        

Allowance for loan losses balance, end of period

   $ 6,197     $ 5,741     $ 5,837  
                        

Ratios:18

      

Net loan charge-offs to average total loans

     0.05 %     0.23 %     0.09 %

Allowance for loan losses to average total loans

     1.35 %     1.40 %     1.44 %

Allowance for loan losses to total loans at end of period

     1.26 %     1.33 %     1.35 %

Allowance for loan losses to total nonperforming loans

     76.04 %     148.81 %     121.28 %

Net loan charge-offs to allowance for loan losses at end of period

     3.94 %     16.63 %     6.15 %

Net loan charge-offs to provision for loan losses

     34.86 %     72.35 %     43.78 %

 


17

Includes a $446,000 charge to the allowance for loan losses for the difference between total debt outstanding and the estimated fair value, less selling costs on other real estate owned recorded. (See nonperforming assets above).

18

Total loans are gross loans, which excludes the allowance for loan losses, and net of deferred fees.

 

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Table of Contents

INVESTMENTS

The Company’s investment portfolio provides income to the Company and also serves as a source of liquidity. Total yield, risk and maturity are among the factors considered in building the investment portfolio. Pursuant to FASB 115, securities must be classified as “held to maturity,” “available for sale,” or “trading securities.” Those securities held in the “available for sale” category must be carried on the Company’s books at fair market value. At September 30, 2007 and December 31, 2006, 100% of the investment securities owned by the Company were classified as “Available for Sale.”

At September 30, 2007, the Company’s investment portfolio at fair value consisted of $30.2 million in U.S. government agency securities, $71.4 million in federal agency mortgage-backed securities and $24.6 million in obligations of states and local government securities for a total of $126.2 million. At December 31, 2006, the Company’s investment portfolio at fair value consisted of $30.2 million in U.S. government agency securities, $19.7 million in federal agency mortgage-backed securities and $22.7 million in obligations of states and local government securities for a total of $72.6 million.

The Company’s investment portfolio increased $53.5 million or 74% to $126.2 million. During the third quarter of 2007, the Company entered into a $45.1 million repurchase agreement that included an interest rate floor to mitigate interest rate risk in a declining rate environment. The repurchase agreement was collateralized by the purchase of three federal agency mortgage-backed securities totaling $48.6 million. In addition, obligations of states and local government securities increased $1.8 million as the Company took advantage of relative value in that sector.

The following table is a comparison of amortized cost and fair value of investment securities as of the dates indicated:

Investment Portfolio

 

     September 30, 2007    December 31, 2006
     Amortized
Cost
  

Unrealized

Gains

  

Unrealized

Losses

   

Fair

Value

   Amortized
Cost
  

Unrealized

Gains

  

Unrealized

Losses

   

Fair

Value

     (Dollars in Thousands)

Available for Sale:

                     

U.S. government agency securities

   $ 30,000    $ 224    $ —       $ 30,224    $ 30,000    $ 210    $ —       $ 30,210

Federal agency mortgage-backed securities

     70,811      733      (124 )     71,420      19,597      190      (61 )     19,726

Obligations of states and local government securities

     25,201      62      (709 )     24,554      22,782      120      (189 )     22,713
                                                         

Total

   $ 126,012    $ 1,019    $ (833 )   $ 126,198    $ 72,379    $ 520    $ (250 )   $ 72,649
                                                         

The Company also had investments in interest-bearing time certificates of deposit at other financial institutions totaling $2.0 million at September 30, 2007 and $2.9 million at December 31, 2006.

 

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Table of Contents

DEPOSITS

Total deposits increased $31.4 million, or 7%, to $487.9 million at September 30, 2007 from $456.5 million at December 31, 2006. Noninterest-bearing demand deposits decreased $2.5 million or 2% at September 30, 2007 as compared to December 31, 2006. Interest bearing demand deposits decreased $9.2 million or 37%, while money market deposit accounts increased $33.2 million, or 22% at September 30, 2007 as compared to December 31, 2006. Savings deposit accounts decreased $6.1 million or 34% at September 30, 2007 as compared to December 31, 2006. Time deposits of $100,000 or greater increased $27.1 million, or 36% at September 30, 2007 as compared to December 31, 2006, and other time deposits decreased $11.1 million, or 15%.

The increase in money market deposit accounts was primarily the result of the Company’s efforts to attract new customers. The decrease in other time deposits was primarily the result of the Company allowing brokered certificates of deposit to run off and replacing them with less expensive FHLB borrowings.

Cost of funds

The Company’s cost of funds is calculated as total interest expense on interest-bearing deposits and other interest-bearing liabilities, annualized as a percentage of average interest-bearing deposits and other interest-bearing liabilities.

The rate paid on the Bank’s interest-bearing deposits increased to 3.96% for the nine months ended September 30, 2007 from 3.12% for the same period in 2006. For all interest bearing liabilities, the average rate for the nine months ended September 30, 2007 was 4.31% as compared to 3.39% for the same period in 2006. Market rate increases, coupled with the increase in rates paid on money market deposit accounts as a result of the Company’s efforts to attract new customers impacted the Company’s cost of funds.

From September 30, 2006 to September 30, 2007 the percentage of total average deposits represented by time deposits increased from 26% to 35%. The shift in this average deposit mix also contributed to the increase in cost of funds for the first nine months of 2007 versus 2006.

 

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The following table summarizes the distribution of average deposits and the average rates paid for the periods indicated:

Average Deposits and Other Borrowings19

 

     Nine Months Ended September 30,  
     2007     2006  
    

Average

Balance

   Average
Rate
   

Average

Balance

   Average
Rate
 
     (Dollars in Thousands)  

Demand deposits, noninterest bearing

   $ 108,092    0.00 %   $ 106,168    0.00 %
                  

Interest-bearing deposits:

          

Interest-bearing demand deposits

     20,552    0.34 %     26,364    0.35 %

Money market deposits

     171,539    3.88 %     157,411    3.33 %

Savings deposits

     13,067    0.84 %     21,842    1.03 %

Time deposits $100,000 or greater

     87,427    4.82 %     54,117    4.03 %

Other time deposits

     80,582    4.66 %     52,878    3.78 %
                  

Total interest-bearing deposits

     373,167    3.96 %     312,612    3.12 %
                  

FHLB borrowings

     2,924    5.08 %     —      0.00 %

Federal funds purchased

     744    5.57 %     —      0.00 %

Repurchase agreement

     40,906    5.94 %     2,198    5.72 %

Subordinated notes payable to subsidiary trusts

     16,458    7.91 %     18,306    7.82 %
                  

Total deposits and other borrowings

   $ 542,291    3.45 %   $ 439,284    2.57 %
                  

Average rate excluding noninterest bearing demand deposits

      4.31 %      3.39 %
          

The following table summarizes the composition of average deposits as a percentage of total average deposits for the periods indicated:

Percent of Total Average Deposit Composition

 

     Nine Months Ended
September 30,
 
     2007     2006  
    

Percent of

Total

   

Percent of

Total

 

Demand deposits, noninterest bearing

   22.46 %   25.35 %

Interest-bearing deposits:

    

Interest-bearing demand deposits

   4.27 %   6.30 %

Money market deposits

   35.64 %   37.58 %

Savings deposits

   2.72 %   5.22 %

Time deposits $100,000 or greater

   18.17 %   12.92 %

Other time deposits

   16.74 %   12.63 %
            

Total average deposits

   100.00 %   100.00 %
            

 


19

Rates for these periods on which calculations are based have been annualized using actual days.

 

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The following table sets forth the scheduled maturities of time certificates of deposit accounts outstanding in amounts of $100,000 or more for the periods indicated:

 

     3 Months
or Less
  

Over 3 Months

Through 6
Months

   Over 6 Months
Through 12
Months
   Over 12
Months
   Total
     (Dollars in Thousands)

September 30, 2007

   $ 38,418    $ 25,232    $ 18,929    $ 19,243    $ 101,822
                                  

December 31, 2006

   $ 23,514    $ 23,418    $ 19,739    $ 8,093    $ 74,764
                                  

LIQUIDITY AND MARKET RISK MANAGEMENT

Liquidity

Liquidity is defined as the Company’s ability to raise cash when it needs it at a reasonable cost and with a minimum of principal loss. The Company must be capable of meeting all obligations to our customers at any time and, therefore, active management of our liquidity position is critical.

Given the uncertain nature of our customers’ demands as well as the Company’s desire to take advantage of earnings enhancement opportunities, the Company must have available adequate sources of on and off balance sheet funds that can be acquired in time of need. Accordingly, in addition to the liquidity provided by normal cashflows, liquidity must be supplemented with additional sources. As of September 30, 2007 the Company had Federal Funds borrowing arrangements with five correspondent banks totaling $50.0 million, and a secured line of credit with the FHLB totaling approximately $32.6 million. Other funding alternatives may also be appropriate, including, wholesale and retail repurchase agreements and Brokered certificates of deposit to a limit of 30% of total consolidated assets.

As of September 30, 2007, brokered deposits totaled $33.0 million or were 5% of total consolidated assets.

The Company will periodically (at least quarterly) review a Tier 3 Basic Surplus/Deficit calculation. If the calculation produces a positive net number “BASIC SURPLUS”, then all of the Company’s short-term and potentially volatile liabilities are covered by its liquid asset position. Conversely, a negative number “BASIC DEFICIT” represents the extent to which non-liquid assets are being supported by vulnerable liabilities. Since there can be a significant cost associated with carrying excess liquidity, the Company will exercise care to avoid unnecessary expense/opportunity loss in this regard. The Board of Directors also authorizes the use of qualifying FHLB loan collateral and Brokered CD’s in the Company’s liquidity/funds management practices to supplement basic surplus.

The Company’s policy is to maintain the liquidity ratio at above 10%. The Company’s liquidity ratio is a measure of liquid assets to total consolidated assets. On a consolidated basis, the liquidity ratio was 21.3% at September 30, 2007 and 24.8% at December 31, 2006.

Management’s position is that the standby funding sources available to the Company are adequate and reliable to meet the Company’s current and anticipated short-term liquidity needs.

 

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The following table sets forth certain information with respect to the Company’s liquidity as of the periods indicated:

Liquidity/Basic Surplus

 

     September 30,
2007
    December 31,
2006
 
     (Dollars in Thousands)  
I. Liquid Assets     

Federal funds sold

   $ —       $ 2,900  

Available/unencumbered security collateral

     10,700       17,450  

Unpledged government and agency guaranteed loans

     570       132  

Interest-bearing deposits in financial institutions maturing within 30 days

     100       —    
                

Total liquid assets

     11,370       20,482  
                
II. Short Term / Potentially Volatile Liabilities & Coverages     

Federal funds purchased

     (5,610 )     —    

25% of regular time deposits maturing within 30 days

     (1,131 )     (730 )

30% of time deposits $100,000 or greater maturing within 30 days

     (4,610 )     (1,885 )

10% of other deposits

     (32,267 )     (30,725 )
                

Basic Surplus

     (32,248 )     (12,858 )
                
III. Qualifying FHLB Loan Collateral     

Maximum borrowing capacity

     32,556       34,255  

Current FHLB advance balances

     (25,000 )     —    
                

Basic Surplus with FHLB

     (24,692 )     21,397  
                
IV. Brokered Deposit Access     

Maximum Board authorized brokered CD capacity

     198,103       165,338  

Current brokered CD balances

     (33,002 )     (50,324 )
                

Basic Surplus with FHLB and brokered CD’s

   $ 140,409     $ 136,411  
                

Percent of assets

     21.3 %     24.8 %

Market Risk Management

Market risk arises from changes in interest rates, exchange rates, commodity prices and equity prices. The Company’s market risk exposure is primarily that of interest rate risk, and it has established policies and procedures to monitor and limit earnings and balance sheet exposure to changes in interest rates. The Company does not engage in the trading of financial instruments, nor does the Company have exposure to currency exchange rates. The Company’s earnings depend primarily upon the difference between the income it receives from its interest earning assets and its cost of funds, principally interest expense incurred on interest-bearing liabilities. Interest rates charged by the Company on its loans are affected principally by the demand for loans, the supply of money available for lending purposes, and competitive factors. In turn, these factors are influenced by general economic conditions and other constraints beyond the Company’s control, such as governmental economic and tax policies, general supply of money in the economy, governmental budgetary actions and the actions of the Federal Reserve Board (“FRB”).

 

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Interest Rate Risk Management

The principal objective of interest rate risk management (often referred to as “asset/liability management”) is to manage the financial components of the Company’s statement of condition in a manner that will optimize the risk/reward equation for earnings and capital in relation to changing interest rates. The Company has adopted formal policies and practices to monitor and manage interest rate risk exposure. As part of this effort, the Company measures interest rate risk utilizing a modeling program from an outside vendor, enabling Management to better manage economic risk and interest rate risk.

The fundamental objective of the Company’s management of its assets and liabilities is to maximize the economic value of the Company while maintaining adequate liquidity and an exposure to interest rate risk deemed by Management to be acceptable. Management believes an acceptable degree of exposure to interest rate risk results from the management of assets and liabilities through maturities, pricing and mix to attempt to neutralize the potential impact of changes in market interest rates. The Company’s profitability is dependent to a large extent upon its net interest income, which is the difference between its interest income on interest-earning assets such as loans and securities, and its interest expense on interest-bearing liabilities, such as deposits and borrowings. The Company, like other financial institutions, is subject to interest rate risk to the degree that its interest-earning assets reprice differently than its interest-bearing liabilities, i.e., not at the same time, or to the same magnitude. The Company manages its mix of assets and liabilities with the goal of limiting its exposure to interest rate risk, ensuring adequate liquidity, and coordinating its sources and uses of funds. Interest income and interest expense are affected by general economic conditions and by competition in the marketplace. The Company’s interest and pricing strategies are driven by its asset/liability management analyses and by local market conditions.

In connection with the above-mentioned strategy, the Company studies the change in net interest income and net interest margin given immediate and parallel interest rate shocks over a 12-month horizon. The Company’s goal is to manage the effect of these changes within Board-established parameters of “less than a 10% change” for up/down 200 basis points. Shown below are possible changes to net interest income and the net interest margin based upon the model’s program under 200 basis point increases or decreases as of September 30, 2007:

 

Change

(in Basis Points)

 

Net Interest Income

(next twelve months)

 

Change in Net

Interest Income

    % Change in
Net Interest Income
    Net Interest
Margin
 
(Dollars in Thousands)  
+ 200   $ 32,164   $ 2,503     8.44 %   5.39 %
– 200     27,166     (2,494 )   (8.41 %)   4.55 %

These results indicate the effect of immediate rate changes and do not consider the yield from reinvesting in short-term versus long-term instruments. The above profile illustrates that if there were an immediate and sustained downward adjustment of 200 basis points in interest rates, the net interest margin over the next twelve months would likely be 4.55%. Conversely, if there were an immediate increase of 200 basis points in interest rates, the Company’s net interest margin would likely be 5.39%. The net interest margin will improve if rates rise and decline if rates fall. Management and the Board of Directors consider the results indicated by the report to be acceptable.

 

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CAPITAL RESOURCES

The Federal Reserve Board and the FDIC have both established guidelines to implement risk-based capital requirements. Falling below minimum established levels might limit a bank or bank holding company from certain activities. Failure to satisfy applicable guidelines may also subject a banking institution to a variety of enforcement actions by Federal regulatory authorities.

The Company and the Bank are required to maintain the following minimum ratios: Total risk-based capital ratio of at least 8%, Tier 1 risk-based capital ratio of at least 4%, and a leverage ratio of at least 4%. Total capital is classified into two components: Tier 1 (common shareholders equity, qualifying perpetual preferred stock to certain limits, minority interests in equity accounts of consolidated subsidiary and trust preferred securities to certain limits, including notes payable to unconsolidated special purpose entities that issue trust preferred securities, less goodwill and other intangibles) and Tier 2 (supplementary capital including allowance for possible credit losses to certain limits, certain preferred stock, eligible subordinated debt, and trust preferred securities, including notes payable to unconsolidated special purpose entities that issue trust preferred securities that are in excess of the limits for inclusion in Tier 1 capital). Under the established guidelines, the Company has attained the highest level of capitalization, characterized as “Well Capitalized.” It is the intent of the Company to continue to maintain “Well Capitalized” ratios.

Total shareholders’ equity was $49.4 million at September 30, 2007, compared to $42.2 million at December 31, 2006. The increase of $7.2 million, or 17% during the first nine months of 2007 was primarily due to $6.2 million in year-to-date net income, $461,000 credited to capital in relation to compensation expense associated with the issuance of stock options and the proceeds of $526,000 from the exercise of stock options, including tax benefit.

 

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The following table illustrates the capital and prompt corrective action guidelines applicable to the Company and the Bank, as well as their total risk-based capital ratios, Tier 1 capital ratios and leverage ratios as of the dates indicated:

 

    

Actual

Amount/Ratio

   

Minimum

Capital
Requirement

Amount/Ratio

   

Minimum

To Be Well

Capitalized Under

Prompt Corrective

Action Provisions

Amount/Ratio

 

As of September 30, 2007:

               

Total capital to risk-weighted assets:

               

the Company

   $ 63,696    11.99 %   $ 42,504    8.00 %   $ 53,130    10.00 %

the Bank

     61,749    11.62 %     42,496    8.00 %     53,120    10.00 %

Tier 1 capital to risk-weighted assets:

               

the Company

     57,051    10.74 %     21,252    4.00 %     31,878    6.00 %

the Bank

     55,105    10.37 %     21,248    4.00 %     31,872    6.00 %

Tier 1 capital to average assets:

               

the Company

     57,051    9.05 %     25,212    4.00 %     31,515    5.00 %

the Bank

     55,105    8.75 %     25,194    4.00 %     31,493    5.00 %

As of December 31, 2006:

               

Total capital to risk-weighted assets:

               

the Company

   $ 61,806    12.92 %   $ 38,284    8.00 %   $ 47,855    10.00 %

the Bank

     59,691    12.47 %     38,283    8.00 %     47,854    10.00 %

Tier 1 capital to risk-weighted assets:

               

the Company

     51,827    10.83 %     19,142    4.00 %     28,713    6.00 %

the Bank

     53,701    11.22 %     19,142    4.00 %     28,712    6.00 %

Tier 1 capital to average assets:

               

the Company

     51,827    9.46 %     21,905    4.00 %     27,381    5.00 %

the Bank

     53,701    9.82 %     21,885    4.00 %     27,356    5.00 %

Of the Company’s $57.1 million of Tier 1 capital at September 30, 2007, $12.0 million consisted of Trust Preferred Securities. Trust Preferred Securities, up to the amount of 25% of core capital, may be included in Tier 1 capital for regulatory purposes, but classified as long-term debt in accordance with generally accepted accounting principles, however, no assurance can be given that trust preferred securities will continue to be treated as Tier 1 capital in the future.

On July 7, 2007, Centennial Capital Trust I (the “Trust”), a wholly-owned subsidiary of 1st Centennial Bancorp (the “Company”), redeemed 100% of its trust preferred securities that were issued on July 11, 2002 with a maturity date of October 7, 2032, as allowed by the early redemption provisions of the transaction documents concerning those securities. Simultaneously, the Company retired the $6,186,000 principal amount of junior subordinated debentures issued to the Trust that became due and payable upon redemption of the trust preferred securities. The Trust, which was dissolved on July 12, 2007, returned the $186,000 in capital to the Company in exchange for the cancellation of the common securities in that amount originally issued by the Trust to the Company at the close of the transaction in 2002.

 

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Table of Contents
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information concerning quantitative and qualitative disclosures about market risk is included as part of Part I, Item 2 above. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Market Risk Management.”

 

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

The Company’s Chief Executive Officer and its Chief Financial Officer, after evaluating the effectiveness of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a – 15(e) promulgated under the Exchange Act) as of the end of the period covered by this quarterly report (the “Evaluation Date”) have concluded that as of the Evaluation Date, the Company’s disclosure controls and procedures were adequate and effective to ensure that material information relating to the Company and its consolidated subsidiary would be made known to them by others within those entities, particularly during the period in which this quarterly report was being prepared.

Changes in Internal Controls

There were no significant changes in the Company’s internal controls over financial reporting or in other factors that occurred in the third quarter of 2007 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.

PART II – OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

In the normal course of business, the Company from time to time is involved in claims and legal proceedings. In the opinion of management, any liability resulting from such proceedings would not have a material adverse effect on the Company’s financial condition or results of operation.

 

ITEM 1A. RISK FACTORS

The following discussion describes material changes from the risk factors included in our annual report on Form 10-K for the fiscal year ended December 31, 2006, and should be read in conjunction with the risk factors section of the Form 10-K and all other information contained in this Form 10-Q and other reports filed by the Company with the SEC. The remaining risk factors disclosed in our Form 10-K have not changed in any material respect.

Concentrations of real estate loans could subject us to increased risks in the event of a real estate recession or natural disaster, and may also subject us to increased regulatory risks.

Approximately $299.7 million or 60.5% of our loan portfolio as of September 30, 2007, and $254.3 million or 58.7% of our loan portfolio as of December 31, 2006, was concentrated in real estate loans. Of this amount, as of September 30, 2007, $221.1 million represented construction and development loans, $2.6 million represented residential loans, and $76.0 million represented commercial and multi-family loans. As of September 30, 2007, our total nonperforming assets increased to $9.2 million, or 1.87% of total loans and other real estate owned, compared to $3.9 million or .89% at December 31, 2006. As of September 30, 2007, approximately $8.9 million or 96.3% of the nonperforming assets involved real estate loans. The Southern California real estate market ended 2006 with declining prices and a slower sales pace. If real estate sales and appreciation continue to weaken, we might experience an increase in the percentage of nonperforming assets in our commercial real estate and commercial and industrial loan portfolios. If the level of our nonperforming real estate loans and other real estate owned further increases, the result could be reduced income, increased expenses, and less cash available for lending and other activities.

 

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As the primary collateral for many of our loans rests on commercial real estate properties, deterioration in the real estate market in the areas we serve could reduce the value of the collateral for many of our loans and negatively impact the repayment ability of many of our borrowers. In addition, such deterioration would likely reduce the amount of loans we make to businesses in the construction and real estate industry, which could negatively impact our business. Similarly, the occurrence of a natural disaster like those California has experienced in the past, including earthquakes, brush fires, and flooding, could impair the value of the collateral we hold for real estate secured loans and negatively impact our results of operations.

The Company has approximately $2.1 million in construction and development loans that are in the general area of the recent California fires that began in October 2007. We are unable to determine the extent of damage at this point, however, fire insurance coverage is in place on all properties eliminating the Company’s potential exposure to loss.

In addition, the banking regulators have begun to give commercial real estate (“CRE”) loans greater scrutiny, due to perceived risks relating to the cyclical nature of the real estate market and the related risks for lenders with high concentrations of such loans. The regulators may require banks with higher levels of CRE loans to implement improved underwriting, internal controls, risk management policies and portfolio stress testing, and may possibly require higher levels of allowances for possible loan losses and capital levels as a result of CRE lending growth and exposures.

 

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Stock Repurchases

On September 21, 2007 the Board of Directors of the Company approved a plan to incrementally repurchase up to an aggregate of $3.0 million of the Company’s common stock. There were no repurchases during the third quarter of 2007. The repurchase program commenced on October 17, 2007 and will continue for a period of twelve months thereafter. See “Notes to Consolidated Financial Statements – Note 5, Stock Repurchase Program.”

 

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None

 

ITEM 5. OTHER INFORMATION

None.

 

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ITEM 6 EXHIBITS

 

Exhibit No.   

Description of Exhibits

3.1    Articles of Incorporation of the Company20
3.2    Amendment to Articles of Incorporation of the Company21
3.3    Amendment to Articles of Incorporation of the Company22
3.4    Restated By-Laws of the Company23
10.1    Form of Indemnification Agreement24
10.2    Amended and Restated Stock Incentive Plan25
10.3    1st Centennial Bank Employee Stock Ownership Plan (with 401(k) provisions) dated August 1, 200425
10.4    Employment Agreement of Beth Sanders dated December 1, 200425
10.5    Employment Agreement of Suzanne Dondanville dated December 1, 200425
10.6    Salary Continuation Agreement of Anne Elizabeth Sanders dated December 1, 200126
10.7    Salary Continuation Agreement of Suzanne Dondanville dated December 17, 200227
10.8    Salary Continuation Agreement of Clifford Schoonover dated December 17, 200227
10.9    Amendment to Salary Continuation Agreement of Anne Elizabeth Sanders dated December 1, 200128
10.10    Amendment to Salary Continuation Agreement of Suzanne Dondanville dated December 17, 200228
10.11    Amendment to Salary Continuation Agreement of Clifford Schoonover dated December 17, 200228
10.12    Salary Continuation Agreement of Thomas E. Vessey dated April 7, 200629
10.13    Salary Continuation Agreement of John P. Lang dated April 7, 200629
10.14    Form of Agreement between 1st Centennial Bank and Officers with respect to Death Benefit.30
10.15    Indenture for Trust Preferred Securities dated September 28, 200531
10.16    Amended and Restated Declaration of Trust for Trust Preferred Securities dated September 28, 200531
10.17    Guarantee Agreement for Trust Preferred Securities dated September 28, 200531
10.18    Indenture for Trust Preferred Securities dated January 15, 200432
10.19    Amended and Restated Declaration of Trust for Trust Preferred Securities dated January 15, 200432
10.20    Guarantee Agreement for Trust Preferred Securities dated January 15, 200432

20

Incorporated by reference to exhibit of the same number on Form S-4 dated October 20, 1999.

21

Incorporated by reference to exhibit of the same number on Form 10-QSB for the quarter ended June 30, 2002.

22

Incorporated by reference to exhibit of the same number on Form SB-2 dated March 13, 2003.

23

Incorporated by reference to exhibit of the same number on Form 8-K dated January 19, 2007.

24

Incorporated by reference to exhibit 10.2 on Form SB-2 dated March 21, 2001.

25

Incorporated by reference to exhibit 10.10, 10.9, 10.31 and 10.32, respectively, on Form 10-KSB for the year ended December 31, 2004.

26

Incorporated by reference to exhibit 10.30 on Form 10-QSB for the quarter ended September 30, 2004.

27

Incorporated by reference to exhibit 10.17 and 10.18, respectively, on Form SB-2 dated March 13, 2003.

28

Incorporated by reference to exhibit 10.25, 10.24 and 10.26, respectively, on Form 10-KSB for the year ended December 31, 2003.

29

Incorporated by reference to exhibit 99.1 on Form 8-K dated April 11, 2006.

30

Incorporated by reference to exhibit 99.1 on Form 8-K dated November 3, 2006.

31

Incorporated by reference to exhibit 10.35, 10.36 and 10.37, respectively, on Form 10-Q for the quarter ended September 30, 2005.

32

Incorporated by reference to exhibit 10.25, 10.26 and 10.27, respectively, on Form 10-QSB for the quarter ended March 31, 2004.

 

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10.21    Indenture for Trust Preferred Securities dated July 11, 200233
10.22    Amended and Restated Declaration of Trust for trust preferred securities dated July 11, 200233
10.23    Guarantee Agreement for Trust Preferred Securities dated July 11, 200233
10.24    Director Deferred Compensation Plan/Agreement entered into with each non-employee Director effective July 20, 200734
31.1    Certification of Chief Executive Officer (Section 302 Certification)
31.2    Certification of Chief Financial Officer (Section 302 Certification)
32    Certification of Periodic Financial Report (Section 906 Certification)

33

Incorporated by reference to exhibit 10.17, 10.18 and 10.19, respectively, on Form 10-QSB for the quarter ended September 30, 2002.

34

Incorporated by reference to exhibit 99.1 on Form 8-K dated July 20, 2007.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on this 7th day of November 2007.

 

1ST CENTENNIAL BANCORP
/s/    Thomas E. Vessey

Thomas E. Vessey

President and Chief Executive Officer

 

/s/    Beth Sanders

Beth Sanders

Executive Vice President and Chief Financial Officer

 

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