10-K 1 a09-1633_110k.htm 10-K

Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-K

 

(Mark One)

 

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

 

For the fiscal year ended December 31, 2008

 

OR

 

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

 

For the transition period from              to             

 

Commission file number 001-33890

 

1ST PACIFIC BANCORP

(Exact name of registrant as specified in its charter)

 

California
(State or Other Jurisdiction of
Incorporation or Organization)

 

20-5738252
(IRS Employer
Identification No)

 

 

 

9333 Genesee Avenue #300
San Diego, California
(Address of Principal Executive Offices)

 

92121
(Zip Code)

 

(858) 875-2000

(Issuer’s telephone number)

 

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

 

Title of each class

 

Name of each exchange on which registered

 

Common Stock, No Par Value

 

The NASDAQ Stock Market LLC

 

 

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
(None)

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x

 

Note-Checking above box will not relieve any registrant required to file reports pursuant to Section 13 or 15(d) of the Exchange Act from their obligations under those Sections.

 

Persons who respond to the collection of information contained in this form are not required to respond unless the form displays a currently valid OMB control number.

 

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 o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

 

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

 

Large accelerated filer o

Accelerated filer o

 

 

Non-accelerated filer   o (Do not check if a smaller reporting company)

Smaller reporting company x

 

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

 

The aggregate market value of the common stock held by non-affiliates of the Registrant as of June 30, 2008 was approximately $36.1 million. The number of Registrant’s shares of common stock outstanding at March 24, 2009 was 4,980,481.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain information required by Part III of this Annual Report is incorporated by reference from (i) the Registrant’s definitive proxy statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A if filed not later than 120 days after the end of the fiscal year covered by this Annual Report, or (ii) if the Registrant’s definitive proxy statement is not filed within the 120 day period, then from an amendment to this Annual Report, which will be filed not later than the end of the 120 day period.

 

 

 



Table of Contents

 

1st Pacific Bancorp

 

TABLE OF CONTENTS

 

 

 

PAGE

 

 

 

PART I

 

1

ITEM 1.

BUSINESS

1

ITEM 1A.

RISK FACTORS

16

ITEM 1B.

UNRESOLVED STAFF COMMENTS

24

ITEM 2.

PROPERTIES

24

ITEM 3.

LEGAL PROCEEDINGS

25

ITEM 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

25

 

 

 

PART II

 

25

ITEM 5.

MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

25

ITEM 6.

SELECTED FINANCIAL DATA

27

ITEM 7.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

28

ITEM 7A.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

51

ITEM 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

52

ITEM 9.

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

52

ITEM 9A(T).

CONTROLS AND PROCEDURES

52

ITEM 9B.

OTHER INFORMATION

53

 

 

 

PART III

 

54

ITEM 10.

DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

54

ITEM 11.

EXECUTIVE COMPENSATION

54

ITEM 12.

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

54

ITEM 13.

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

55

ITEM 14.

PRINCIPAL ACCOUNTING FEES AND SERVICES

55

 

 

 

PART IV

 

55

ITEM 15.

EXHIBITS, FINANCIAL STATEMENT SCHEDULES

55

 

 

 

SIGNATURES

59

 

 

INDEX TO FINANCIAL STATEMENTS

61

 



Table of Contents

 

PART I

 

ITEM 1.                                                     BUSINESS

 

General

 

1st Pacific Bancorp (the “Company”, “we”, “our”, or “us”) is a California corporation incorporated on August 4, 2006 and is registered with the Board of Governors of the Federal Reserve System as a bank holding company under the Bank Holding Company Act of 1956, as amended.  1st Pacific Bank of California (the “Bank”) is a wholly-owned bank subsidiary of the Company and was incorporated in California on April 17, 2000.  The Bank is a California corporation licensed to operate as a commercial bank under the California Banking Law by the California Department of Financial Institutions (the “DFI”).  In accordance with the Federal Deposit Insurance Act, the Federal Deposit Insurance Corporation (the “FDIC”) insures the deposits of the Bank.  The Bank is a member of the Federal Reserve System.

 

A reorganization to form a holding company was completed on January 16, 2007, whereby all outstanding shares of the Bank were converted into an equal number of shares of the Company. Prior to the reorganization, the Company had minimal activity, which was primarily related to preparing for the reorganization.  At present, the Company does not engage in any material business activities other than ownership of the Bank. References to the Company are references to 1st Pacific Bancorp (including the Bank), except for periods prior to January 16, 2007, in which case, references to the Company are to the Bank.

 

After completing its initial public offering, the Company commenced operations on November 17, 2000, from a branch office in the Golden Triangle area of San Diego and a branch office in the Tri-Cities area of North San Diego County (“North County”).  In the following years, the Company opened additional branch offices, one in the Mission Valley area of San Diego, one in the Inland North County area of San Diego and one in El Cajon.

 

On July 1, 2007, the Company completed the acquisition of Landmark National Bank (“Landmark”), with assets of approximately $109.0 million. Landmark’s two established offices became part of the Bank’s branch network; one in Solana Beach and one in downtown La Jolla. As a result of the acquisition, the financial results found herein reflect the combined entity beginning July 2, 2007.

 

During the third quarter of 2007, the Company moved its corporate headquarters location within the University Towne Centre area of San Diego and relocated the Golden Triangle branch office to the same facility. In February 2008, the Company opened a limited service branch office in downtown San Diego.

 

The Company is organized as a single operating unit with eight branch offices. The Company’s primary source of revenue is interest earned on loans it provides to customers.  The Company funds its lending activities primarily through providing deposit products and services to customers, but also through advances from the Federal Home Loan Bank of which we are a member, correspondent banks, the Federal Reserve Bank and brokered deposits.  The Company’s customers are predominately small and medium-sized businesses and professionals in San Diego County.  As of December 31, 2008, the Company has grown to approximately $421 million in total assets.

 

Strategy

 

The Company’s mission statement is: “To build relationships that create significant results for our customers, employees, shareholders and community.”  The Company believes that to be successful in its competitive environment, it needs to attract and retain great people (e.g. directors and employees) to foster and grow loyal client relationships, which build enduring franchise value.  This strategy is synopsized by the Company’s corporate motto:  People.Relationships.Results.

 

Services Offered

 

The primary operational focus of the Company is to meet the financial service needs of its target market — small and medium-sized businesses and professionals — within its service area.  Therefore, the Company offers a full line of loan and deposit products and certain related financial services designed to cater to this target market.  As a community bank, the Company’s personnel are actively involved in the community and an emphasis is placed on personalized “relationship banking,” where the banking relationship is predicated on the banker’s familiarity with the customer and its business.

 

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Lending Services. As discussed in further detail below, the Company’s lending activities focus on commercial and residential real estate loans, construction loans, commercial business loans and loans made or guaranteed through the Small Business Administration (the “SBA”) loan program responsive to the target market’s needs.  The Company believes these loan products take advantage of the local economy and the consolidation of banking institutions in San Diego County and contiguous areas, which have created opportunities for an independent, service-oriented bank.

 

Real Estate Loans.  The Company offers real estate loans for construction and term financing.  Construction loans include loans for single-family homes (both owner occupied and speculative), small residential tract developments, commercial projects (such as multi-family housing, industrial, office and retail centers) and early stage acquisition and development loans for land and lots.  Permanent financing is offered for commercial properties and single-family residential properties.

 

Commercial Loans.  The Company offers the following types of commercial loans:

 

·                                          Short-term working capital loans, both secured and unsecured.

 

·                                          Revolving credit accounts, secured and unsecured, such as credit extensions supported by formal business assets (e.g. accounts receivable and inventory).

 

·                                          Single purpose loans, such as term loans for facilities, plant and equipment.

 

·                                          Stand-by letters of credit.

 

SBA Loan Programs.  The SBA, headquartered in Washington, D.C., and operating in 10 regions throughout the United States, offers financial assistance to eligible small businesses in the form of partial government guarantees on loans made to such businesses by qualified participating lenders under the SBA’s guaranteed loan program (the “7(a) program”).  In order to be eligible for the 7(a) program, a business generally must be operated for profit and, depending on the industry of the potential borrower, must fall within specified limitations on numbers of employees or annual revenues.  The Company is an SBA qualified participating lender and, in 2002, was awarded SBA’s “Preferred Lender” status.  This Preferred Lender status allows the Company to make loans under SBA programs without prior SBA approval.

 

SBA 7(a) program loans are SBA-guaranteed loans made by approved financial institutions.  For term loans, the loan guarantees vary from 75% to 85% of the loan balance, depending on the size of the loan, and terms vary from five to twenty-five years depending on the purpose of the loan.  Revolving loans are limited to a maximum term of seven years and the loan guarantee may not exceed 50% of the loan amount.  The aggregate balance of the SBA guaranteed portions of all outstanding SBA loans to one borrower and its affiliates may not exceed $2.0 million.

 

SBA 7(a) program loans are typically written at variable rates of interest, which rates are generally limited by SBA guidelines.  These guidelines limit the maximum rate for loans with maturities less than seven years to 225 basis points over the lowest prime-lending rate published in The Wall Street Journal (“WSJ Prime”).  The maximum rate for loans with maturities in excess of seven years is 275 basis points over the WSJ Prime.  Typically rates are adjusted on the first day of each calendar quarter.

 

In addition to participation in the SBA’s 7(a) programs, the Company also offers loans primarily for real estate-related projects under Section 504 of the Small Business Administration Act of 1953 (“504 loans”), such as for purchasing land and improvements, construction, modernizing or converting existing facilities and purchasing certain machinery and equipment.  Under the 504 loan program, the borrower must provide at least 10% of the equity for the financing.  Under a typical 504 loan, the Company will make a loan for 50% of the principal amount, which is secured by, among other assets, a first priority mortgage on the underlying property.  The Company will provide the remaining amount of the funds as a short-term loan with a maturity from 90 days up to one year (the “Bridge Loan”).  The borrower repays the Bridge Loan with the proceeds received from a bond issuance by a certified development company — a not-for-profit corporation established to create and issue debt securities that are fully guaranteed by the SBA.  The debt securities are sold to institutional investors.  Under the 504 loan program, SBA debentures may be issued for up to $4.0 million and, if a public policy is met, up to $8.0 million for manufacturers.

 

Like many other government programs, the lending programs of the SBA are federal government programs authorized by legislation and uncertainties surround the SBA programs due to reliance on the United States

 

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Congress and the federal budgeting process for each fiscal year.  There can be no assurance that the SBA lending program will continue in its present manner.

 

Consumer Loans.  The Company loans for personal, family or household purposes.  These loans represent a small portion of the Company’s overall loan portfolio.  However, these loans are important in terms of servicing customer needs in the market area of the Company’s offices and ancillary lending needs of the Company’s primary target market.

 

Deposit Products and Services. The Company’s expertise is developing custom-tailored financial solutions for individuals, businesses and professionals desiring personalized banking services.  The diverse needs of its commercial and consumer customers are considered and, as such, the Company offers a wide range of accounts and services, designed around the preferences of our customers.  Account officers consult with the various specialists in the Company to satisfy the customer’s immediate and long-range deposit and borrowing needs. As a community bank, the following services offered are designed to make banking easy and convenient.

 

Bank Deposits.  The Company offers personal and business checking, money market, savings and certificates of deposit accounts which can all be tied into a one-statement package.  The types and terms of such accounts are offered on a competitive basis.  The interest rates payable by the Company on the various types of interest-bearing deposit accounts are a function of a number of factors, including rates paid by the Company’s competitors, the need for liquidity for lending operations and the changes in monetary policy as announced by the Federal Open Market Committee.

 

Cash Management Services.  The Company specializes in meeting the unique banking needs of business owners.  The Company accomplishes this by having developed a comprehensive set of cash management tools and services.  Some of the cash management products the Company offers are online banking, automated clearing house (“ACH”) origination, wire transfers, daily sweep products, lockbox processing and account transfers / management.  The Company also has a wire transfer system with advanced features for business customers that, among other things, provide immediate confirmation of wire receipts.  In addition to these products, the Company offers courier service to collect deposits from San Diego-area customers and has a correspondent relationship with another bank allowing the Company to accept deposits at thousands of third party locations for non-local depository needs.

 

The Company also offers a service called Remote Deposit Capture which allows the customer to create and submit a deposit from their place of business. In March 2007, an additional feature called BusinessPro Deposit Link was introduced. This feature was added to the Company’s online banking program for businesses. Deposit Link allows customers to make deposits into their checking accounts from their offices. Checks can be scanned, transmitted and deposited to their business checking accounts using office computers. This service is valuable to businesses that frequently make deposits because it reduces the number of bank visits and/ or courier costs. The Company has thirty (30) Deposit Link Service customers as of February 2009.

 

Internet Banking.  Through internet banking customers may conduct their banking business remotely from any location and business customers are able to access cash management products, originate wire transfers and complete ACH transactions. Business customers may have multiple user access with separately defined user capabilities.

 

Marketing Focus

 

The Company markets and advertises its services primarily to targeted customers in its primary service area. The Company focuses on meeting the needs of its targeted customers, as well as being well informed about its market and competition.  Among other things, the Company’s key focus is to establish and build strong financial relationships with its customers using a trusted advisor and relationship approach.  The Company communicates to customers and prospects directly through its business development sales force and through media advertising and direct mail communications.

 

The Company established an Advisory Board in November 2002, which consists of many local community and business leaders.  In addition to their roles as advisors to the Company, the Advisory Board members represent the Company at events with the objective of increasing the Company’s visibility.  Furthermore, members of the Company’s Board of Directors are visible and active in the San Diego community.  Over time, the Company expects to continue to benefit from involvement in these civic and community activities and the goodwill and recognition it provides to the Company.  The Company’s on-going public relations efforts emphasize its local ownership, relationship—based philosophy, customer service and commitment to its community.

 

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Service Area

 

The Company considers its primary market to be the greater San Diego County region and this is where it has chosen to locate all of its branch offices. San Diego and the surrounding county has grown from a small military town to a population of approximately three million people in part because of its desirable climate, diversified economy and employment base.

 

The Company’s executive office and its original head office are both located in the Golden Triangle area of San Diego, which is a hub of the “North City” business center.  The Company’s second original branch office is located in the Tri-Cities area of North County (Oceanside, Carlsbad and Vista).  The Company’s third branch office was opened in 2003 in the Mission Valley area of San Diego.  In 2005, the Company opened its fourth branch office in the Inland North County Area of San Diego along the Interstate 15 corridor. A fifth branch office was opened in April 2006 in the city of El Cajon in San Diego’s East County Area.  Effective July 1, 2007, the Company completed its acquisition of Landmark and added two branch offices in Solana Beach and La Jolla to the Company’s branch network. In February 2008, the Company opened a limited service branch office in downtown San Diego.

 

Risk Management

 

As a fundamental part of its business, the Company has developed risk management practices to identify, measure, monitor and control the risks involved in its various products and lines of business.  While the Company’s business is dependent on taking risks, appropriate management of these business risks is critical to its success.  The Company has a risk management program to evaluate a broad spectrum of risks, including, but not limited to, credit risk, market risk, liquidity risk, operational risk, legal risk and reputational risk.  In assessing its risk management practices across the Company’s functional areas (e.g. lending, branch operations, informational technology, asset and liability management, and administration), management considers the following elements of a sound risk management system in each critical area:  the level of board and senior management oversight; the adequacy of policies, procedures and limits; the adequacy of internal controls; the results of internal monitoring and / or independent reviews and audits; and the experience of its personnel.

 

While the Company believes it has a sound risk management program that will address its future growth plans, the Company’s ability to manage future growth will depend on, among other things, its ability to manage associated risks, including: monitoring operations, controlling funding costs and operating expenses, maintaining positive customer relations, and hiring and retaining qualified personnel.

 

Competition

 

The banking business in California, generally, and specifically in the greater San Diego and adjacent areas, is highly competitive with respect to both loans and deposits.  The business is dominated by a relatively small number of major banks, most of which have many offices operating over wide geographic areas.  Many of the major commercial banks and their affiliates, including those headquartered outside California, offer certain services (such as trust and securities brokerage services) that are not offered directly by the Company.  By virtue of their greater total capitalization, such banks have substantially higher lending limits and substantially larger advertising and promotional budgets.  In addition, the Company faces strong competition from other community banks headquartered in the greater San Diego area that are also serving individuals and businesses.

 

In recent years, a large number of mergers and consolidations of both banks and savings entities have occurred in California and throughout the nation.  A substantial number of the larger banks have been involved in major mergers.  The result is that these institutions generally have centralized and standardized services and some lending functions and decisions are sent outside the area.  Acquisitions by major interstate bank holding companies and other large acquirers in the greater San Diego vicinity have resulted in numerous branch consolidations in the area.  Many long-standing relationships have been disrupted or severed, while many other customers are now subjected to less personalized and more “standardized” services.

 

As a result of this merger and consolidation activity, since 2000, community banking in San Diego has undergone a growth period and a significant number of new or de novo institutions have opened.  Despite the increased competition from newer community banks, larger institutions continue to control the majority of the deposit market share in the region.  This continues to present the Company with the opportunity to attract customers who are dissatisfied with the level of service provided by larger banks.  Additionally, it is expected that merger activity will continue to provide opportunities in its market area.

 

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In order to compete with the major financial institutions in the Company’s primary service areas, the contacts of the Company’s organizers, founders, advisors, directors and officers are used to the fullest extent possible with residents and businesses in the Company’s primary service areas.  Specialized services, local promotional activity and personal contacts by the Company’s officers, directors and other employees are emphasized. Programs have been developed to specifically address the needs of small to medium-sized businesses, professional businesses, as well as business owners and their employees.  Legal lending limits sometimes prevent the Company from making a loan on its own. In these circumstances, the Company can arrange for loans to be made on a participation basis with other financial institutions and intermediaries.

 

Subsidiaries

 

The Bank is a subsidiary of our Company.

 

On June 28, 2007, the Company formed a Delaware trust affiliate, FPBN Trust I (the “Trust”) for the purpose of issuing trust preferred securities. The Company accounts for its investment in the Trust using the equity method under which the subsidiaries net earnings are recognized in the Company’s statement of income, pursuant to Financial Accounting Standards Board Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” Pursuant to FIN 46, the Trust is not consolidated into the Company’s financial statements. The Federal Reserve Board has ruled that subordinated notes payable to unconsolidated special purpose entities (“SPE’s”) such as the Trust, net of the bank holding company’s investment in the SPE, qualify as Tier 1 Capital, subject to certain limits.

 

Employees

 

Currently, the Company employs Messrs. James H. Burgess, Larry A. Prosi, and Richard H. Revier, under written employment agreements.  See “Item 10, Directors, Executive Officers and Corporate Governance,” below.  On December 31, 2008, the Company employed 100 persons full-time and 5 persons part-time.  None of the Company’s employees are represented by any collective bargaining agreements.  The Company considers its relations with employees to be excellent.

 

SUPERVISION AND REGULATION

 

The following summarizes the material elements of the regulatory framework that apply to banks and bank holding companies and is only a summary and does not purport to be complete.  It does not describe all of the statutes, regulations and regulatory policies that are applicable.  Also, it does not restate all of the requirements of the statutes, regulations and regulatory policies that are described.  Consequently, the following summary is qualified in its entirety by reference to the applicable statutes, regulations and regulatory policies.  No assurance can be given that such statutes and regulations will not change in the future.  Moreover, any changes may have a material effect on the business of the Company.  As a listed company on NASDAQ, the Company is subject to NASDAQ rules for listed companies.

 

General

 

Bank Holding Company Regulation.  The Company is a bank holding company within the meaning of the Bank Holding Company Act, and is registered as such with and subject to the supervision of the Federal Reserve Board (“FRB”).  Generally, a bank holding company is required to obtain the approval of the FRB before it may acquire all or substantially all of the assets of any bank, or ownership or control of the voting shares of any bank if, after giving effect to such acquisition of shares, the bank holding company would own or control more than 5% of the voting shares of such bank.  The FRB’s approval is also required for the merger or consolidation of bank holding companies.  The Company is required to file reports with the FRB and provide such additional information as the FRB may require.  The FRB also has the authority to examine the Company and each of its subsidiaries, as well as any arrangements between it and any of its subsidiaries, with the cost of any such examination to be borne by the Company.

 

Banking subsidiaries of bank holding companies are also subject to certain restrictions imposed by federal law in dealings with their holding companies and other affiliates.  Subject to certain restrictions set forth in the Federal Reserve Act, a bank can loan or extend credit to an affiliate, purchase or invest in the securities of an affiliate, purchase assets from an affiliate, or issue a guarantee, acceptance, or letter of credit on behalf of an affiliate; provided that the aggregate amount of the above transactions of a bank and its subsidiaries does not exceed 10% of the capital stock and surplus of the bank on a per affiliate basis or 20% of the capital stock and surplus of the

 

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bank on an aggregate affiliate basis.  In addition, such transactions must be on terms and conditions that are consistent with safe and sound banking practices and, in particular, a bank and its subsidiaries generally may not purchase from an affiliate a low-quality asset, as that term is defined in the Federal Reserve Act.  Such restrictions also prevent a bank holding company and its other affiliates from borrowing from a banking subsidiary of the bank holding company unless the loans are secured by marketable collateral of designated amounts.  Further, the Company and the Bank are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services.

 

Under the FRB’s regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe and unsound manner.  In addition, it is the FRB’s policy that in serving as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks.  A bank holding company’s failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the FRB to be an unsafe and unsound banking practice or a violation of the FRB’s regulations or both.  Under certain conditions, the FRB may conclude that certain actions of a bank holding company, such as payment of cash dividends, would constitute unsafe and unsound banking practices because they violate the FRB’s “source of strength” doctrine.

 

A bank holding company is prohibited from engaging in or acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company engaged in nonbanking activities.  One of the principal exceptions to this prohibition is for activities found by the FRB to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In making these determinations, the FRB considers whether the performance of such activities by a bank holding company would offer advantages to the public which outweigh possible adverse effects.

 

As a public company, the Company is subject to the Sarbanes-Oxley Act of 2002.  The Sarbanes-Oxley Act amends certain parts of the Securities and Exchange Act of 1934, as amended (the “Exchange Act”) and is intended to protect investors by, among other things, improving the reliability of financial reporting, increasing management accountability, and increasing the independence of directors and our external accountants.

 

The Company is subject to the periodic reporting requirements of the Exchange Act, which include but are not limited to the filing of annual, quarterly and other current reports with the Securities and Exchange Commission (“SEC”).

 

Banking Regulation.  Various requirements and restrictions under federal and state laws affect the operation of the Company.  As a California state-chartered bank, the Company is regulated, supervised and regularly examined by the DFI.  In addition, the FRB is the Company’s primary federal regulator.  Federal regulations address several areas including loans, deposits, check and item processing, investments, mergers and acquisitions, borrowings, dividends, and the number and locations of branch offices. Deposits of the Company are insured up to the maximum limits allowed by the FDIC.  As a result of this deposit insurance function, the FDIC has certain supervisory authority and powers over FDIC-insured institutions.

 

Proposed Legislative and Regulatory Changes

 

Proposals pending in Congress would, among other things, change lending practices related to loans secured by single-family residences, restrict “predatory” and “subprime” mortgage activities, forestall foreclosures on single family homes, protect renters of foreclosed properties, license mortgage loan originators, restrict ownership of industrial banks, enhance the privacy of personal information. Certain of these proposals, if adopted, could significantly change the regulation or operations of banks and the financial services industry.  The Company cannot predict whether any of these proposals will be adopted, and, if adopted, how these proposals will affect us or the Bank.

 

Federal Reserve Bank Regulation

 

Each state-chartered bank that is a member of the FRB is referred to as a “state member bank.”  The Bank, like all other state member banks, subscribes to capital stock in the FRB of its district (the Federal Reserve Bank of San Francisco in the case of the Bank) in an amount equal to 6% of its combined capital and surplus (but excluding retained earnings); 3% must be paid-in and the remaining 3% is on call.  The FDIC insures the deposits of the Bank and monitors the Bank in such capacity.  The FRB discount window and other services are available to all

 

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depository institutions on an equivalent basis.  However, being a state member bank reduces the number of federal supervisors from two to one where a bank is owned by a bank holding company.

 

Impact of Monetary Policies

 

Banking is a business that depends on rate differentials.  In general, the difference between the interest rate paid by the Company on its deposits and other borrowings and the interest rate earned by the Company on loans, securities and other interest-earning assets comprises the major source of the Company’s earnings.  These rates are highly sensitive to many factors which are beyond the control of the Company and, accordingly, the earnings and growth of the Company are subject to the influence of economic conditions generally, both domestic and foreign, including inflation, recession, and unemployment; and also to the influence of monetary and fiscal policies of the United States and its agencies, particularly the FRB.  The FRB implements national monetary policy, such as seeking to curb inflation and combat recession, by its open-market dealings in United States government securities, by adjusting the required level of reserves for financial institutions subject to reserve requirements, by placing limitations upon savings and time deposit interest rates, and through adjustments to the discount rate applicable to borrowings by banks which are members of the Federal Reserve System.  The actions of the FRB in these areas influence the growth of bank loans, investments, and deposits and also affect interest rates.  The nature and timing of any future changes in such policies and their impact on the Company cannot be predicted; however, the impact on the Company’s net interest margin, whether positive or negative, depends on the degree to which the Company’s interest-earning assets and interest-bearing liabilities are rate sensitive.  In addition, adverse economic conditions could make a higher provision for loan losses a prudent course and could cause higher loan charge-offs, thus adversely affecting the Company’s net income.

 

Federal Banking Loan Regulation

 

On December 6, 2006, the federal bank regulatory agencies released final guidance on “Concentrations in Commercial Real Estate Lending” (the “Final Guidance”), largely consistent with the proposed guidance they released on January 10, 2006.  This guidance defines commercial real estate (“CRE”) loans as exposures secured by raw land, land development and construction (including 1-4 family residential construction), multi-family property, and non-farm nonresidential property where the primary or a significant source of repayment is derived from rental income associated with the property or the proceeds of the sale, refinancing, or permanent financing of the property.  Loans on owner occupied CRE are generally excluded.

 

The Final Guidance requires that appropriate processes be in place to identify, monitor and control risks associated with real estate lending concentrations.  This could include enhanced strategic planning, CRE underwriting policies, risk management, internal controls, portfolio stress testing and risk exposure limits as well as appropriately designed compensation and incentive programs.  Higher allowances for loan losses and higher capital levels may also be required.  The Final Guidance is triggered when CRE loan concentrations exceed either:

 

·                                          Total reported loans for construction, land development, and other land of 100% or more of a bank’s total capital; or

 

·                                          Total reported loans secured by multifamily and nonfarm nonresidential properties and loans for construction, land development, and other land of 300% or more of a bank’s total capital.

 

Management of the Company believes that the Final Guidance may apply to the Company’s CRE lending activities due to its concentration in construction and land development loans. The Company has always had meaningful exposures to loans secured by commercial real estate due to the nature of its growing markets and the loan needs of both its retail and commercial customers.  The Company believes its long-term experience in CRE lending, underwriting policies, internal controls, and other policies currently in place are generally appropriate in managing its concentrations as required under the Final Guidance.  Furthermore, the Company has adopted additional enhancements to its analysis and review of CRE concentrations consistent with many of the requirements found in the Final Guidance.

 

Banking Legislation

 

From time to time legislation is proposed or enacted which has the effect of increasing the cost of doing business and changing the competitive balance between banks and other financial and non-financial institutions.  These laws have generally had the effect of altering competitive relationships existing among financial institutions, reducing the historical distinctions between the services offered by banks, savings and loan associations and other

 

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financial institutions, and increasing the cost of funds to banks and other depository institutions.  Certain of the potentially significant changes, which have been enacted in the past several years, are discussed below.

 

The Sarbanes-Oxley Act of 2002.  On July 30, 2002, in the wake of numerous corporate scandals and in an attempt to protect investors and help restore investor confidence by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, President George W. Bush signed into law the Sarbanes-Oxley Act of 2002 (the “Act”).  The Act applies to any issuer, such as the Company, that has securities registered under, or is otherwise required to file reports under, the Exchange Act.  The Act imposes new and unprecedented corporate disclosure and governance mandates on public companies, including the Company.

 

While certain provisions of the Act, such as accelerated filing deadlines for periodic reports, do not currently apply to the Company, most of the Act’s provisions are (or upon implementation will be) applicable.  These provisions include (i) the requirement for certifications of each annual and quarterly report by the issuer’s principal executive and financial officers, with criminal penalties imposed for knowing or willful violations, (ii) the forfeiture of bonuses or profits received by such officers if accounting restatements are required as a result of misconduct, (iii) disclosure of all material off-balance sheet transactions and relationships that may have a material effect upon the financial status of an issuer and of any “material correcting adjustments” in the issuer’s financials, (iv) disclosure of management’s assessment of internal controls and procedures, (v) disclosure as to whether the issuer has adopted a “code of ethics” for its senior financial officers and, if not, an explanation as to why not, and (vi) prohibitions or limits on loans to officers, directors and other insiders except to the extent such loans comply with FRB Regulation O.  The Act also imposes certain additional regulations, such as accelerated filing periods for reports on Form 4 of changes in the beneficial ownership of officers, directors and principal security holders.

 

The Act also imposes increased requirements on auditors and the auditing procedures of their public clients, including prohibitions on the performing of specified non-audit services contemporaneously with an audit.  The Act heightens the requirements for, and the authority of, audit committees.  Among other provisions, the Act vests an issuer’s audit committee with direct responsibility for the appointment, compensation and oversight of any registered public accounting firm engaged to perform audit services and with the ability to hire independent outside legal counsel and other advisors.

 

The Act also requires that each audit committee member be entirely “independent” (meaning that no member may be affiliated with the issuer or may accept (or have recently received) any consulting, advisory or other compensatory fees from the issuer) and be a member of the issuer’s board of directors and that the committee include a designated “audit committee financial expert.”

 

Finally, the Act requires that legal counsel for subject companies report any evidence of material violations of securities laws or breaches of fiduciary duty to or by their client and imposes federal criminal penalties, including fines and imprisonment of up to 25 years, upon those convicted of defrauding shareholders of public companies.

 

In 2009, the Company will be required to comply with Section 404 of the Sarbanes Oxley Act of 2002, which requires the Company’s independent public accounting firm, which audits the Company’s financial statements to include in the annual report an attestation report on the effectiveness of management’s assessment of the Company’s internal controls over financial reporting. The Company has experienced increased costs associated with the increased level of disclosure and compliance required under the Act, and expects a certain amount of unknown additional costs associated with this additional requirement.

 

Gramm-Leach-Bliley Act.  The Financial Services Act of 1999, known as the Gramm-Leach-Bliley Act (“GLBA”), was signed into law on November 12, 1999 and became effective on March 11, 2000.  The GLBA repeals provisions of the Glass-Steagall Act, which had prohibited commercial banks and securities firms from affiliating with each other and engaging in each other’s businesses.  Thus, many of the barriers prohibiting affiliations between commercial banks and securities firms have been eliminated.

 

The Bank Holding Company Act (“BHCA”) was amended by GLBA to allow a new “financial holding company” (“FHC”) to offer banking, insurance, securities and other financial products to consumers.  Specifically, the GLBA amended Section 4 of the BHCA in order to provide for a framework for the engagement in new financial activities.  A bank holding company (“BHC”) may elect to become an FHC if all its subsidiary depository institutions are well capitalized and well managed.

 

Under the GLBA, national banks (as well as FDIC-insured state banks, subject to various requirements) are permitted to engage through “financial subsidiaries” in certain financial activities permissible for affiliates of FHCs. 

 

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However, to be able to engage in such activities the bank must also be well capitalized and well managed and receive at least a “satisfactory” rating in its most recent Community Reinvestment Act examination.  In addition, if the bank ranks as one of the top 50 largest insured banks in the United States, it must have an issue of outstanding long-term debt rated in one of the three highest rating categories by an independent rating agency.  If the bank falls within the next group of 50, it must either meet the debt-rating test described above or satisfy a comparable test jointly agreed to by the FRB and the Treasury Department.  No debt rating is required for any bank, such as the Bank, not within the top 100 largest insured banks in the United States.

 

The Company cannot be certain of the effect of the foregoing legislation on its business, although there is likely to be consolidation among financial services institutions and increased competition for the Company.

 

The Riegle-Neal Act.  The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Riegle-Neal Act”), enacted on September 29, 1994, repealed the McFadden Act of 1927, which required states to decide whether national or state banks could enter their state, and allowed banks to open branches across state lines beginning on June 1, 1997.  The Riegle-Neal Act also repealed the 1956 Douglas Amendment to the BHCA, which placed the same requirements on BHCs.  The repeal of the Douglas Amendment now makes it possible for banks to buy out of-state banks in any state and convert them into interstate branches.

 

The Riegle-Neal Act provides that interstate branching and merging of existing banks is permitted, provided that the banks are at least “adequately capitalized” and demonstrate good management.  The states are also authorized to enact a law to permit interstate banks to branch de novo.

 

On September 28, 1995, the California Interstate Banking and Branching Act of 1995 (“CIBBA”) was enacted and signed into law allowing early interstate branching in California.  CIBBA authorizes out-of-state banks to enter California by the acquisition of or merger with a California bank that has been in existence for at least five years, unless the California bank is in danger of failing or in certain other emergency situations.

 

Federal Deposit Insurance Corporation Improvement Act of 1991.  The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) was signed into law on December 19, 1991. FDICIA recapitalized the FDIC’s Bank Insurance Fund, granted broad authorization to the FDIC to increase deposit insurance premium assessments and to borrow from other sources, and continued the expansion of regulatory enforcement powers, along with many other significant changes.

 

FDICIA establishes five categories of capitalization: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized.”  If a bank falls in the “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized” categories, it will be subject to significant enforcement actions by its primary federal regulator).  See “Enforcement Powers-Corrective Measures for Capital Deficiencies,” below.

 

FDICIA also grants the regulatory agencies authority to prescribe standards relating to internal controls, credit underwriting, asset growth and compensation, among others, and requires the regulatory agencies to promulgate regulations prohibiting excessive compensation or fees.  Many regulations have been adopted by the regulatory agencies to begin to implement these provisions and subsequent legislation (the Riegle-Neal Act, discussed above) gives the regulatory agencies the option of prescribing the safety and soundness standards as guidelines rather than regulations.

 

As previously noted, FDICIA places restrictions on certain bank activities authorized under state law.  FDICIA generally restricts activities through subsidiaries to those permissible for national banks, thereby effectively eliminating real estate investment powers. Insurance activities are also limited, except to the extent permissible for national banks.

 

USA Patriot Act.  The United and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA Patriot Act”) was signed into law on October 26, 2001.  The USA Patriot Act requires financial institutions, such as the Company, to implement and follow procedures designed to help prevent, detect and prosecute international money laundering and the financing of terrorism.  Title III of the USA Patriot Act is the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (“IMLAFATA”).  In general, the IMLAFATA amends current law, primarily the Bank Secrecy Act (see “—Bank Secrecy Act,” below), to authorize the Secretary of the Treasury, in consultation with the heads of other government agencies, to adopt special measures applicable to banks, bank holding companies and other financial institutions including enhanced record-keeping and reporting requirements for certain financial transactions that are

 

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of primary money laundering concern, due diligence requirements concerning the beneficial ownership of certain types of accounts, and restrictions or prohibitions on certain types of accounts with foreign financial institutions.  Among its other provisions, the IMLAFATA requires financial institutions to: (i) establish an anti-money laundering program; (ii) establish due diligence policies, procedures and controls with respect to private banking accounts and correspondent banking accounts involving foreign individuals and certain foreign banks; and (iii) avoid establishing, maintaining, administering or managing correspondent accounts in the United States for, or on behalf of, a foreign bank that does not have a physical presence in any country.  In addition, the IMLAFATA contains a provision encouraging cooperation among financial institutions, regulatory authorities and law enforcement authorities with respect to individuals, entities and organizations engaged in, or reasonably suspected of engaging in, terrorist acts or money laundering activities.  The IMLAFATA expands the circumstances under which deposited funds may be forfeited and requires covered financial institutions to respond under certain circumstances to requests for information from federal banking agencies within 120 hours.  The IMLAFATA also amends the BHCA and the Bank Merger Act to require the federal banking agencies to consider the effectiveness of a financial institution’s anti-money laundering activities when reviewing an application under these Acts.  Among other programs implemented to comply with the USA Patriot Act, the Company implemented a customer identification program.

 

Bank Secrecy Act.  The Financial Recordkeeping and Reporting of Currency and Foreign Transactions Act of 1970 (the “Bank Secrecy Act”) is a disclosure law that forms the basis of the United States federal government’s framework to prevent and detect money laundering and to deter other criminal enterprises.  Following the September 11, 2001 terrorist attacks, an additional purpose was added to the Bank Secrecy Act:  “To assist in the conduct of intelligence or counter-intelligence activities, including analysis, to protect against international terrorism.”  Under the Bank Secrecy Act, financial institutions such as the Bank are required to maintain certain records and file certain reports regarding domestic currency transactions and cross-border transportations of currency.  This, in turn, allows law enforcement officials to create a paper trail for tracing illicit funds that resulted from drug trafficking or other criminal activities.  Among other requirements, the Bank Secrecy Act requires financial institutions to report imports and exports of currency in excess of $10,000 and, in general, all cash transactions in excess of $10,000.  The Bank has established a Bank Secrecy Act compliance policy under which, among other precautions, the Bank keeps currency transaction reports to document cash transactions in excess of $10,000 or in multiples totaling more than $10,000 during one business day, monitors certain potentially suspicious transactions such as the exchange of a large number of small denomination bills for large denomination bills, and scrutinizes electronic funds transfers for Bank Secrecy Act compliance.

 

Administrative Actions

 

Following the September 11, 2001 terrorist attacks on the United States, President George W. Bush signed an executive order on September 24, 2001 that has a number of consequences for the operations of commercial banks.  First, it ordered the freezing of assets of persons on a list included in the order and requires each financial institution to monitor its deposits to determine whether they should be frozen.  Second, it makes it illegal to do business with any of the persons or entities named on the list.  This means that the Bank is obligated to carefully screen its customers on an ongoing basis to assure that the Bank is permitted to do business with them.  These types of administrative orders and similar regulations of bank regulators may increase the cost of operating the Company and it is possible that further such orders will be made although the Company is not aware of any at this time.

 

The Financial Stability Plan

 

In February 2009, the U.S. Department of the Treasury outlined the “Financial Stability Plan: Deploying our Full Arsenal to Attack the Credit Crisis on All Fronts.” The Financial Stability Plan includes a wide variety of measures intended to address the domestic and global financial crisis and deterioration of credit markets. Many aspects of the Financial Stability Plan are conceptual in nature and contemplate future specific regulations and further regulatory and legislative enactment. Key aspects of the Financial Stability Plan are described below.

 

The Financial Stability Plan includes a variety of measures aimed at addressing issues in the U.S. banking sector. These measures include requiring banking institutions with assets in excess of $100 billion to undergo a forward-looking comprehensive “stress test” and providing such institutions with access to a U.S. Treasury-provided “capital buffer” to help absorb losses if the results of the test indicate that additional capital is needed and it cannot be obtained in the private sector; a public-private investment fund which will be designed to involve both public and private capital and public financing for the acquisition of troubled and illiquid assets in the banking sector; substantial expenditures to support government-sponsored enterprises in the housing sector and a commitment of funds to help prevent avoidable foreclosures of owner-occupied residential real estate; a consumer and business lending initiative intended to support the purchase of loans by providing financing to private investors to help

 

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unfreeze and lower interest rates for auto, small business, credit card and other consumer and business credit; increased transparency and disclosure of exposure on bank balance sheets; requirements relating to accountability and monitoring of funds received by banking institutions under the Financial Stability Plan; restrictions on dividends, stock repurchases and acquisitions on banks receiving assistance under the Financial Stability Plan; and limitations on executive compensation for senior executives at institutions receiving funds under the Financial Stability Plan, including a cap of $500,000 in total annual compensation (not including restricted stock payable only when the government is receiving payments on its investment), “say on pay” shareholder votes and new disclosure and accountability requirements applicable to luxury purchases. As the Company has less than $100 billion in assets, we do not believe that the stress test will apply to the Company and it is too early to tell whether and to what extent the other provisions may affect us.

 

Restrictions on Transactions With Insiders

 

Sections 23A and 23B of the Federal Reserve Act regulate transactions between insured institutions and their “affiliates” and transactions by the Bank that benefit affiliates.  For these purposes, an “affiliate” is a company under common control with the institution.  In general, Section 23A imposes limits on the dollar amount of such transactions, and also requires certain levels of collateral for loans to affiliates.  Section 23B generally requires that certain transactions between a bank and its respective affiliates be on terms substantially the same, or at least as favorable to such bank, as those prevailing at the time for comparable transactions with or involving other nonaffiliated persons.  At this time the Bank does not have any “affiliates” other than the Company.

 

The restrictions on loans to directors, executive officers, principal stockholders and their related interests (collectively referred to herein as “insiders”) contained in the Federal Reserve Act and Regulation O promulgated thereunder apply to all federally insured institutions and their subsidiaries and holding companies.  These restrictions include limits on loans to one borrower and conditions that must be met before such a loan can be made.  There is also an aggregate limitation on all loans to insiders and their related interests.  These loans cannot exceed the institution’s total unimpaired capital and surplus, and the FDIC may determine that a lesser amount is appropriate.  Insiders are subject to enforcement actions for knowingly accepting loans in violation of applicable restrictions.

 

Deposit Insurance Assessments

 

On October 3, 2008, President Bush signed into law the Emergency Economic Stabilization Act of 2008 after the Senate and House passed legislation which temporarily increases deposit insurance coverage from $100,000 to $250,000 per depositor per insured bank through December 31, 2009. The legislation provides that the basic deposit insurance limit will return to $100,000 after December 31, 2009. Certain retirement accounts, such as Individual Retirement Accounts, remain insured up to $250,000 per depositor per insured bank.

 

The Bank chose to participate in the increased deposit insurance program outlined above which was implemented by the FDIC. The program provides full deposit insurance coverage for all funds in noninterest bearing transaction deposit accounts through December 31, 2009. The cost of participating was a 10 basis points surcharge in addition to the current deposit insurance assessment. There were no charges for the first 30 days.  The new insurance coverage is over and above the $250,000 in coverage already provided. The FDIC provides separate insurance coverage for deposit accounts held in different categories of ownership. Customers may qualify for more than $250,000 in coverage at one insured bank if they own deposit accounts in different categories.

 

Each bank is required to pay deposit insurance premiums. The premium amount is based upon a risk classification system established by the FDIC. For the first quarter of 2009 only, the FDIC’s Board adopted new rates that will raise the current rates uniformly by seven basis points. The FDIC proposed to establish new initial base assessment rates that will be subject to adjustment as described below effective April 1, 2009.

 

To determine a Bank’s initial base assessment rate, the FDIC proposes to: (1) introduce a new financial ratio into the financial ratios method applicable to most Risk Category 1 institutions to include brokered deposits above a threshold that are used to fund rapid asset growth; (2) for a large Risk Category 1 institution with long-term debt issuer ratings, combine weighted average CAMELS component ratings, the debt issuer ratings, and the financial ratios method assessment rate; and (3) use a new uniform amount and pricing multipliers for each method.

 

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The FDIC also proposes to introduce three adjustments that could be made to an institution’s initial base assessment rate: (1) a potential decrease for long-term unsecured debt, including senior and subordinated debt and, for small institutions, a portion of Tier 1 capital; (2) a potential increase for secured liabilities above a threshold amount; and (3) for non-Risk Category 1 institutions, a potential increase for brokered deposits above a threshold amount.

 

Banks with higher levels of capital and a low degree of supervisory concern are assessed lower premiums than banks with lower levels of capital or a higher degree of supervisory concern. Insured institutions are not allowed to disclose their risk assessment classification and no assurance can be given as to what the future level of premiums will be.

 

·                  As of January 1, 2009, the FDIC implemented a new interim rate schedule which will apply to the June 30, 2009 payment, based on March 31, 2009 data.  Under this interim rule the base charge for annual insurance deposit assessments ranges from a minimum of 12 basis points to a maximum of 50 basis points per $100 of insured deposits depending upon the risk assessment category into which the institution falls.

 

·                  A new proposed rate schedule will take effect beginning April 1, 2009. These new rates will apply to the September 30, 2009 payment based on June 30, 2009 data and beyond. Depending on the institution’s initial risk category and adjustments described above, the charge for annual insurance deposit assessments ranges from a minimum of 7 to 77.5 basis points per $100 of insured deposits.

 

On March 2, 2009, the Company received notification from the FDIC announcing that an interim rule for a special assessment of 20 basis points for June 30, 2009, to be collected September 30, 2009, would be charged. This assessment was adopted to assist in bringing the FDIC reserve ratio back up to the statutorily mandated minimum of 1.15 within a reasonable period of time.

 

These significant increases in insurance premiums and the cost of special assessments could have an adverse effect on the operation expenses and result of operations of the Company. Management cannot predict what insurance assessment rates will be in the future. The FDIC is authorized to terminate a depository institution’s deposit insurance upon a finding by the FDIC that the institution’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the institution’s regulatory agency. The Company’s premium amount for the year ended December 31, 2008, was $282,616 compared to $222,912 for the year ended December 31, 2007.

 

Risk-Based Capital Guidelines

 

The federal banking agencies have issued risk-based capital guidelines that include a definition of capital and a framework for calculating risk weighted assets by assigning assets and off-balance sheet items to broad credit risk categories. A bank’s or bank holding company’s risk-based capital ratio is calculated by dividing its qualifying total capital (the numerator of the ratio) by its risk-weighted assets (the denominator of the ratio).

 

On December 16, 2008, the federal banking agencies approved a final rule on the deduction of goodwill from Tier 1 capital. This rule will permit a banking organization to reduce the amount of goodwill it must deduct from Tier 1 capital by any associated deferred tax liability. The regulatory capital deduction for goodwill will be equal to the maximum capital reduction that could occur as a result of a complete write-off of the goodwill under generally accepted accounting principles (GAAP). The final rule is effective in January 2009 and banking organizations may adopt its provisions for purposes of regulatory capital reporting for the period ending December 31, 2008.

 

Qualifying total capital consists of two types of capital components: “core capital elements” (comprising Tier 1 capital) and “supplementary capital elements” (comprising Tier 2 capital).  The Tier 1 component must represent at least 50% of qualifying total capital and may consist of the following items that are defined as core capital elements: (i) common stockholders’ equity; (ii) qualifying noncumulative perpetual preferred stock (including related surplus); and (iii) minority interest in the equity accounts of consolidated subsidiaries.  The Tier 2 component may consist of the following items: (i) allowance for loan and lease losses (subject to limitations); (ii) perpetual preferred stock and related surplus (subject to conditions); (iii) hybrid capital instruments (as defined) and mandatory convertible debt securities; and (iv) term subordinated debt and intermediate-term preferred stock, including related surplus (subject to limitations).

 

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Assets and credit equivalent amounts of off-balance sheet items are assigned to one of several broad risk categories, according to the obligor, or, if relevant, the guarantor or the nature of collateral.  The aggregate dollar value of the amount in each category is then multiplied by the risk weight associated with that category.  The resulting weighted values from each of the risk categories are added together, and this sum is the institution’s total risk weighted assets that comprise the denominator of the risk-based capital ratio.

 

A two-step process determines risk weights for all off-balance sheet items.  First, the “credit equivalent amount” of off-balance sheet items is determined, in most cases by multiplying the off-balance sheet item by a credit conversion factor.  Second, the credit equivalent amount is treated like any balance sheet asset and generally is assigned to the appropriate risk category according to the obligor, or, if relevant, the guarantor or the nature of the collateral.

 

All banks and bank holding companies are required to meet a minimum ratio of qualifying total capital to risk weighted assets of 8%, of which at least 4% should be in the form of Tier 1 capital.  The Bank’s and Company’s total capital and Tier 1 capital to risk weighted assets as of December 31, 2008, exceeded these requirements.

 

The regulatory agencies have adopted leverage requirements that apply in addition to the risk-based capital requirements.  Under these requirements, banks and bank holding companies are required to maintain core capital of at least 3% of their quarterly average assets (the “Leverage Ratio”).  However, an institution may be required to maintain core capital of at least 4% or 5% or possibly higher, depending upon its activities, risks, rate of growth, and other factors deemed material by regulatory authorities.  At December 31, 2008, the Bank’s and Company’s leverage ratio was in excess of this requirement.

 

Enforcement Powers

 

Federal regulatory agencies have broad and strong enforcement authority reaching a wide range of persons and entities. Some of these provisions include those which: (i) establish a broad category of persons subject to enforcement under the Federal Deposit Insurance Act; (ii) establish broad authority for the issuance of cease and desist orders and provide for the issuance of temporary cease and desist orders;  (iii) provide for the suspension and removal of wrongdoers on an industry-wide basis; (iv) prohibit the participation of persons suspended or removed or convicted of a crime involving dishonesty or breach of trust from serving in another insured institution; (v) require regulatory approval of new directors and senior executive officers in certain cases; (vi) provide protection from retaliation against “whistleblowers” and establish rewards for “whistleblowers” in certain enforcement actions resulting in the recovery of money; (vii) require the regulators to publicize all final enforcement orders;  (viii) require each insured financial institution to provide its independent auditor with its most recent Report of Condition (“Call Report”); (ix) permit the imposition of significant penalties for failure to file accurate and timely Call Reports; and (x) provide for the assessment of significant civil money penalties and the imposition of civil and criminal forfeiture and other civil and criminal fines and penalties.

 

Crime Control Act of 1990.  The Crime Control Act of 1990 further strengthened the authority of federal regulators to enforce capital requirements, increased civil and criminal penalties for financial fraud, and enacted provisions allowing the FDIC to regulate or prohibit certain forms of golden parachute benefits and indemnification payments to officers and directors of financial institutions.

 

Corrective Measures for Capital Deficiencies.  The prompt corrective action regulations, which were promulgated to implement certain provisions of FDICIA, also effectively impose capital requirements on national banks, by subjecting banks with less capital to increasingly stringent supervisory actions.  For purposes of the prompt corrective action regulations, a bank is “undercapitalized” if it has a total risk-based capital ratio of less than 8%; a Tier 1 risk-based capital ratio of less than 4%; or a leverage ratio of less than 4% (or less than 3% if the bank has received a composite rating of 1 in its most recent examination report and is not experiencing significant growth).  A bank is “adequately capitalized” if it has a total risk-based capital ratio of 8% or higher; a Tier 1 risk-based capital ratio of 4% or higher; a leverage ratio of 4% or higher (3% or higher if the bank was rated a composite 1 in its most recent examination report and is not experiencing significant growth); and does not meet the criteria for a “well capitalized” bank.  A bank is “well capitalized” if it has a total risk-based capital ratio of 10% or higher; a Tier 1 risk-based capital ratio of 6% or higher; a leverage ratio of 5% or higher; and is not subject to any written requirement to meet and maintain any higher capital level(s).  There is no assurance as to what capital ratios the Bank will be able to maintain. As of December 31, 2008, the Bank was “adequately capitalized”.

 

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As a result of 1st Pacific Bank of California being considered “adequately capitalized”, we are no longer able to accept, renew or rollover brokered deposits unless and until such time as we receive a waiver from the FDIC.  There can be no assurance that such a waiver will be granted, on terms requested, or in time for 1st Pacific Bank of California to effectively utilize brokered deposits as a source of required liquidity.  If 1st Pacific Bank of California does not receive such a waiver, we will not be able to use new brokered deposits or renew existing brokered deposits as a source of liquidity.  Even with a waiver, the interest rate limitations on brokered deposits could have the effect of reducing demand for some deposit products.

 

Under the provisions of FDICIA and the prompt corrective action regulations, for example, an “undercapitalized” bank is subject to a limit on the interest it may pay on deposits.  Also, an undercapitalized bank cannot make any capital distribution, including paying a dividend (with some exceptions), or pay any management fee (other than compensation to an individual in his or her capacity as an officer or employee of the bank).  Such a bank also must submit a capital restoration plan to its primary federal regulator for approval, restrict total asset growth and obtain regulatory approval prior to making any acquisition, opening any new branch office or engaging in any new line of business.  Additional broad regulatory authority is granted with respect to “significantly undercapitalized” banks, including forced mergers, ordering new elections for directors, forcing divestiture by its holding company, if any, requiring management changes, and prohibiting the payment of bonuses to senior management.  Additional mandatory and discretionary regulatory actions apply to “significantly undercapitalized” and “critically undercapitalized” banks, the latter being a bank with capital at or less than 2%.  The primary federal regulator may appoint a receiver or conservator for a “critically undercapitalized” bank after 90 days, even if the bank is still solvent.  Failure of a bank to maintain the required capital could result in such bank being declared insolvent and closed.

 

Community Reinvestment Act and Fair Lending Developments

 

The Company is subject to certain fair lending requirements and reporting obligations involving home mortgage lending operations and Community Reinvestment Act (“CRA”) activities.  The CRA generally requires the federal banking agencies to evaluate the record of financial institutions in meeting the credit needs of their local communities, including low and moderate income neighborhoods. In addition to substantial penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and CRA into account when regulating and supervising other activities.

 

The federal banking agencies have adopted regulations to measure a bank’s compliance with its CRA obligations on a performance-based evaluation system. This system bases CRA ratings on an institution’s actual lending service and investment performance rather than the extent to which the institution conducts needs assessments, documents community outreach or complies with other procedural requirements. In March 1994, the Federal Interagency Task Force on Fair Lending issued a policy statement on discrimination in lending. The policy statement describes the three methods that federal agencies will use to prove discrimination: overt evidence of discrimination, evidence of disparate treatment and evidence of disparate impact.

 

Allowance For Loan and Lease Losses

 

On December 13, 2006, the FRB and the other federal financial institution regulatory agencies issued an interagency policy statement on the allowance for loan and lease losses (the “Policy Statement”). The Policy Statement replaces a 1993 policy statement, which described the responsibilities of the boards of directors and management of banks and savings associations and of examiners regarding allowance for loan and lease losses. In addition to the Policy Statement, the accounting profession groups periodically provide guidance to the banking industry on allowance for loan and lease losses (“ALLL”) methodology.

 

 The Policy Statement outlines the responsibility of the institution’s management and board of directors regarding their roles in maintaining ALLL at an appropriate level and for documenting its analysis. Management should evaluate the ALLL reported on the balance sheet as of the end of each quarter, or more frequently if warranted, and charge or credit the provision for loan and lease losses (“PLLL”) to bring the ALLL to an appropriate level as of each evaluation date. The determinations of the amounts of the ALLL and PLLL should be based on management’s current judgments about the credit quality of the loan portfolio, and should consider all known relevant internal and external factors that affect loan collectability as of the evaluation date.

 

In carrying out its responsibility for maintaining an appropriate ALLL, management is expected to adopt and adhere to written policies and procedures that, at a minimum, ensure that: (1) the institution’s process for determining an appropriate level for ALLL is based on a comprehensive, well-documented, and consistently applied analysis of its loan portfolio; (2) the institution has an effective loan review system and controls (including an effective loan classification or credit grading system) that identify, monitor, and address asset quality problems in an accurate and timely manner; (3) the institution has adequate data capture and reporting systems to supply the information necessary to support and document its estimate of an appropriate ALLL; (4) the institution evaluates any loss estimation models before they are employed and modifies the models’ assumptions, as needed, to ensue that the resulting loss estimates are consistent with GAAP; (5) the institution promptly charges off loans, or portions of loans, that available information confirms to be uncollectible, and; (6) the institution periodically validates the ALLL methodology.

 

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The Policy Statement also provides guidance to examiners in evaluating the credit quality of an institution’s loan portfolio, the appropriateness of its ALLL methodology and documentation, and the appropriateness of the reported ALLL in the institution’s regulatory reports. In their review and classification or grading of the loan portfolio, examiners should consider all significant factors that affect the collectability of the portfolio, including the value of any collateral.

 

Other Aspects of Federal and State Law

 

The Company is also subject to federal and state statutory and regulatory provisions covering, among other things, security procedures, technology and information security and risk assessment, currency and foreign transactions reporting, insider and affiliated party transactions, management interlocks, truth-in-lending, electronic funds transfers, funds availability, electronic banking, check image processing, financial privacy, truth-in-savings, home mortgage disclosure, and equal credit opportunity.  There are also a variety of federal statutes that restrict the acquisition of control of the Company and/or the Bank.

 

Proposed Legislation

 

From time to time, various types of federal and state legislation have been proposed that could result in additional regulation of, and restrictions on, the business of the Company.  It cannot be predicted whether any legislation currently being considered will be adopted or how such legislation or any other legislation that might be enacted in the future would affect the business of the Company.

 

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ITEM 1A.                                            RISK FACTORS

 

The following risk factors and all other information contained in this Annual Report on Form 10-K and the documents incorporated by reference in this Form 10-K should be carefully considered before investing.  Investing in our common stock involves a high degree of risk.  The risks and uncertainties described below are not the only ones we face.  Additional risks and uncertainties not presently known to us or that we currently believe are immaterial also may impair our business.  If any of the events described in the following risks occur, our business, results of operations and financial condition could be materially adversely affected.  In addition, the trading price of our common stock could decline due to any of the events described in these risks, and you may lose all or part of your investment.

 

We have reported a substantial net loss for the year ended December 2008.  Although we were profitable in each of the previous five years, no assurance can be given as to when or if we will return to profitability.

 

Our business has historically been that of a portfolio lender, which means that our profitability depends primarily on our ability to originate quality loans and collect loan fees, interest and principal as they come due.  When loans become non-performing or their ultimate collection is in doubt, our income is adversely affected.  Our provision for loan losses was $15.9 million for 2008 and was a significant contributing factor to our reported net loss for the year of $21.9 million. Our ability to return to profitability will significantly depend on the stabilization and subsequent successful resolution of our non-performing assets and other real estate owned in our loan portfolio and the successful execution of our revised business strategies, the timing and certainty of which cannot be predicted, and no assurance can be given that we will be successful in such efforts.

 

Our loan portfolio suffered substantial deterioration during 2008 and we continue to work through significant non-performing loans or loans otherwise adversely classified. No assurance can be given that the portfolio will not experience further weakness or loss.

 

Like most insured financial institutions, 1st Pacific Bank of California employs an asset quality rating system where assets are assigned a pass, special mention or classified rating. “Pass” assets represent those assets where there is a reasonable likelihood the asset will be repaid in accordance with its terms.  Assets designated as “special mention” have potential weaknesses that deserve management’s close attention.  If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the bank’s credit position at some future date.  While a higher level of loss reserves may be established, special mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.  All other assets not rated as “pass” or “special mention” are designated as “classified assets,” which consist of all loans classified as substandard, doubtful and loss.  As a result of the significant weakening in economic conditions in our market area, our loan portfolio has suffered significant deterioration during 2008.  No assurance can be given that additional loans will not be designated as “classified” or that existing classified loans will not migrate into lower classifications within that designation, resulting in additional provisions for loan losses.  Our management team will need to continue to implement its strategy for reducing our classified assets, which includes, among other options, selling loans and other real estate owned, which may result in additional losses and expenses, or restructuring loans, which may result in reduced income from the current stated contractual rate.

 

We face lending risks, especially with respect to our small- and medium-sized business clients.

 

The risk of loan defaults or borrowers’ inabilities to make scheduled payments on their loans is inherent in the banking business. Moreover, we focus primarily on lending to small- and medium-sized businesses. These businesses may not have the capital or other resources required to weather significant business downturns or downturns in the markets in which they compete. Consequently, we may assume greater lending risks than other financial institutions which have a smaller concentration of those types of loans and which tend to make loans to larger businesses. Borrower defaults or borrowers’ inabilities to make scheduled payments may result in losses which may exceed our allowances for loan losses. These risks, if they occur, may require higher than expected loan loss provisions which, in turn, can materially impair profitability, capital adequacy and overall financial condition.

 

We could suffer losses if we do not properly assess lending risks.

 

Each loan involves inherent risk that the borrower will not be able to repay the loan.  Although we attempt to evaluate the risks related to each loan we make, if we do not adequately assess and protect ourselves against these

 

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risks, we may not be fully repaid.  We could suffer significant loan losses if there is a systemic fault in our loan underwriting or if we have not identified all of the important risks of different types of lending.

 

Our ability to raise deposits will be impaired because the Bank will most likely be deemed to be “adequately capitalized” for regulatory purposes.

 

As a result of recent changes to 1st Pacific Bank of California’s loan loss reserves, it will most likely be deemed to be “adequately capitalized” after its next call report is filed.  Institutions that are “adequately capitalized” must obtain a waiver from the Federal Deposit Insurance Corporation in order to accept, renew or roll over brokered deposits. In addition, certain interest-rate limits apply to an “adequately capitalized” institution’s brokered and solicited deposits.  There can be no assurance that such a waiver will be granted, or granted on the terms requested.  Even with a waiver, the interest rate limitations on brokered and solicited deposits could have the effect of reducing demand for some of the deposit products. If 1st Pacific Bank of California’s level of deposits were to be reduced, either by the lack of a full brokered deposit waiver or by the interest rate limits on brokered or solicited deposits, 1st Pacific Bank of California would likely be forced to further reduce its assets, and seek alternative funding sources that may not be available.  Other possible consequences of 1st Pacific Bank of California now being “adequately capitalized” include the potential for increases in 1st Pacific Bank of California’s borrowing costs and terms from the Federal Home Loan Bank and other financial institutions, as well as increases in its premiums to the Deposit Insurance Fund administered by the Federal Deposit Insurance Corporation to insure deposits.  Such changes could have a materially adverse effect on our operations.

 

We are limited in the amount we can lend to any individual borrower.

 

We are limited in the amount that we can lend to a single borrower. Therefore, the size of the loans which we can offer to potential customers is less than the size of loans that our competitors with larger lending limits can offer. Legal lending limits also affect our ability to seek relationships with larger and more established businesses. We may not be able to attract and retain customers seeking loans in excess of their lending limits because we cannot make such loans and we may not be able to find other lenders willing to participate in such loans with us on favorable terms.

 

The current changing economic environment poses significant challenges for us.

 

We are operating in a challenging and uncertain economic environment, including generally uncertain national and local conditions. Financial institutions continue to be affected by the softening of the real estate market and constrained financial markets. While we have no sub-prime residential loans or securities backed by such loans on our books, we have some direct exposure to the residential real estate market and we are affected by these events. Continued declines in real estate values, home sales volumes and financial stress on borrowers as a result of the uncertain economic environment, including job losses, interest rate resets on adjustable rate mortgage loans and other factors could have adverse effects on our borrowers which would adversely affect our financial condition and results of operations. This deterioration in economic conditions coupled with the national economic recession could drive losses beyond that which is provided for in our allowance for loan losses and result in the following other consequences:

 

·              loan delinquencies, problem assets and foreclosures may increase;

 

·              demand for our products and services may decline;

 

·              low cost or non-interest bearing deposits may decrease;

 

·              collateral for our loans, especially real estate, may decline in value, in turn reducing customers’ borrowing power, and reducing the value of assets and collateral associated with our existing loans and;

 

·              increased regulatory scrutiny.

 

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Declines in Southern California real estate values could materially impair profitability and financial condition.

 

Approximately 74% of our loans are secured by real estate collateral. Nearly all of the real estate securing these loans is located in Southern California, primarily in San Diego County. Real estate values are generally affected by factors such as:

 

·              the socioeconomic conditions of the area where real estate collateral is located;

 

·              fluctuations in interest rates;

 

·              the availability of real estate financing;

 

·              property and income tax laws;

 

·              local zoning ordinances governing the manner in which real estate may be used; and

 

·              federal, state and local environmental regulations.

 

However, declines in real estate values could significantly reduce the value of the real estate collateral securing our loans, increasing the likelihood of defaults. Moreover, if the value of real estate collateral declines to a level that is not enough to provide adequate security for the underlying loans, we will need to make additional loan loss provisions which, in turn, will reduce our profits. Also, if a borrower defaults on a real estate secured loan, we may be forced to foreclose on the property and carry it as a nonearning asset which, in turn, may reduce net interest income.

 

Our valuation and write-downs of other real estate owned may not accurately reflect current market values or be adequate to address current and future losses, which could affect our financial condition and profitability.

 

Although we typically obtain appraisals on our other real estate owned prior to taking title to the properties and at other intervals thereafter, due to the rapid and severe deterioration in our markets, there can be no assurance that such valuations accurately reflect the current market value which may be paid by a willing purchaser in an arms-length transaction.  Moreover, we cannot provide assurance that the losses associated with the other real estate owned will not exceed the estimated amounts and adversely affect future results of our operations.  The calculation for the adequacy of write-downs of our other real estate owned is based on several factors, including the appraised value of the real property, economic conditions in the property’s sub-market, comparable sales, current buyer demand, availability of financing, entitlement and development obligations and costs, and historic loss experience.  All of these factors have caused significant write-downs in recent periods and can change without notice based on market and economic conditions.  Therefore, our valuation of write-downs of other real estate owned may not accurately reflect current values or be adequate to address current and future losses, which could affect our financial condition and profitability.

 

Changing interest rates may adversely affect our financial performance.

 

Our profitability largely depends on the difference between the rates of interest we earn on our loans and investments, and the interest rates we pay on deposits and other borrowings. This relationship, known as the net interest margin, is subject to fluctuation and is affected by economic and competitive factors which influence interest rates, the volume and mix of interest-earning assets and interest-bearing liabilities, and the level of nonperforming assets. Fluctuations in interest rates will affect the demand of customers for our products and services. We are subject to interest rate risk to the degree that our interest-bearing liabilities reprice or mature more slowly or more rapidly or on a different basis than our interest-earning assets. Given our current volume and mix of interest-bearing liabilities and interest-earning assets, our interest margin could be expected to increase during times of rising interest rates and decline during times of falling interest rates. Therefore, significant fluctuations in interest rates may have an adverse effect on our results of operations.

 

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We are limited in our ability to pay cash dividends.

 

1st Pacific Bancorp depends on dividends from 1st Pacific Bank of California in order to pay cash dividends to its security holders. In addition, the amount and timing of any dividends is at the discretion of 1st Pacific Bancorp’s board of directors.

 

Our ability to service our debt, pay dividends, and otherwise satisfy our obligations as they come due is substantially dependent on capital distributions from 1st Pacific Bank of California which we have agreed with the California Department of Financial Institutions and the Federal Reserve Bank of San Francisco not to take.

 

The primary source of our funds from which we service our debt and pay our obligations and dividends is the receipt of dividends from 1st Pacific Bank of California.  This source of funds is no longer available.  The availability of dividends from 1st Pacific Bank of California is limited by various statutes and regulations.  Based on the financial condition of 1st Pacific Bank of California and other factors, 1st Pacific Bank of California has agreed with the applicable regulatory authorities to restrict payment of dividends or other payments, including payments to us.  In this regard, 1st Pacific Bank of California has agreed with the California Department of Financial Institutions and the Federal Reserve Bank of San Francisco to seek their approval before paying dividends to us.  We do not believe that the California Department of Financial Institutions or the Federal Reserve Bank of San Francisco will permit payment of any dividends by 1st Pacific Bank of California to us.  As a result of 1st Pacific Bank of California’s continued inability to pay dividends to us, we may not be able to service our debt, pay our obligations or pay dividends on our outstanding equity securities.  The continued inability to receive dividends from 1st Pacific Bank of California has and will continue to adversely affect our business, financial condition, results of operations and prospects.

 

The Federal Reserve Bank of San Francisco has also requested certain limits on our paying of dividends, making payments on trust preferred securities or any other capital distributions based upon 1st Pacific Bank of California’s financial condition.  In this regard, the Federal Reserve Bank of San Francisco has advised us that it expects we will not pay any dividends, make payments on trust preferred securities or make any other capital distributions, without at least 30 days prior written approval of the Federal Reserve Bank of San Francisco. As a result, our business, financial condition, results of operations and prospects have been and will continue to be materially adversely affected. We deferred payment on the trust preferred securities for the first time recently and do not anticipate resuming those payments in the near term. Our inability to receive dividends from 1st Pacific Bank of California could adversely affect our business, financial condition, results of operations and prospects in the event there is a default in the payment of the trust preferred securities, and that can occur after 20 consecutive quarterly deferral periods and in other circumstances because upon the event of default, an immediate payment demand could be made on us of all amounts due under the trust preferred instruments. Currently, the outstanding principal amount of the trust preferred securities is $5 million.

 

We are reliant upon brokered deposits and other funding alternatives that may increase our cost of funds, adversely affect our operating results and may result in a shortage of financing sources.

 

We derive liquidity through core deposit growth and payoff, maturity and sale of investment securities and loans. We have found it necessary to also solicit deposits from brokers.  These brokered deposits represent funds that brokers gather from third parties and package in batches in order to find higher interest rates that are typically available for certificates of deposits with large balances, as compared to individually deposited smaller denomination deposits.  Deposit holders then earn a higher rate on the money that they have invested, and the broker charges a fee for its service.  As part of its funding strategy, 1st Pacific Bank of California generally obtains brokered deposits of various maturities to ensure that any run-off of brokered deposits is staggered and manageable.  While brokered deposits are typically more expensive than core deposits, such funds can be obtained relatively quickly, without expensive marketing costs, and do not typically allow for early withdrawal provisions.  However, as a result of 1st Pacific Bank of California no longer being considered to be “well-capitalized”, we are no longer able to accept, renew or rollover brokered deposits unless and until such time as we receive a waiver from the Federal Deposit Insurance Corporation. There can be no assurance that such a waiver will be granted, on the terms requested, or in time for 1st Pacific Bank of California to effectively utilize brokered deposits as a source of required liquidity.  If 1st Pacific Bank of California does not receive such a waiver, we will not be able to use new brokered deposits or renew existing brokered deposits as a source of liquidity. Even with a waiver, the interest rate limitations on brokered and solicited deposits could have the effect of reducing demand for some of the deposit products.

 

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We rely on Federal Home Loan Bank system borrowings for secondary and contingent liquidity sources.

 

We utilize borrowings from the Federal Home Loan Bank system for secondary and contingent sources of liquidity.  Also, from time to time, we utilize this borrowing source to capitalize on market opportunities to fund investment and loan initiatives.  Our Federal Home Loan Bank system borrowings totaled $50 million at December 31, 2008.  Based on recent adjustments by the FHLB to the Bank’s borrowing capacity on pledged loan collateral, the Bank has only limited ability for additional borrowing under the existing arrangements.  Although the Bank is working to provide the FHLB with “detailed collateral reporting” to increase its borrowing capacity, there is no guarantee the FHLB will increase the Bank’s borrowing capacity beyond its current level.  Further, as the advances come due and are repaid by 1st Pacific Bank of California to the Federal Home Loan Bank, the Federal Home Loan Bank is not obligated to re-lend the funds to 1st Pacific Bank of California.  If we are unable to find alternative sources of liquidity which, if available, will probably be at a higher cost and on terms that do not match the structure of our liabilities as well as Federal Home Loan Bank system borrowings do, then our liquidity position may be further weakened.

 

Our future growth may be limited if we are not able to raise additional capital.

 

Banks and bank holding companies are required to conform to regulatory capital adequacy guidelines and maintain their capital at specified percentages of their assets. These guidelines may limit our ability to grow and could result in banking regulators requiring increased capital levels or reduced loan and other earning asset levels. Therefore, in order to continue to increase our earning assets and net income, we may, from time to time, need to raise additional capital. Additional capital may not be available or, if it is, that additional capital may not be available on economically reasonable terms.

 

Our ability to grow may be impacted by our capital levels.

 

We intend to continue to expand our businesses and operations to increase deposits and loans. Continued growth may present operating and other problems that could adversely affect our business, financial condition and results of operations. Among other things growth without additional capital could cause us to become inadequately capitalized and subject us to regulatory enforcement action, see “SUPERVISION AND REGULATION – Enforcement Powers.” Our growth may place a strain on our administrative, operational, personnel and financial resources and increase demands on our systems and controls. Our ability to manage growth successfully will depend on our ability to attract qualified personnel and maintain cost controls and asset quality while attracting additional loans and deposits on favorable terms, as well as on factors beyond our control, such as economic conditions and interest rate trends. If we grow too quickly and are not able to attract qualified personnel, control costs and maintain asset quality, this continued rapid growth could materially adversely affect our financial performance.

 

We compete against larger banks and other institutions.

 

We compete for loans and deposits with other banks, savings and thrift associations and credit unions located in our service areas, as well as with other financial services organizations such as brokerage firms, insurance companies and money market mutual funds. These competitors aggressively solicit customers within their market area by advertising through direct mail, the electronic media and other means. Many competitors have been in business longer, have established customer bases and are substantially larger. These competing financial institutions offer services, including international banking services that we can only offer through correspondents, if at all. Additionally, these competitors have greater capital resources and, consequently, higher lending limits. At December 31, 2008, our lending limit per borrower was approximately $5.4 million for unsecured loans and $9.0

 

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million for secured loans. These limitations were calculated using the California Financial Code, Article 1 for lending limits and are primarily based on the capital level of the Bank. Finally, some competitors are not subject to the same degree of regulation.

 

We compete against banks and other institutions that have received Federal capital.

 

We have applied for, but at this time have not received, funding from the U.S. Treasury under the Capital Purchase Program of the Troubled Asset Relief Program, known as TARP.  Many of our competitors have already received TARP money and therefore have increased their capital resources and lending limits.  These competitors may be better able to compete against us due to this new source of capital from which we have not received any capital.

 

Current banking laws and regulations affect activities.

 

We are subject to extensive regulation. Supervision, regulation and examination of banks and bank holding companies by regulatory agencies are intended primarily to protect depositors rather than security holders. These regulatory agencies examine bank holding companies and commercial banks, establish capital and other financial requirements and approve acquisitions or other changes of control of financial institutions. Our ability to establish new facilities or make acquisitions requires approvals from applicable regulatory bodies. Changes in legislation and regulations will continue to have a significant impact on the banking industry. Although some of the legislative and regulatory changes may benefit us, others may increase our costs of doing business and indirectly assist our non-bank competitors who are not subject to similar regulation.

 

The requirements of being a public company may strain our resources and distract management.

 

As a public company, we are subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”). These requirements are extensive. The Exchange Act requires that we file annual, quarterly and current reports with respect to our business and financial condition. The Sarbanes-Oxley Act requires that we maintain effective disclosure controls and procedures and internal controls for financial reporting. In order to maintain and improve the effectiveness of our disclosure controls and procedures and internal control over financial reporting, significant resources and management oversight are required. This may divert management’s attention from other business concerns, which could have a material adverse effect on our business, financial condition and results of operations.

 

Economic conditions either nationally or locally in areas in which our operations are concentrated may adversely affect our business.

 

Deterioration in local, regional, national or global economic conditions could cause us to experience a reduction in deposits and new loans, an increase in the number of borrowers who default on their loans and a reduction in the value of the collateral securing their loans, all of which could adversely affect our performance and financial condition. Unlike larger banks that are more geographically diversified, we provide banking and financial services locally, specifically, within San Diego County. Therefore, we are particularly vulnerable to adverse local economic conditions.

 

The efforts of the federal government to stabilize the financial institution sector could result in more rigorous competition for 1st Pacific Bank of California.

 

Since the beginning of 2008, the financial sector has consolidated as large institutions have combined, often with federal government assistance.  In some cases, the federal rescue efforts also have resulted in substantial government funds being put into these institutions as new capital or commitments to guarantee new or existing debt.  These institutions are now in a stronger position to compete with our bank, especially for on-line banking products such as certificates of deposit and home mortgage loans, by offering higher rates on deposits and lower rates on loans.

 

The efforts of the federal government to stabilize the financial institution sector could result in more costs than benefits to 1st Pacific Bank of California.

 

Most of the extraordinary rescue efforts of the federal government in 2008 and 2009 have been designed to assist large, money-center financial institutions and broker-dealers in order to avoid further risk to the functioning of the national and international financial systems.  1st Pacific Bank of California is expected to receive little direct

 

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benefit from those efforts, although the federal insurance on 1st Pacific Bank of California’s deposits rose from $100,000 to $250,000 per account holder, temporarily.  1st Pacific Bank of California is likely to help pay for these rescue efforts, however, through higher premiums paid to the Federal Deposit Insurance Corporation.  For example, the Federal Deposit Insurance Corporation has established a Temporary Liquidity Guarantee Program to guarantee temporarily all newly-issued senior unsecured debt of certain financial institutions.  1st Pacific Bank of California will not participate in this program but any losses from the program will be assessed against all FDIC-insured institutions, regardless of whether they participate. Further, these rescue efforts may lead to higher corporate income tax rates.  Any such losses and higher taxes or assessments would adversely affect 1st Pacific Bank of California’s net income.

 

Legislative or other government action to provide mortgage relief may negatively impact our business.

 

As delinquencies, defaults and foreclosures in and of residential mortgages have increased dramatically, there are several federal, state and local initiatives that would, if made final, restrict our ability to foreclose and resell the property of a customer in default. Any restriction on our ability to foreclose on a loan, any requirement that we forego a portion of the amount otherwise due on a loan or any requirement that we modify any original loan terms is likely to negatively impact our business, financial condition, liquidity and results of operations. These initiatives have come in the form of proposed legislation and regulations, including those pertaining to federal bankruptcy laws, government investigations and calls for voluntary standard setting.

 

Regardless of whether a specific law is proposed or enacted, there are several federal and state government initiatives that seek to obtain the voluntary agreement of servicers to subscribe to a code of conduct or statement of principles or methodologies when working with borrowers facing foreclosure on their homes. Generally speaking, the principles call for servicers to reach out to borrowers with adjustable rate mortgages before their loans “reset” with higher monthly payments that might result in a default by a borrower and seek to modify loans prior to the reset. Applicable servicing agreements, federal tax law and accounting standards generally limit the ability of a servicer to modify a loan before the borrower has defaulted on the loan or the servicer has determined that a default by the borrower is reasonably likely to occur. Servicing agreements generally require the servicer to act in the best interests of the investors or at least not to take actions that are materially adverse to the interests of the investors. Compliance with the code or principles contemplated by various federal and state initiatives must conform to these other contractual, tax and accounting standards. As a result, servicers have to confront competing demands from consumers and those advocating on their behalf to make home retention the overarching priority when dealing with borrowers in default, on the one hand, and the requirements of investors to maximize returns on the loans, on the other. If we are unable to strike the right balance between these demands and requirements, the results of our operations could be adversely affected.

 

Our financial condition and results of operations would be adversely affected if our allowance for loan losses is not sufficient to absorb actual losses or if we are required to increase our allowance.

 

Despite our underwriting criteria, we may experience loan delinquencies and losses. In order to absorb losses associated with nonperforming loans, we both maintain an allowance for loan losses based on, among other things, historical experience, an evaluation of economic conditions, and regular reviews of delinquencies and loan portfolio quality. Determination of the allowance inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. We may be required to increase our allowance for loan losses for any of several reasons. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in our allowances. In addition, actual charge-offs in future periods, if not adequately reserved for, will require additional increases in our allowances for loan losses. Any increases in our allowances for loan losses will result in a decrease in our net income and, possibly, our capital, and may materially affect our results of operations in the period in which the allowance is increased.

 

We rely on our management and other key personnel, and the loss of any of them may adversely affect our operations.

 

We are and will continue to be dependent upon the services of our executive management team. In addition, we will continue to depend on our ability to retain and recruit key banking officers. The unexpected loss of services of any key management personnel or banking officers could have an adverse effect on our business and financial condition because of their skills, knowledge of our market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.  In the event that the employment of our executive officers is

 

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terminated in the future without cause, under the terms of their respective employment agreements, most of our executive officers would be entitled to receive continued salary at the rate then in effect for varying periods of time following termination. Such obligations to make severance payments could be triggered in the event we are acquired and the executive officer is terminated in connection with such acquisition.

 

Failure to implement new technologies in our operations may adversely affect our growth or profits.

 

Advances in technology increasingly affect the market for financial services, including banking services and consumer finance services. Our ability to compete successfully in these markets may depend on the extent to which we are able to exploit such technological changes. However, we may not be able to properly or timely anticipate or implement such technologies or properly train our staff to use such technologies. Further, the added cost of technology for small banks such as us adversely affects our profitability. Any failure to adapt to new technologies could adversely affect our business, financial condition or operating results.

 

We may be subject to an increased likelihood of class action litigation and additional regulatory enforcement.

 

The market price of our common stock has declined substantially over the past year, reflective of such factors as our reported losses, investors’ perceptions about our business prospects and the financial services industry in general.  The occurrence of these events could result in shareholder class action lawsuits, even if the activities subject to complaint are not unlawful.  These events and negative publicity may result in more regulation and legislative scrutiny of our industry practices and may expose us to increased shareholder litigation and additional regulatory enforcement actions, which could adversely affect our business.

 

We can issue common stock and preferred stock without your approval, diluting your proportional ownership interest.

 

Our articles of incorporation authorize us to issue 10,000,000 shares of common stock and 10,000,000 shares of preferred stock. As of February 28, 2009, we had no shares of preferred stock outstanding and had 4,980,481 shares of common stock issued and outstanding. We also have 1,545,976 shares reserved under our stock option plans covering our directors, officers, employees and consultants. As of February 28, 2009, there were options and warrants outstanding to purchase a total of 980,148 shares at a weighted average price of $8.38 per share.  Consequently, any shares of common stock or preferred stock that we issue subsequent to your purchase of our stock will dilute your proportional ownership interest in us.

 

The price of our common stock may decrease, preventing you from selling your shares at a profit.

 

The market price of our common stock could decrease and prevent you from selling your shares at a profit. The market price of our common stock has fluctuated in recent years. Fluctuations may occur, among other reasons, due to:

 

·              operating results;

 

·              market demand;

 

·              announcements by competitors;

 

·              economic changes;

 

·              general market conditions; and

 

·              legislative and regulatory changes.

 

The trading price of our common stock may continue to fluctuate in response to these factors and others, many of which are beyond our control.

 

“Penny Stock” rules may make buying or selling our common stock difficult.

 

While our market price is below $5.00 per share, trading in our common stock may be subject to the “penny stock” rules. The SEC has adopted regulations that generally define a penny stock to be any equity security that has a market price of less than $5.00 per share, subject to certain exceptions. These rules would require that any broker-dealer that would recommend our common stock to persons other than prior customers and accredited investors,

 

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must, prior to the sale, make a special written suitability determination for the purchaser and receive the purchaser’s written agreement to execute the transaction. Unless an exception is available, the regulations would require the delivery, prior to any transaction involving a penny stock, of a disclosure schedule explaining the penny stock market and the risks associated with trading in the penny stock market. In addition, broker-dealers must disclose commissions payable to both the broker-dealer and the registered representative and current quotations for the securities they offer. The additional burdens imposed upon broker-dealers by such requirements may discourage broker-dealers from effecting transactions in our common stock, which could severely limit the market price and liquidity of our common stock.

 

An investment in our common stock is not an insured deposit.

 

Our common stock is not a bank deposit and, therefore, is not insured against loss by the Federal Deposit Insurance Corporation, commonly referred to as the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in our common stock is subject to the same market forces that affect the price of common stock in any company.

 

ITEM 1B.                                            UNRESOLVED STAFF COMMENTS

 

The Company is not aware of any unresolved comments from the staff of the SEC.

 

ITEM 2.                                                     PROPERTIES

 

The Company’s corporate headquarters is located at 9333 Genesee Avenue #300, San Diego, California. In addition, the Company currently operates eight branch offices in San Diego County. Each office is leased pursuant to an operating lease, the principal terms of which are outlined in the table below.  For additional information regarding the Company’s premises and equipment see Note D to the Financial Statements included in “Item 8, Financial Statements,” below.

 

 

 

 

 

Approx.

 

Monthly

 

 

 

Date

 

 

 

Usable Sq.

 

Monthly

 

Lease

 

Opened

 

Address

 

Footage

 

Obligation

 

Expiration

 

9/2007

 

Corporate Headquarters
9333 Genesee Avenue, Ste. 300, San Diego, CA

 

11,327

 

$

42,030

 

8/2017

 

 

 

 

 

 

 

 

 

 

 

9/2007

 

University Towne Centre Branch Office
9333 Genesee Avenue, Ste. 100, San Diego, CA

 

4,461

 

$

16,736

 

8/2017

 

 

 

 

 

 

 

 

 

 

 

11/2000

 

Tri-Cities Branch Office
3500 College Blvd., Oceanside, CA

 

2,838

 

$

11,056

 

12/2009

 

 

 

 

 

 

 

 

 

 

 

8/2003

 

Mission Valley Branch Office
8889 Rio San Diego Dr., San Diego, CA

 

3,904

 

$

11,671

 

8/2013

 

 

 

 

 

 

 

 

 

 

 

2/2005

 

Inland North County Branch Office
13500 Evening Creek Dr. North, Ste. 100, San Diego, CA

 

4,664

 

$

17,669

 

2/2012

 

 

 

 

 

 

 

 

 

 

 

8/2007

 

East County Branch Office
343 E. Main St., El Cajon, CA

 

4,000

 

$

10,460

 

7/2017

 

 

 

 

 

 

 

 

 

 

 

7/2007

 

Solana Beach Branch Office
937 Lomas Santa Fe Drive, Solana Beach, CA

 

7,513

 

$

24,244

 

8/2011

 

 

 

 

 

 

 

 

 

 

 

7/2007

 

La Jolla Branch Office
7817 Ivanhoe Avenue, Ste. 100, La Jolla, CA

 

7,008

 

$

29,807

 

1/2018

 

 

 

 

 

 

 

 

 

 

 

2/2008

 

Downtown San Diego Office
525 B Street, Suite 1500, San Diego, CA

 

550

 

$

1,500

 

10/2009

 

 

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Table of Contents

 

Management believes that the Company’s present facilities are in good physical condition and are adequately covered by insurance. Certain of the leases noted above contain options to extend the term of the lease.  The Company is confident that, if necessary, it would be able to secure suitable alternative space on similar terms without having a substantial effect on operations.

 

ITEM 3.                                                     LEGAL PROCEEDINGS

 

The Company and its subsidiaries are involved only in routine litigation incidental to the business of banking, none of which the Company’s management expects to have a material adverse effect on the Company.

 

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

 

No matters were submitted for a vote of security holders during the fourth quarter of 2008.

 

PART II

 

ITEM 5.

MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

Market Information

 

Our common stock began trading on the NASDAQ Global Market (“NASDAQ”) under the symbol “FPBN” as of January 3, 2008, and continues to be listed there as of the date hereof. Before such listing, from January 30, 2007 until January 3, 2008, our common stock was quoted on the OTC Bulletin Board (“OTCBB”) under the symbol “FPBN.” Prior to our bank holding company reorganization and the Company’s stock being quoted on the OTCBB, the Bank’s common stock was quoted on the OTCBB under the symbol “FPBS”.  The OTCBB is a regulated quotation service that displays real-time quotes, last-sale prices and volume information in over-the-counter equity securities.  Unlike the NASDAQ, the OTCBB does not impose listing standards and does not provide automated trade executions.  Historical trading in the Company’s and the Bank’s stock has not been extensive and such trades cannot be characterized as constituting an active trading market.

 

The following table sets forth, for the fiscal periods indicated, the high and low sales prices or closing bid prices for our common stock for the two most recent fiscal years (the Bank’s common stock for periods prior to our bank holding company reorganization). The quotations for the periods in which our common stock traded on the OTC Bulletin Board reflect inter-dealer prices, without retail mark-up, markdown or commission and may not represent actual transactions. Trading prices are based on published financial sources.

 

 

 

High

 

Low

 

Share Volume

 

2007

 

 

 

 

 

 

 

First Quarter

 

$

16.35

 

$

15.25

 

88,516

 

Second Quarter

 

$

16.45

 

$

14.75

 

74,264

 

Third Quarter

 

$

15.30

 

$

12.75

 

89,458

 

Fourth Quarter

 

$

13.20

 

$

9.01

 

174,204

 

 

 

 

 

 

 

 

 

2008

 

 

 

 

 

 

 

First Quarter

 

$

10.75

 

$

7.27

 

136,067

 

Second Quarter

 

$

9.00

 

$

7.50

 

86,206

 

Third Quarter

 

$

8.20

 

$

3.75

 

266,253

 

Fourth Quarter

 

$

8.00

 

$

1.60

 

270,174

 

 

Stockholders

 

As of December 31, 2008, the Company had approximately 500 common stock holders of record.

 

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Table of Contents

 

Dividends

 

To date, 1st Pacific Bancorp has not paid any cash dividends.  Payment of stock or cash dividends in the future will depend upon 1st Pacific Bancorp’s earnings and financial condition and other factors deemed relevant by the Board of Directors, as well as 1st Pacific Bancorp’s legal ability to pay dividends.

 

Further, under California law, 1st Pacific Bancorp would be prohibited from paying dividends unless: (1) its retained earnings immediately prior to the dividend payment equals or exceeds the amount of the dividend; or (2) immediately after giving effect to the dividend the sum of 1st Pacific Bancorp’s assets would be at least equal to 125% of its liabilities, and 1st Pacific Bancorp’s current assets would be at least equal to its current liabilities, or, if the average of its earnings before taxes on income and before interest expense for the two preceding fiscal years was less than the average of its interest expense for those fiscal years, the current assets of 1st Pacific Bancorp would be at least equal to 125% of its current liabilities.  The primary source of funds with which dividends could be paid to shareholders would come from cash dividends received by 1st Pacific Bancorp from the Bank. During 2007, the Bank paid $4,400,000 in cash dividends to 1st Pacific Bancorp. No dividends were paid in 2008. 1st Pacific Bancorp also must service the debt on its Trust Preferred Securities (which are further discussed in the section below entitled “Liquidity Management, Interest Rate Risk, Financing and Capital Resources”) before declaring or paying any dividends. Pursuant to its rights under the indenture agreement, in January 2009, the Company elected to defer interest payments on the Trust Preferred Securities and may continue this election for up to twenty consecutive quarterly periods.

 

The Bank, as a state-chartered bank, is subject to dividend restrictions set forth in the California Financial Code, and administered by the DFI. Under such restrictions, the Bank may not pay cash dividends in an amount which exceeds the lesser of the retained earnings of the Bank or the Bank’s net income for the last three fiscal years (less the amount of distributions to shareholders during that period of time).  If the above test is not met, cash dividends may only be paid with the prior approval of the DFI, in an amount not exceeding the Bank’s net income for its last fiscal year or the amount of its net income for the current fiscal year. Such restrictions do not apply to stock dividends, which generally require neither the satisfaction of any tests nor the approval of the DFI. Notwithstanding the foregoing, if the DFI finds that the shareholders’ equity is not adequate or that the declarations of a dividend would be unsafe or unsound, the DFI may order the state bank not to pay any dividend.  The FRB may also limit dividends paid by the Company. Based on these regulations and the Company’s current financial results, 1st Pacific Bancorp has resolved not to declare or pay any dividends without prior approval of the FRB and the Bank has agreed not to declare or pay any dividends without prior approval of the FRB and the DFI.

 

Equity Compensation Plan Information

 

See “Item 12, Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters — Securities Authorized for Issuance Under Equity Compensation Plan,” below.

 

Purchases of Equity Securities by Company and Affiliated Purchases

 

Neither the Company nor any affiliate of the Company has repurchased any of its common or preferred stock during the fourth quarter of the fiscal year covered by this report, and no stock repurchase plan has been adopted.

 

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Table of Contents

 

ITEM 6.                                                     SELECTED FINANCIAL DATA

 

The following selected financial data of the Company has been derived from and should be read in conjunction with the Company’s audited Financial Statements and notes included in “Item 8, Financial Statements and Supplementary Data.” The information contained in this summary may not be indicative of future financial condition or results of operations.

 

Selected Financial Data

 

 

 

As of or For the Periods Ending December 31,

 

 

 

2008

 

2007(1)

 

2006

 

2005

 

2004

 

 

 

(dollars in thousands, except per share data)

 

Summary of Operations

 

 

 

 

 

 

 

 

 

 

 

Interest Income

 

$

27,228

 

$

29,201

 

$

23,460

 

$

16,695

 

$

10,363

 

Interest Expense

 

10,370

 

11,960

 

8,217

 

4,125

 

1,923

 

Net Interest Income

 

16,858

 

17,241

 

15,243

 

12,570

 

8,440

 

Provision for Loan Losses

 

15,900

 

338

 

444

 

553

 

850

 

Noninterest Income

 

1,222

 

710

 

539

 

491

 

466

 

Goodwill Impairment

 

10,364

 

 

 

 

 

Other Noninterest Expense

 

16,830

 

13,402

 

9,973

 

8,532

 

5,993

 

Income (Loss) before Income Taxes

 

(25,014

)

4,211

 

5,364

 

3,976

 

2,063

 

Income Taxes (Benefit)

 

(3,154

)

1,746

 

2,189

 

1,626

 

837

 

Net Income (Loss)

 

$

(21,860

)

$

2,465

 

$

3,176

 

$

2,350

 

$

1,226

 

 

 

 

 

 

 

 

 

 

 

 

 

Per Share Data

 

 

 

 

 

 

 

 

 

 

 

Net Income (Loss) — Basic

 

$

(4.41

)

$

.56

 

$

.82

 

$

.61

 

$

.34

 

Net Income (Loss) — Diluted

 

(4.41

)

.52

 

.76

 

.56

 

.32

 

Tangible Book Value

 

4.26

 

6.68

 

6.67

 

5.77

 

5.16

 

Ending Number of Shares Outstanding

 

4,980,481

 

4,944,443

 

3,889,692

 

3,849,540

 

3,819,920

 

Weighted Average Number of Shares Outstanding

 

4,961,074

 

4,405,191

 

3,865,330

 

3,840,596

 

3,560,036

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance Sheet Data — At Period End

 

 

 

 

 

 

 

 

 

 

 

Total Assets

 

$

420,910

 

$

414,647

 

$

318,464

 

$

265,582

 

$

209,709

 

Total Loans

 

351,899

 

349,819

 

275,266

 

230,382

 

188,552

 

Allowance for Loan Losses

 

5,059

 

4,517

 

3,251

 

2,809

 

2,265

 

Investment Securities

 

25,053

 

23,746

 

8,998

 

3,146

 

5,940

 

Other Real Estate Owned

 

1,390

 

 

 

 

 

Total Deposits

 

333,836

 

345,362

 

261,838

 

237,208

 

180,291

 

Total Shareholders’ Equity

 

22,581

 

44,974

 

25,936

 

22,230

 

19,697

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating Ratios and Other Selected Data

 

 

 

 

 

 

 

 

 

 

 

Return on Average Assets

 

-4.98

%

.67

%

1.13

%

1.01

%

.71

%

Return on Average Equity

 

-48.82

%

6.96

%

13.25

%

11.28

%

7.00

%

Efficiency Ratio

 

150.41

%

74.66

%

63.19

%

65.32

%

67.29

%

Net Interest Margin

 

4.09

%

4.87

%

5.61

%

5.56

%

5.06

%

Dividend Payout Ratio

 

0.00

%

0.00

%

0.00

%

0.00

%

0.00

%

Tangible Equity to Assets

 

5.07

%

8.20

%

8.14

%

8.37

%

9.39

%

 

 

 

 

 

 

 

 

 

 

 

 

Selected Asset Quality Ratios — At Period End

 

 

 

 

 

 

 

 

 

 

 

Nonperforming Loans to Total Loans

 

3.49

%

1.59

%

0.00

%

0.46

%

0.00

%

Nonperforming Assets to Total Assets

 

3.54

%

1.34

%

0.00

%

0.40

%

0.00

%

ALLL as a Percentage of Total Loans

 

1.44

%

1.29

%

1.18

%

1.22

%

1.20

%

 


(1) FYE 2007 includes the acquisition of Landmark National Bank, effective July 1, 2007.

 

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Table of Contents

 

ITEM 7.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

BASIS OF PRESENTATION

 

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”), is intended to assist the reader in understanding the operations and present business condition of the Company. This discussion, which refers to the Company on a consolidated basis, should be read in conjunction with the Company’s audited consolidated financial statements and corresponding notes thereto, included in “Item 8 — Financial Statements and Supplementary Data” of this report, as well as the information in the “Forward-Looking Information” and “Item 1A — Risk Factors.”

 

On January 16, 2007, 1st Pacific Bancorp acquired 100% of the outstanding shares of common stock of 1st Pacific Bank of California which were converted into an equal number of shares of common stock of 1st Pacific Bancorp.  There was no cash involved in the transaction. The reorganization was accounted for as a pooling of interests and the consolidated financial statements contained herein have been restated to give full effect to this transaction. The presentation of the 2006 financial statements has been changed to show the effect of the bank holding company reorganization and reflects consolidation of holding company assets of approximately $19,000 and a net loss of approximately $26,000 for the period ended December 31, 2006.

 

1st Pacific Bancorp is inactive except for interest expense associated with the junior subordinated debentures (related to the trust preferred securities; discussed further in the section below entitled “Liquidity Management, Interest Rate Risk, Financing and Capital Resources”) and minimal other expenses. Therefore, financial information is primarily reflective of the Bank.

 

The MD&A below includes the following sections:

 

·                  Financial Overview — a general description of our business and a summary of the financial results for the current year.

 

·                  Distribution of Assets, Liabilities and Stockholders’ Equity: Interest Rates and Interest Differential — average balances and average rates earned and paid in the past three years, analysis of changes in interest due to volume and rate.

 

·                  Liquidity Management, Interest Rate Risk, Financing and Capital Resources — a discussion of liquidity, interest rate risk, short-term and other borrowings, capital resources and the effects of inflation on interest rates.

 

·                  Loan Portfolio — a discussion of types of loans, maturities and sensitivities of loans to changes in interest rates analysis, loan quality discussion, loan concentrations and allowance for loan losses.

 

·                  Deposits — a discussion of sources of deposits, distribution of average deposits and average rates paid and scheduled maturity distribution of time deposits of $100,000 or more.

 

·                  Noninterest Income and Noninterest Expense — a discussion of material changes in noninterest income and noninterest expense.

 

·                  Income Taxes — a discussion of changes in income tax expense.

 

·                  Contractual Obligations —a discussion of contractual obligations by cross-reference to “Item 8 - Financial Statements and Supplementary Data.”

 

·                  Off-Balance Sheet Arrangements — a discussion of the Company’s off-balance sheet financial instruments.

 

·                  Critical Accounting Policies and Estimates — a discussion of accounting policies considered material to the presentation of the Company’s financial statements.

 

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Table of Contents

 

FINANCIAL OVERVIEW

 

We are a San Diego-based bank holding company for 1st Pacific Bank of California.  We provide traditional commercial financial services to small and medium-sized businesses and individuals in several San Diego County communities.  The comparability of our 2008 financial results with our 2007 financial results is affected by the Company’s acquisition of Landmark National Bank (“Landmark”), which was completed July 1, 2007, and operating results include the operations of Landmark since the date of the acquisition. For further discussion on this acquisition, see Note O, “Merger-Related Activity” of our Consolidated Financial Statements included in “Item 8-Financial Statements and Supplementary Data” of this report.

 

During 2008, total assets increased 1.5% to $420.9 million from $414.6 million at year end 2007. Compared to the prior year-end, FHLB borrowings, increased from $10.0 million to $50.0 million. Total deposits decreased approximately $11.5 million to $333.8 million and total loans outstanding increased approximately $2.1 million to $351.9 million.

 

Net loss for the year ended December 31, 2008, was $21.9 million versus net income of $2.5 million in 2007. The net loss was primarily the result of a one-time, non-recurring 100% write-down of goodwill in the amount of $10.4 million and the addition of $15.9 million to the allowance for loan losses to cover loan charge-offs and provide reserves for increased problem loans.

 

The Bank’s net interest margin was under pressure beginning mid-2007 when the pricing of loans and deposits became very competitive.  This pressure on net interest margin intensified as the Federal Open Market Committee (“FOMC”) implemented an easing policy beginning in September 2007. During 2008, the FOMC began an extensive rate reduction campaign, which reduced the Bank’s prime rate 400 basis points by year-end. The Bank met the prime rate reductions with aggressive repricing of deposits, which helped to shield the net interest margin from the severe prime rate reduction.

 

While the Bank plans for modest growth in 2009, the year is likely to be one where we continue to feel pressure on our capital and net interest margin and strong competition for deposits, especially in light of our not being able to accept brokered deposits without regulatory approval, see “SUPERVISION AND REGULATION – Enforcement Powers.” Pressure on net interest margin is expected to continue in 2009 as a result of the low rate environment and as the Bank works through its nonperforming assets. Along with continued loan growth, the Bank expects significant workouts in its special assets portfolio. Management also anticipates continued volatility in its net interest margin due to changes in earning asset mix, changes in cost of funds, and changes in the level of interest rates or the direction of interest rates.

 

Noninterest expenses increased from $13.4 million in 2007 to $27.2 million in 2008, a $13.8 million increase.  The bulk of this variance can be explained by two events experienced by the Company in 2008: (1) a goodwill write-off of $10.4 million, and; (2) an other-than-temporary impairment (“OTTI”) charge of $800,000 on a corporate bond investment. Both of these events were due to the volatile economic and market conditions in late 2008.

 

The Company also, for the first time in history, posted significant loan charge-offs of $15.4 million. Non-performing loans increased 121% between December 2007 and December 2008, from 1.34% of total assets to 2.91%, respectively. The percentage of non-performing assets, which includes $1.4 million in OREO and $1.3 million in non-accrual debt securities, to total assets increased from 1.34% at December 31, 2007 to 3.54% at December 31, 2008. The level of loan loss reserve at December 31, 2008 was 1.44%; up from 1.29% at December 2007. The loan loss provision charged against earnings during 2008 was $15.9 million up from $338,000 in 2007.

 

As a result of the losses experienced in 2008, the Bank is considered “adequately” capitalized at December 31, 2008. The Bank has implemented a number of initiatives to improve its operating results and is evaluating a number of alternatives to improve its capital ratios back to the “well-capitalized” level. The Company will continue to focus on the financial services needs within our target market — small and medium-sized businesses and professionals in the greater San Diego County area. There are a number of factors that could prevent the Company from achieving its plans, see “Risk Factors.”

 

29



Table of Contents

 

DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS’ EQUITY; INTEREST RATES AND INTEREST DIFFERENTIAL

 

The following table sets forth a summary of average balances with corresponding interest income and interest expense as well as average yield and cost information for the periods indicated. Nonaccrual loans are included in the calculation of the average balances of loans, and interest not accrued is excluded.

 

Average Balances with Rates Earned and Paid

 

 

 

For the Periods Ended December 31,

 

 

 

2008

 

2007

 

2006

 

 

 

(dollars in thousands)

 

 

 

Average
Balance

 

Interest
Earned
or Paid

 

Average
Yield or
Rate
Paid

 

Average
Balance

 

Interest
Earned
or Paid

 

Average
Yield or
Rate
Paid

 

Average
Balance

 

Interest
Earned
or Paid

 

Average
Yield or
Rate
Paid

 

Assets

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest-Earning Assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investment Securities

 

$

30,116

 

$

1,585

 

5.26

%

$

15,564

 

$

812

 

5.22

%

$

6,448

 

$

285

 

4.42

%

Federal Funds Sold and Other

 

15,718

 

340

 

2.16

%

20,127

 

1,009

 

5.01

%

13,208

 

650

 

4.92

%

Federal Reserve, FHLB and Bankers’ Bank Stock

 

4,551

 

200

 

4.40

%

2,820

 

139

 

4.92

%

1,794

 

90

 

5.00

%

Loans (1)

 

362,067

 

25,103

 

6.93

%

315,255

 

27,241

 

8.64

%

250,369

 

22,435

 

8.96

%

Total Interest-Earning Assets

 

412,452

 

27,228

 

6.60

%

353,766

 

29,201

 

8.25

%

271,819

 

23,460

 

8.63

%

Noninterest-Earning Assets, net

 

26,274

 

 

 

 

 

14,522

 

 

 

 

 

8,442

 

 

 

 

 

Total Assets

 

$

438,726

 

 

 

 

 

$

368,288

 

 

 

 

 

$

280,261

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest-Bearing Liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest-bearing Checking

 

$

15,851

 

$

76

 

0.48

%

$

15,219

 

$

154

 

1.01

%

$

14,200

 

$

174

 

1.22

%

Savings & Money Market

 

99,023

 

2,190

 

2.21

%

95,754

 

3,824

 

3.99

%

67,989

 

2,541

 

3.74

%

Time Deposits under $100k

 

39,636

 

1,540

 

3.88

%

25,864

 

1,260

 

4.87

%

26,109

 

1,092

 

4.18

%

Time Deposits, $100k or More

 

118,110

 

4,870

 

4.12

%

108,056

 

5,509

 

5.10

%

82,840

 

3,756

 

4.53

%

Other Borrowings

 

46,414

 

1,694

 

3.65

%

20,584

 

1,213

 

5.89

%

10,819

 

654

 

6.04

%

Total Interest-Bearing Liabilities

 

319,034

 

10,370

 

3.25

%

265,477

 

11,960

 

4.51

%

201,957

 

8,217

 

4.07

%

Demand Deposits

 

70,628

 

 

 

 

 

64,319

 

 

 

 

 

52,550

 

 

 

 

 

Other Liabilities

 

4,290

 

 

 

 

 

2,831

 

 

 

 

 

1,573

 

 

 

 

 

Shareholders’ Equity

 

44,774

 

 

 

 

 

35,661

 

 

 

 

 

24,181

 

 

 

 

 

Total Liabilities and Shareholders’ Equity

 

$

438,726

 

 

 

 

 

$

368,288

 

 

 

 

 

$

280,261

 

 

 

 

 

Net Interest Income

 

 

 

$

16,858

 

 

 

 

 

$

17,241

 

 

 

 

 

$

15,243

 

 

 

Net Interest Margin (Net Interest Income / Interest-Earning Assets)

 

 

 

 

 

4.09

%

 

 

 

 

4.87

%

 

 

 

 

5.61

%

 


(1) Interest income includes amortized loan fees, net of costs, of approximately $396,000, $540,000 and $706,000 in 2008, 2007 and 2006, respectively.

 

The principal component of the Company’s revenues is net interest income.  Net interest income is the difference (the “interest rate spread”) between the interest earned on the Company’s loans and investments and the interest paid on deposits and other interest-bearing liabilities.  As the Company is asset sensitive, net interest margin typically improves during a rising rate environment and declines during a declining rate environment.

 

For 2008, net interest income was $16.9 million compared to $17.2 million for the year ending December 31, 2007, a 2% decrease.  Even though the Bank’s volume of average earning assets increased $58.3 million in 2008 to $412.5 million, a 16% increase, net interest income declined as a result of the sharp decrease in net interest margin from 4.87% to 4.09%, a reduction of 78 basis points. This decrease in net interest margin compared to the prior year reflects the cumulative effects of changes in monetary policy, including a 400 basis point reduction in the Bank’s prime rate by year-end 2008. The severe drop in the federal funds target rate from 4.25% at December 31, 2007 to 0.25% by the end of 2008 has had a detrimental effect on the Bank’s net interest margin.

 

To counter the contraction of its net interest margin, the Company regularly and aggressively repriced deposit rates downward as the prime lending rate made a rapid descent. Because of the prime lending rate drop the percentage of loan assets which were priced at their floor increased to 42% as of December 31, 2008. Despite these factors, net interest margin has been negatively affected by interest rate cuts, the resulting decrease in total loan yields and the active competition in the local market for deposits.  The Company closely monitors and manages its

 

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interest rate sensitivity; however, management anticipates instability of its net interest margin to continue due to changes in the earning asset mix, changes in cost of funds, and changes in the level of interest rates or the direction of interest rates.  For further information regarding the Company’s interest rate risk, see the “Liquidity Management, Interest Rate Risk, Financing and Capital Resources” section below.

 

For 2007, net interest income was $17.2 million compared to $15.2 million for the year ending December 31, 2006, a 13% increase.  This growth in net interest income for the year ending December 31, 2007 primarily relates to the increase in average earning assets, which increased from $271.8 million in 2006 to $353.8 million in 2007, a 30% increase, mostly due to the acquisition of Landmark which was effective July 1, 2007. However, this volume increase was offset by the decrease in the net interest margin from 5.61% to 4.87%, a decline of 74 basis points, or 13%.  This decrease in net interest margin compared to the prior year reflects the cumulative effects of changes in monetary policy, including 100 basis points in increases to the target Federal Funds rate between January and June of 2006 and then a cumulative 100 basis point cut in the target Federal Funds rate in a three-month period beginning in September of 2007.  The federal funds target rate was 4.25% at December 31, 2007.

 

The following tables show the changes in interest income and expense as a result of changes in volume and rate for each of the last two fiscal years.  Changes due to both rate and volume are allocated to volume.

 

Analysis of Volume and Interest Rate Changes

 

 

 

(dollars in thousands)

 

 

 

Year Ended December 31, 2008
Versus the Year Ended
December 31, 2007

 

 

 

Amount of Change Attributed to

 

 

 

Volume

 

Rate

 

Total
Change

 

Investment securities (1)

 

$

766

 

$

7

 

$

773

 

Federal funds sold

 

(95

)

(574

)

(669

)

Other earning assets

 

76

 

(15

)

61

 

Loans

 

3,246

 

(5,384

)

(2,138

)

Changes in interest income

 

3,993

 

(5,966

)

(1,973

)

 

 

 

 

 

 

 

 

NOW, savings and money market

 

75

 

(1,787

)

(1,712

)

Time deposits under $100,000

 

535

 

(255

)

280

 

Time deposits of $100,000 or more

 

415

 

(1,054

)

(639

)

Other borrowings

 

943

 

(462

)

481

 

Changes in interest expense

 

1,968

 

(3,558

)

(1,590

)

Total change in net interest income

 

$

2,025

 

$

(2,408

)

$

(383

)

 

 

 

Year Ended December 31, 2007
Versus the Year Ended
December 31, 2006

 

 

 

Amount of Change Attributed to

 

 

 

Volume

 

Rate

 

Total
Change

 

Investment securities

 

$

474

 

$

53

 

$

527

 

Federal funds sold

 

347

 

12

 

359

 

Other earning assets

 

50

 

(1

)

49

 

Loans

 

5,607

 

(801

)

4,806

 

Changes in interest income

 

6,478

 

(737

)

5,741

 

 

 

 

 

 

 

 

 

NOW, savings and money market

 

1,119

 

144

 

1,263

 

Time deposits under $100,000

 

(11

)

179

 

168

 

Time deposits of $100,000 or more

 

1,285

 

468

 

1,753

 

Other borrowings

 

575

 

(16

)

559

 

Changes in interest expense

 

2,968

 

775

 

3,743

 

Total change in net interest income

 

$

3,510

 

$

(1,512

)

$

1,998

 

 

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(1)          Bank-qualified municipals receive preferential treatment for federal income tax purposes. Changes shown are before any such Federal tax benefit.

 

The Company expects its risk exposure to changes in interest rates during 2009 to remain manageable and within acceptable policy ranges. Management will continue to strive for an optimal balance between risk and earnings.

 

LIQUIDITY MANAGEMENT, INTEREST RATE RISK, FINANCING AND CAPITAL RESOURCES

 

Liquidity Management

 

Balance sheet liquidity, which is a measure of an entity’s ability to meet fluctuations in deposit levels and provide for customers’ credit needs, is managed through various funding strategies that reflect the maturity structures of the sources of funds being gathered and the assets being funded.

 

The Bank’s liquidity results primarily from funds provided by short-term liabilities such as demand deposits, certificates of deposit, and short-term borrowings and is augmented by payments of principal and interest on loans.  The Bank has access to short-term investments, primarily Federal funds sold, which is the primary means for providing immediate liquidity. As an additional aid to managing short-term liquidity needs, the Bank also maintains credit facilities at correspondent banks which may be reduced or withdrawn at any time, and borrowing facilities through its Federal Home Loan Bank membership and the FRB Discount Window which may include provisions for pledging of collateral. Below is a summary of the total borrowing capacity available under these facilities and amounts outstanding at December 31, 2008:

 

Capacity and Outstanding Borrowings

 

Source of Borrowing Facility

 

Capacity

 

Outstanding at 12/31/2008

 

Secured line based on pledged loan collateral at:

 

 

 

 

 

Federal Home Loan Bank

 

$

59,330,025

 

$

50,000,000

 

Federal Reserve Bank

 

$

36,471,740

 

$

0

 

Unsecured lines at correspondent banks

 

$

10,000,000

 

$

0

 

 

The objective of the Bank’s asset/liability strategy is to manage and monitor liquidity proactively to ensure the safety and soundness of the Bank’s capital base, while maintaining adequate net interest margins and spreads to provide an appropriate return to shareholders.  The Bank has procedures in place to manage its liquidity on a daily basis and maintains “contingency” sources of liquidity, whereby a certain level of liquidity sources are reserved to be used for unforeseen contingency purposes. To allow for more efficient balance sheet management, the Company manages its “on” balance sheet liquidity ratios and “off” balance sheet liquidity sources. Additionally, the Bank has established thresholds for non-core deposits. Non-core deposits are defined as time deposits greater than $100,000 and all brokered deposits.  Brokered deposits are deposits obtained through any person engaged in the business of placing deposits or facilitating the placement of deposits, of third parties with insured depository institutions, with some limited exceptions.  Brokered deposits also include deposits obtained through any insured depository institution that is not well capitalized, or any employee of such institution, which engages in the solicitation of deposits by offering rates of interest which are significantly higher than the prevailing rates of interest on deposits offered by other insured depository institutions in such depository institution’s normal market area. During 2008, total brokered deposits increased from $48.2 million at December 31, 2007, to $84.9 million at December 31, 2008. This increase of $36.7 million in total brokered deposits is primarily the result of increased balances in the Certificate of Deposit Account Registry Service (“CDARs”) reciprocal program, which are considered brokered deposits and increased by $28.8 million during 2008 and totaled $36.2 million at December 31, 2008.

 

As a result of the Bank no longer being considered “well-capitalized,” the Bank is no longer able to accept, renew or rollover brokered deposits unless and until such time as it receives a waiver from the FDIC. See also “SUPERVISION AND REGULATION - Enforcement Powers.”  The Bank intends to apply for a waiver, from the FDIC to continue to accept, renew or rollover CDARS reciprocal brokered deposits; however, there can be no guarantee this waiver will be granted and, if not, the Bank will need to seek other alternatives, which may be more costly for funding purposes, as these deposits mature.

 

In August 2008, the Company modified its policy as a result of an increased interest in CDARs and the desire of the Bank to continue to offer this program as an option to its customers seeking additional deposit insurance. CDARs deposits continue to be considered brokered, however, they are not viewed as having the same degree of volatility as other traditional brokered deposits. As of December 31, 2008, total CDARs deposits were $36.2 million compared to $7.3 million at December 31, 2007.

 

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In order to manage the Bank’s liquidity, management monitors a number of liquidity ratios, including the level of liquid assets to funding sources (both on and off the balance sheet), the level of dependence on non-core funding sources, the level of loans to funding sources, the level of short-term investments to total assets, contingent sources to total deposits, available liquidity to total funding and the level of unfunded loan commitments.  As of December 31, 2008, management considers the Bank’s liquidity sufficient to meet the Bank’s liquidity needs.

 

Despite the significant net loss in 2008, the Company had positive cash flow from operations because the goodwill impairment charge and the provision for loan losses are non-cash expenses. Net financing activities of $28.7 million; primarily from increased borrowings, were used to fund net investing activities of $22.7 million, primarily net increase in loans funded.

 

1st Pacific Bancorp is a company separate and apart from the Bank and must provide for its own liquidity. As of December 31, 2008, 1st Pacific Bancorp had no borrowings other than junior subordinated debentures and had approximately $39,000 in unrestricted cash. See Note P, Condensed Financial Information of Parent Company only, to the consolidated financial statements for additional financial information regarding 1st Pacific Bancorp.

 

Substantially all of 1st Pacific Bancorp’s revenues are obtained from dividends declared and paid by the Bank. Banking regulations limit the amount of cash dividends that may be paid without prior approval of the Bank’s primary regulatory agency. The California Financial Code provides that a bank may not make a cash distribution to its shareholder in excess of the lesser or the Bank’s undivided profits or the Bank’s net income for its last three fiscal years less the amount of any distribution made by the Bank to shareholders during the same period. As a result of the net loss experienced in 2008 and agreement with the Bank’s regulators, it is unlikely the Bank will be able to make dividend payments to 1st Pacific Bancorp in the foreseeable future. Pursuant to its rights under the indenture agreement, the Company has elected to defer interest payments on the subordinated debentures and may continue such deferment for up to twenty calendar quarters. Management is evaluating alternate means to provide 1st Pacific Bancorp with cash to meet its other minimal operating expenses.

 

Interest Rate Risk

 

The objectives of interest rate risk management are to control exposure of net interest income to risks associated with interest rate movements in the market, to achieve consistent growth in net interest income and to profit from favorable market opportunities.  Even with perfectly matched repricing of assets and liabilities, risks remain in the form of prepayment of assets and timing lags in adjusting certain assets and liabilities that have varying sensitivities to market interest rates and basis risk.

 

The table below sets forth the interest rate sensitivity of the Company’s interest-earning assets and interest-bearing liabilities as of December 31, 2008, using the interest rate sensitivity gap ratio.  For purposes of the following table, an asset or liability is considered rate-sensitive within a specified period when it can be repriced or matures within its contractual terms.  When the rate on a loan with a floating rate has reached a contractual floor or ceiling level, the loan is treated as a fixed rate loan for purposes of determining its rate-sensitivity until the rate is again free to float.

 

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Table of Contents

 

Interest Rate Sensitivity of Interest-Earning Assets and Liabilities

 

 

 

Estimated Maturity or Repricing

 

 

 

Up to
Three
Months

 

Over Three
Months
To Less
Than One
Year

 

Over
One to
Five
Years

 

Over
Five
Years

 

Total

 

 

 

(dollars in thousands)

 

Interest-Earning Assets:

 

 

 

 

 

 

 

 

 

 

 

Investment Securities

 

$

3,674

 

$

1,925

 

$

3,313

 

$

16,141

 

$

25,053

 

Federal Funds Sold

 

18,010

 

 

 

 

18,010

 

Loans

 

111,831

 

75,528

 

92,713

 

71,827

 

351,899

 

Totals

 

$

133,515

 

$

77,453

 

$

96,026

 

$

87,968

 

$

394,962

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest-Bearing Liabilities:

 

 

 

 

 

 

 

 

 

 

 

Interest-Bearing Checking

 

$

16,731

 

$

 

$

 

$

 

$

16,731

 

Savings & Money Market

 

77,037

 

 

 

 

77,037

 

Time Deposits

 

33,129

 

131,930

 

12,474

 

 

177,533

 

Other Borrowings

 

10,155

 

15,000

 

35,000

 

 

60,155

 

Totals

 

$

137,052

 

$

146,930

 

$

47,474

 

$

 

$

331,456

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest Rate Sensitivity Gap

 

$

(3,537

)

$

(69,477

)

$

48,552

 

$

87,968

 

$

63,506

 

Cumulative Interest Rate
Sensitivity Gap

 

$

(3,537

)

$

(73,014

)

$

(24,462

)

$

63,506

 

$

63,506

 

Cumulative Interest Rate
Sensitivity Gap Ratio Based on Total Assets

 

-0.84

%

-17.35

%

-5.81

%

15.09

%

15.09

%

 

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Table of Contents

 

Gap analysis is a method of analyzing exposure to interest rate risk, by measuring the ability of the Company to reprice its interest rate-sensitive assets and liabilities.  The actual impact of interest rate movements on the Company’s net interest income may differ from that implied by any gap measurement, depending on the direction and magnitude of the interest rate movements and the repricing characteristics of various on and off-balance sheet instruments, as well as competitive pressures.  These factors are not fully reflected in the foregoing gap analysis and, as a result, the gap report may not provide a complete assessment of the Company’s interest rate risk.  In addition to gap analysis, such as the table above, the Company estimates the effect of changing interest rates on its net interest income using the repricing and maturity characteristics of its assets and liabilities and the estimated effects on yields and costs of those assets and liabilities.

 

Based on the gap analysis and the Company’s assessment of its exposure to interest rate risk, the Company is considered to be “asset sensitive.”  In general, “asset sensitive” means that, over time, the Company’s assets will reprice faster than its liabilities.  In a rising interest rate environment, net interest income can be expected to increase and, in a declining interest rate environment, net interest income can be expected to decrease.  In addition, a rising interest rate environment will affect the Company’s ability to reprice loans that bear variable interest rates but are currently at their floor rates and will not fluctuate immediately.  At December 31, 2008, approximately $152 million, or 42% of loans were priced at their floor interest rate.  If interest rates increase, the rates earned on these loans will begin to adjust above their floor rates and the Company’s asset sensitivity will increase. Conversely, in the current declining interest rate environment, the Company will benefit from floor rates built into existing variable rate loans as the indexed rates decline to the floor rates and stop adjusting downwards. The benefit derived, if any, by the Company when loan rates drop to their floor rates may be mitigated by the increased likelihood that those loans may be refinanced by the borrowers with other financial institutions.

 

The impact of inflation on a financial institution can differ significantly from that exerted on other companies.  Banks, as financial intermediaries, have many assets and liabilities, which may move in concert with inflation both as to interest rates and value.  This is especially true for banks with a high percentage of interest rate-sensitive assets and liabilities.  The Company manages its sensitivity to changes in interest rates by performing a gap analysis of its rate sensitive balance sheet and modeling the effects of changes in interest rates on its net interest income.  The Company attempts to structure its mix of financial instruments and manage its interest rate sensitivity gap in order to minimize the potential adverse effects of inflation or other market forces on its net interest income and, therefore, its earnings and capital.

 

Short-Term and Other Borrowings

 

The Bank may borrow up to $10.0 million overnight on an unsecured basis from its correspondent banks; each of these facilities may be withdrawn at any time by the correspondent bank. In addition, the Bank has arranged a borrowing line with the Federal Home Loan Bank of San Francisco (“the FHLB”), under which the Bank may borrow up to 15% of its assets subject to providing adequate collateral and fulfilling other conditions of the line. The Bank also has a secured borrowing facility with the Federal Reserve Bank. See Note H to the Financial Statements included in “Item 8, Financial Statements and Supplementary Data,” below for additional details.

 

As of December 31, 2008, the Bank had $50.0 million in outstanding fixed rate FHLB advances which are outlined below:

 

Year of
Maturity

 

Principal
Balance

 

Weighted Average
Interest Rate

 

2009

 

$

15,000,000

 

2.01

%

2010

 

25,000,000

 

2.88

%

2011

 

5,000,000

 

2.01

%

2012

 

5,000,000

 

4.31

%

 

 

$

50,000,000

 

2.68

%

 

At December 31, 2007, the Bank had $10.0 million outstanding in two term FHLB advances which are still outstanding as of December 31, 2008 in the table above: (1) a $5.0 million advance with an interest rate of 4.5% and a final maturity of September 14, 2009 and callable by the FHLB beginning September 14, 2008 and quarterly thereafter; (2) a $5.0 million advance with an interest rate of 4.31%, and a final maturity of September 13, 2012 and callable by the FHLB on September 13, 2009. As of December 31, 2006, the Bank had $24.0 million outstanding in

 

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Table of Contents

 

FHLB advances under these borrowing lines, which matured in January 2007 and had a weighted average interest rate of 5.34%.

 

Below is a table of maximum amounts of FHLB borrowings outstanding at any month-end during the reporting periods, and the approximate average amounts outstanding and weighted average interest rate as of December 31 of the reporting periods.

 

Year Ended

 

Maximum Amt
Outstanding at
any Month-End

 

Average Balance

 

Weighted
Average
Interest Rate

 

(dollars in thousands)

 

2008

 

$

65,000

 

$

36,247

 

3.31

%

2007

 

$

29,000

 

$

13,006

 

5.11

%

2006

 

$

24,000

 

$

5,786

 

5.29

%

 

On March 31, 2005, the Bank issued $5.0 million in Floating Rate Junior Subordinated Debentures in a private placement offering.  This offering was undertaken in order to raise the Bank’s capital ratios.  Under risk-based capital guidelines, subordinated debentures qualify for Tier 2 capital treatment up to 50% of Tier 1 capital and, therefore, increased the Bank’s total risk-based capital ratio.  The terms of the subordinated debt are: a final maturity of June 15, 2020, a right on behalf of the Bank for early redemptions beginning in June, 2010, and an interest rate which floats quarterly based on 3 Month LIBOR plus a spread of 178 basis points.  The interest rate on the subordinated debt as of December 31, 2008 is 3.78%.

 

On June 28, 2007, the Company completed a private placement of $5.0 million in aggregate principal amount of floating rate preferred securities (the “Trust Preferred Securities”) through a newly-formed Delaware trust affiliate, FPBN Trust I (the “Trust”).  The Trust used the proceeds from the sale of the Trust Preferred Securities together with the proceeds from the sale of Common Securities to purchase $5,155,000 in aggregate principal amount of the Company’s unsecured floating rate junior subordinated debt securities due September 1, 2037, issued by the Company (the “Junior Subordinated Debt Securities”).  As of December 31, 2008, the coupon interest rate was 3.58% (3 month LIBOR plus 1.40%) and floats quarterly.  The Company shall have the right, subject to regulatory approval, to redeem the debt securities, in whole or from time to time in part, on any interest payment date on or after September 1, 2012.  The net proceeds to the Company from the sale of the Junior Subordinated Debt Securities were used by the Company to fund a portion of the cash consideration in the acquisition of Landmark.

 

Capital Resources

 

The Bank opened in November 2000 after completing its initial public offering and raising $11.5 million in capital.  In 2002, the Bank completed a secondary offering of securities, raising $4.2 million in new capital.  During 2003 and 2004, the Bank raised approximately $4.3 million from the conversion of 95% of common stock purchase warrants that were issued in connection with its 2000 initial public offering and the 2002 secondary offering.  On May 16, 2005, the Bank’s board of directors declared a two-for-one stock split of the Bank’s common stock payable to shareholders of record on June 15, 2005.  The shareholders received one additional share for each share they owned.  All share and per share data has been restated for prior periods to reflect this stock split.  In 2007, the Company issued approximately 1.0 million shares valued at $15.9 million in connection with the acquisition of Landmark.

 

The Company’s shareholders’ equity at December 31, 2008 was $22.6 million, a decrease of $22.4 million compared to the $45.0 million at December 31, 2007.  The decrease was primarily the result of net losses for the year which included a one-time goodwill write down of $10.4 million. Tangible book value per share totaled $4.27 at December 31, 2008, compared to $6.68 as of December 31, 2007.

 

In 1990, the banking industry began to phase in new regulatory capital adequacy requirements based on risk-adjusted assets.  These requirements take into consideration the risk inherent in investments, loans, and other assets for both on-balance sheet and off-balance sheet items.  Under these requirements, the regulatory agencies have set minimum thresholds for Tier 1 capital, total capital and leverage ratios.  The Bank’s risk-adjusted capital ratios, shown below as of December 31, 2008, 2007 and 2006 have been computed in accordance with regulatory accounting policies.  See also Note N-”Regulatory Matters” of the Financial Statements and “Item 1, Description of Business - Supervision and Regulation - Risk-Based Capital Guidelines” above for more information on regulatory capital requirements.

 

36



Table of Contents

 

Capital Ratios

 

 

 

December 31,

 

 

 

 

 

2008

 

2007

 

2006

 

Minimum Requirements

 

Tier 1 Capital to Average Assets (“Leverage Ratio”)

 

5.4

%

9.0

%

8.7

%

4.0

%

Tier 1 Capital to Risk-Weighted Assets

 

6.2

%

9.5

%

8.7

%

4.0

%

Total Capital to Risk-Weighted Assets

 

8.7

%

12.0

%

11.5

%

8.0

%

 

On October 3, 2008, the Emergency Economic Stabilization Act of 2008, or EESA, was enacted, which increased FDIC insurance coverage (See “Deposit Insurance Assessments” above), as well as provided up to $700 billion in funding for the financial services industry. Pursuant to the EESA, the U.S. Treasury was initially authorized by congress to use $350 billion for the Troubled Asset Relief Program, or TARP. Of this amount, the U.S. Treasury allocated $250 million to the Capital Purchase Program, or CPP. This program allows a qualifying institution to apply for up to three percent of its total risk-weighted assets in capital, which will be in the form of non-cumulative perpetual preferred stock of the institution with a dividend rate of 5% until the fifth anniversary of the investment and 9% thereafter. The U.S. Treasury will also receive warrants for common stock of the institution equal to 15% of the capital invested. On January 15, 2009, the second $350 billion of TARP funding was released to the U.S. Treasury. The Bank applied in October 2008 for TARP funding of 3% of risk-weighted assets (approximately $12 million) and is currently waiting to hear about the status of the application as of the filing date of this report.

 

Under California law, 1st Pacific Bancorp would be prohibited from paying dividends unless: (1) its retained earnings immediately prior to the dividend payment equals or exceeds the amount of the dividend; or (2) immediately after giving effect to the dividend, the sum of 1st Pacific Bancorp’s assets would be at least equal to 125% of its liabilities, and 1st Pacific Bancorp’s current assets would be at least equal to its current liabilities, or, if the average of its earnings before taxes on income and before interest expense for the two preceding fiscal years was less than the average of its interest expense for the two preceding those fiscal years, the current assets of 1st Pacific Bancorp would be at least equal to 125% of its current liabilities.  The primary source of funds with which dividends could be paid to shareholders would come from cash dividends received by, the Company from the Bank.  The Bank, as a state-chartered bank, is subject to dividend restrictions set forth in the California Financial Code, and administered by the DFI. Under such restrictions, the Bank may not pay cash dividends in an amount which exceeds the lesser of the retained earnings of the Bank or the Bank’s net income for the last three fiscal years (less the amount of distributions to shareholders during that period of time).  If the above test is not met, cash dividends may only be paid with the prior approval of the DFI, in an amount not exceeding the Bank’s net income for its last fiscal year or the amount of its net income for the current fiscal year. The FRB may also limit dividends paid by the Company. Based on these regulations and the Company’s current financial results, the Company has resolved not to declare or pay any dividends without prior approval of the FRB and the Bank has agreed not to declare or pay any dividends without prior approval of the FRB and the DFI.

 

INVESTMENT PORTFOLIO

 

The primary objective of the Company’s investment portfolio is to contribute to maximizing shareholder value by providing adequate liquidity sources to meet fluctuations in the Company’s loan demand and deposit structure.  To meet this objective, the Company invests in securities that generate reasonable rates of return to the Company given its liquidity objectives.  Secondary objectives of the investment portfolio which may be considered include: meeting pledging requirements of public or other depositors; minimizing the Company’s tax liability; accomplishing strategic goals; and assisting various local public entities with their financing needs (which may assist the Company in meeting its CRA objectives).

 

The Board of Directors has established policies regarding the investment activities of the Company, including establishment of risk limits and ensuring that management has the requisite skills to manage the risks associated with the Company’s investment activities.  The Board of Directors reviews portfolio activity and risk levels and requires management to demonstrate compliance with approved risk limits.  Senior management is responsible for establishing and enforcing policies and procedures for conducting investment activities.  Management must have an understanding of the nature and level of various risks involved in the Company’s investments and how such risks fit within the overall risk characteristics of the Company’s balance sheet.

 

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The Chief Financial Officer acts as the Company’s Investment Officer and ensures that the day-to-day guidelines of the Company’s investment policies are properly implemented and that all investments meet regulatory and accounting guidelines.  The Chief Executive Officer or the Chief Financial Officer must approve each investment transaction.  The Company monitors its investment portfolio closely, and accordingly, its composition may change substantially over time.

 

At December 31, 2008, the Company held securities guaranteed or issued by the Federal National Mortgage Association (“FNMA”) totaling $3.9 million which was in excess of 10% of the Company’s shareholder equity.  The contractual maturity distribution based on amortized cost and fair value as of December 31, 2008, is shown below. Mortgage-backed securities (“MBS”) have contractual terms to maturity, but require periodic payments to reduce principal. In addition, expected maturities may differ from contractual maturities because obligors and/or issuers may have the right to call or prepay obligations with or without call or prepayment penalties. See Note B — Investment Securities in the notes to consolidated financial statements for additional information on investment securities.

 

Amounts and Distribution of Investment Portfolio

 

 

 

December 31,

 

 

 

2008

 

2007

 

2006

 

 

 

(dollars in thousands)

 

 

 

Amortized
Cost

 

Market
Value

 

Wghtd
Avg
Yield

 

Amortized
Cost

 

Market
Value

 

Wghtd
Avg
Yield

 

Amortized
Cost

 

Market
Value

 

Wghtd
Avg
Yield

 

Available-for-Sale Securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate Debt Securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

One Year or Less

 

$

2,988

 

$

2,910

 

4.52

%

$

994

 

$

965

 

5.83

%

$

 

$

 

 

 

One Year to Five Years (1)

 

2,749

 

2,668

 

3.06

%

8,902

 

8,692

 

6.22

%

3,958

 

3,985

 

5.86

%

Total

 

5,737

 

5,578

 

3.82

%

9,896

 

9,657

 

6.18

%

3,958

 

3,985

 

5.86

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Bank-Qualified Municipals:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Due after Ten Years (2)

 

4,827

 

4,361

 

4.79

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Collateralized Mortgage Obligations:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Due after Ten Years

 

9,451

 

8,349

 

6.77

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Government-Sponsored Agency Securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

One Year or Less

 

 

 

 

 

1,996

 

1,998

 

5.48

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Government-Sponsored Agency - MBS:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(Unallocated)

 

5,729

 

5,816

 

5.43

%

10,531

 

10,668

 

5.64

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. Agency - MBS (Unallocated)

 

996

 

949

 

4.00

%

1,415

 

1,423

 

5.05

%

5,023

 

5,013

 

6.84

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Investment Securities

 

$

26,740

 

$

25,053

 

4.91

%

$

23,838

 

$

23,746

 

5.64

%

$

8,981

 

$

8,998

 

4.98

%

 


(1)          Includes amortized cost of $1.2 million for a corporate bond which was on non-accrual as of December 31, 2008.

 

(2)          Bank-qualified municipals receive preferential treatment for federal income tax purposes. Weighted average yields shown are before any such Federal tax benefit.

 

During 2008, the Company placed a corporate bond with a par value of $2.0 million on non-accrual status and ultimately recognized $800,000 in OTTI charges during the year. This corporate bond was an investment in debt of Washington Mutual Inc., the bankrupt former parent of Washington Mutual Bank. The OTTI charge reflected a write-down to 60% of par. Trading activity in the bond was limited and volatile; however, in January 2009, the bond was sold and the Bank recognized a gain upon sale.

 

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LOAN PORTFOLIO

 

Types of Loans

 

The Bank originates, purchases, or acquires participating interests in loans for its portfolio and for possible sale in the secondary market.  Total loans were $349.8 million at December 31, 2007 and increased to $351.9 million at December 31, 2008, an increase of $2.1 million, or approximately 1.0%.  Types of loans include construction and land development loans, residential and commercial real estate loans, commercial business loans, SBA loans, and consumer loans. At year end 2008, real estate loans made up 42% of the portfolio and have grown 23% since the prior year. Consumer loans grew by 60% while construction and land loans, commercial loans and SBA loans each declined by 13%, 11% and 44%, respectively. The yield on loans dropped from 8.64% in 2007 to 6.93% in 2008, mostly due to a 400 basis point drop in the prime rate during 2008.

 

Loan Portfolio Composition by Type of Loan

 

 

 

December 31,

 

 

 

2008

 

2007

 

2006

 

2005

 

2004

 

 

 

(dollars in thousands)

 

Loans:

 

 

 

 

 

 

 

 

 

 

 

Construction & Land Development

 

$

109,593

 

$

125,661

 

$

116,389

 

$

94,912

 

$

59,579

 

Real Estate — Residential &Commercial

 

147,965

 

120,531

 

81,131

 

65,123

 

57,058

 

SBA Loans — 7a & 504

 

8,820

 

15,880

 

19,883

 

21,965

 

24,640

 

Commercial Business

 

69,225

 

77,582

 

52,797

 

43,970

 

41,555

 

Consumer

 

16,296

 

10,165

 

5,066

 

4,412

 

5,720

 

Total Loans

 

351,899

 

349,819

 

275,266

 

230,382

 

188,552

 

Allowance for Loan Losses

 

(5,059

)

(4,517

)

(3,251

)

(2,809

)

(2,265

)

Net Loans

 

$

346,840

 

$

345,302

 

$

272,015

 

$

227,573

 

$

186,287

 

 

 

 

 

 

 

 

 

 

 

 

 

Commitments:

 

 

 

 

 

 

 

 

 

 

 

Standby Letters of Credit

 

$

3,819

 

$

5,994

 

$

3,224

 

$

1,649

 

$

153

 

Undisbursed Loans and Commitments to Grant Loans

 

108,235

 

98,385

 

87,527

 

85,661

 

69,034

 

Total Commitments

 

$

112,054

 

$

104,379

 

$

90,751

 

$

87,310

 

$

69,187

 

 

Construction loans are primarily made as interim loans to finance the construction of commercial and single family residential property.  These loans are typically for a term of approximately 12 months.  Other real estate loans consist primarily of commercial and industrial real estate loans.  This type of loan is made based on the income generating capacity of the property or the cash flow of the borrower.  These loans are secured by the property.  In general, our policy is to restrict these loans to no more than 75% of the lower of the appraised value or the purchase price of the property.  We offer both fixed and variable rate loans with maturities that generally do not exceed 15 years, unless the loans are SBA loans secured by real estate or other commercial real estate loans easily sold in the secondary market.

 

A portion of total real estate loans and commercial business loans are made under certain SBA loan programs.  These loans generally are structured such that they may be sold, either as a whole with servicing released, as is the case for SBA 504 loans, or in the case of SBA 7(a) loans, the guaranteed portion may be sold in the secondary market and the servicing is retained.  To date, SBA 7(a) loans have only been sold in a limited number of cases; however, certain SBA 504 loans have been packaged for sale when the rates and terms of the loans do not meet our asset and liability management objectives.

 

Commercial loans are made to provide working capital, finance the purchase of equipment and for other business purposes.  These loans can be “short-term,” with maturities ranging from 30 days to one year, or “term loans” with maturities normally ranging from one to 25 years.  Short-term loans are generally intended to finance current transactions and typically provide for periodic principal payments, with interest payable monthly.  Term loans normally provide for floating interest rates, with monthly payments of both principal and interest.

 

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Table of Contents

 

Maturities and Sensitivities of Loans to Changes in Interest Rates

 

Many of the Bank’s loans have floating interest rates, typically tied to the prime-lending rate as published in The Wall Street Journal.  The majority of these floating rate loans are adjusted at least quarterly.

 

Loan Maturity by Category

 

 

 

December 31, 2008

 

 

 

(dollars in thousands)

 

 

 

Due in
One Year
Or Less

 

Due After
One Year to
Five Years

 

Due After
Five Years

 

Total

 

Construction & Land Development

 

$

92,797

 

$

16,608

 

$

188

 

$

109,593

 

Real Estate - Residential & Commercial

 

39,755

 

32,531

 

75,679

 

147,965

 

SBA Loans - 7a & 504

 

958

 

1,225

 

6,637

 

8,820

 

Commercial Business

 

8,648