10-K 1 d284631d10k.htm FORM 10-K Form 10-K

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2011

COMMISSION FILE NUMBER 001-35026

 

 

 

LOGO

(Exact Name of Registrant as Specified in its Charter)

 

Delaware   95-3673456

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

1021 Anacapa St.

Santa Barbara, California

  93101
(Address of principal executive offices)   (Zip Code)

(805) 564-6405

(Registrant’s telephone number, including area code)

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

 

Title of Each Class

 

Name of Each Exchange on Which Registered

Common Stock, $0.001 par value per share   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  ¨    No  x

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of 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.  x

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

 

Large accelerated filer

 

¨

  

Accelerated filer

 

x

Non-accelerated filer

 

¨  (Do not check if a smaller reporting company)

  

Smaller reporting company

 

¨

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

The aggregate market value of the voting stock held by non-affiliates computed June 30, 2011, based on the sales prices on that date of $31.79 per share: Common Stock—$245,869,904. All directors and executive officers have been deemed, solely for the purpose of the foregoing calculation, to be “affiliates” of the registrant; however, this determination does not constitute an admission of affiliate status for any of these shareholders.

As of February 29, 2012, there were 32,940,687 shares of the issuer’s common stock outstanding.

 

 

DOCUMENTS INCORPORATED BY REFERENCE: Portions of registrant’s Proxy Statement for the Annual Meeting of Shareholders on May 10, 2012 are incorporated by reference into Part III.

 

 

 


TABLE OF CONTENTS

 

               Page  

PART I

       
 

Forward-Looking Statements

     3   
 

Item 1.

  

Business

     5   
 

Item 1A.

  

Risk Factors

     22   
 

Item 1B.

  

Unresolved Staff Comments

     31   
 

Item 2.

  

Properties

     31   
 

Item 3.

  

Legal Proceedings

     32   
 

Item 4.

  

Mine Safety Disclosures

     32   

PART II

       
 

Item 5.

  

Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

     33   
 

Item 6.

  

Selected Financial Data

     36   
 

Item 7.

  

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

     40   
 

Item 7A.

  

Quantitative and Qualitative Disclosures about Market Risk

     87   
 

Item 8.

  

Consolidated Financial Statements and Supplementary Data

     91   
 

Item 9.

  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

     203   
 

Item 9A.

  

Controls and Procedures

     203   
 

Item 9B.

  

Other Information

     203   
    

Glossary

     204   

PART III

       
 

Item 10.

  

Directors, Executive Officers and Corporate Governance

     207   
 

Item 11.

  

Executive Compensation

     207   
 

Item 12.

  

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

     207   
 

Item 13.

  

Certain Relationships and Related Transactions, and Director Independence

     207   
 

Item 14.

  

Principal Accountant Fees and Services

     207   

PART IV

       
 

Item 15.

  

Exhibits and Financial Statement Schedules

     208   

SIGNATURES

     209   

EXHIBIT INDEX

     210   

 

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PART I

Forward-Looking Statements

This Annual Report on Form 10-K contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Pacific Capital Bancorp (the “Company” or “PCBC”) intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in these provisions. All statements, other than statements of historical fact, are “forward-looking statements” for purposes of federal and state securities laws, including, but not limited to, statements about anticipated future operating and financial performance, financial position and liquidity, business prospects, strategic alternatives, business strategies, regulatory and competitive outlook, investment and expenditure plans, capital and financing needs and availability, acquisition and divestiture opportunities, plans and objectives of management for future operations, and other similar forecasts and statements of expectation and statements of assumptions underlying any of the foregoing. Words such as “will likely result,” “aims,” “anticipates,” “believes,” “could,” “estimates,” “expects,” “hopes,” “intends,” “may,” “plans,” “projects,” “seeks,” “should,” “will,” and variations of these words and similar expressions are intended to identify these forward-looking statements.

Forward-looking statements are based on the Company’s current expectations and assumptions regarding its business, the regulatory environment, the economy and other future conditions. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict. The Company’s actual results may differ materially from those contemplated by the forward-looking statements. The Company cautions the reader of these statements therefore against relying on any of these forward-looking statements. They are neither statements of historical fact nor guarantees or assurances of future performance. Important factors that could cause actual results to differ materially from those in the forward-looking statements include, but are not limited to, the following:

 

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Inability to continuously satisfy the requirements of the Operating Agreement dated September 2, 2010 by and between Santa Barbara Bank & Trust, N.A. (the “Bank,” or “SBB&T”) and the Office of the Comptroller of the Currency;

 

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Inability to continually satisfy the requirements of the Written Agreement dated May 11, 2010 by and between the Company and the Federal Reserve Bank of San Francisco, and any further regulatory actions;

 

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Inability to close the proposed merger with UnionBanCal Corporation when expected or at all because required regulatory or other approvals and other conditions to closing are not received or satisfied on a timely basis or at all;

 

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Reputational risks and the reaction of the Company’s customers and employees to the proposed merger;

 

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Diversion of the Company’s resources and Management’s time and focus on merger-related issues;

 

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Inability to generate assets on acceptable terms or at all;

 

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Management’s ability to effectively execute the Company’s business plan;

 

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Inability to raise additional capital, if and when necessary, on acceptable terms or at all;

 

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Inability to receive dividends from the Bank;

 

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Costs and effects of legal and regulatory developments, including the resolution of legal proceedings or regulatory or other governmental inquiries, and the results of regulatory examinations or reviews;

 

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Changes in capital classification;

 

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The impact of current economic conditions and the Company’s results of operations on its ability to borrow additional funds to meet its liquidity needs;

 

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Local, regional, national and international economic conditions and events and the impact they may have on the Company and its clients;

 

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Changes in the economy affecting real estate values;

 

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Inability to attract and retain deposits;

 

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Changes in the level of non-performing assets and charge-offs;

 

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Changes in estimates of future reserve requirements based upon the periodic review thereof under relevant regulatory and accounting requirements;

 

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Changes in the financial performance and/or condition of the Bank’s borrowers;

 

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Effect of additional provision for loan losses;

 

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Long-term negative trends in the Company’s market capitalization;

 

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Effects of any changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Board of Governors of the Federal Reserve System;

 

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Inflation, interest rate, cost of funds, securities market and monetary fluctuations;

 

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Political instability;

 

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Acts of war or terrorism, natural disasters such as earthquakes or fires, or the effects of pandemic flu;

 

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The timely development and acceptance of new products and services and perceived overall value of these products and services by users;

 

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Changes in consumer spending, borrowings and savings habits;

 

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Technological changes, including the implementation of new systems;

 

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Changes in the Company’s organization, management, compensation and benefit plans;

 

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Competitive pressures from other financial institutions;

 

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Continued consolidation in the financial services industry;

 

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Inability to maintain or increase market share and control expenses;

 

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Impact of reputational risk on such matters as business generation and retention, funding and liquidity;

 

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Rating agency downgrades;

 

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Continued volatility in the credit and equity markets and its effect on the general economy;

 

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Effect of changes in laws and regulations (including the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010) and other changes in laws concerning banking, taxes and securities with which the Company and its subsidiaries must comply;

 

  ¡  

Effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board and other accounting standard setters;

 

  ¡  

Other factors that are described under the heading “Risk Factors” in this Form 10-K; and

 

  ¡  

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

Forward-looking statements speak only as of the date they are made, and the Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made, whether as a result of new information, future developments or otherwise, except as may be required by law.

Definition of Terms

Specific accounting and banking industry terms and acronyms used throughout this document are defined in the glossary on pages 204 through 206.

 

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ITEM 1. BUSINESS

Organizational Structure and History

Pacific Capital Bancorp is a bank holding company registered under the Bank Holding Company Act of 1956, as amended (the “BHCA”). The Company provides a wide range of banking, investing and trust services to its clients primarily through its wholly-owned subsidiary, Santa Barbara Bank & Trust, N.A. and its subsidiaries. The Bank is a nationally chartered federal bank regulated primarily by the Office of the Comptroller of the Currency (“OCC”).

The Bank combines the breadth of financial products typically associated with a larger financial institution with the type of individual client service that is typically found in a community bank. The Bank provides full service banking, including all aspects of checking and savings accounts, private and commercial lending, investment advisory and trust services, and several other banking products and services. Products and services are offered through retail locations and other distribution channels to consumers and businesses operating throughout the Central Coast of California, in eight contiguous counties including Santa Barbara, Ventura, Los Angeles, Monterey, San Luis Obispo, Santa Clara, Santa Cruz and San Benito. The Company is headquartered in Santa Barbara, California.

At December 31, 2011, the Company had five wholly-owned subsidiaries. The Bank is consolidated in the financial statements of the Company. Four are unconsolidated subsidiaries used as business trusts in connection with issuance of trust-preferred securities as described in Note 15, “Other Borrowings” of the Consolidated Financial Statements on page 178 of this Form 10-K.

The Bank has three wholly-owned consolidated subsidiaries. Morton Capital Management (“MCM”) and R.E. Wacker Associates, Inc. (“REWA”) are registered investment advisors that provide investment advisory services to individuals, foundations, retirement plans and select institutional clients. The third subsidiary, PCB Service Corporation, is utilized as a trustee of deeds of trust in which the Bank is the beneficiary. The Bank also retains ownership in several low income housing tax credit partnerships (“LIHTCP”) that are not consolidated into the Company’s Consolidated Financial Statements. For additional information regarding the Bank investment in LIHTCP, refer to Note 1, “Summary of Significant Accounting Policies” of the Consolidated Financial Statements.

The Bank commenced operations in 1960 as Santa Barbara National Bank. In 1982, Santa Barbara Bancorp, a bank holding company, was formed and became the sole owner of the Bank through an exchange of the Bank stock for Santa Barbara Bancorp stock. In 1998, Santa Barbara Bancorp merged with another bank holding company, which used First National Bank of Central California and South Valley National Bank as brand names for its subsidiary bank. Santa Barbara Bancorp changed its name to Pacific Capital Bancorp in connection with the merger. In 2002, the two banks were consolidated into one national bank charter, Pacific Capital Bank, N.A. (“PCBNA”). On May 26, 2011, the Company announced the change in name of its national banking subsidiary from Pacific Capital Bank, National Association, to Santa Barbara Bank & Trust, National Association. This name change does not affect the name of the holding company, which remains Pacific Capital Bancorp. The name change was in conjunction with the Company’s strategy to consolidate its five bank brand names: First Bank of San Luis Obispo, First National Bank of Central California, South Valley National Bank, and San Benito Bank, into a single brand name of Santa Barbara Bank & Trust. All retail branches and other lines of the Bank’s business will operate under the Santa Barbara Bank & Trust name. At December 31, 2011, SBB&T conducted its banking services with 47 retail branches. At December 31, 2011, SBB&T conducted its banking services with 47 retail branches.

On August 31, 2010, the Company completed a series of transactions including a $500 million private placement to SB Acquisition Company LLC, a wholly-owned subsidiary of Ford Financial Fund, L.P. (“SB Acquisition”); the exchange of preferred stock held by the United States Department of the

 

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Treasury (“U.S. Treasury”) for common stock; and the completion of a cash tender offer for any and all outstanding trust preferred securities and subordinated bank notes (collectively, the “Recapitalization Transaction”). For additional information regarding the Recapitalization Transaction refer to the Management’s Discussion and Analysis (“MD&A”) section beginning on page 40.

On December 30, 2010, the Company changed its state of incorporation from California to Delaware. Other than the change in corporate domicile, the reincorporation did not result in any change in the business, physical location, management, assets, liabilities or total shareholders’ equity of the Company, nor did it result in any change in location of the Company’s employees, including the Company’s management. Additionally, the reincorporation did not alter any shareholders’ percentage ownership interest or number of shares owned in the Company. The shareholders’ equity section of the accompanying consolidated financial statements has been restated retroactively to give effect to the reincorporation. Such reclassification had no effect on the results of operations or the total amount of shareholders’ equity.

On December 28, 2010, the Company effected a 1-for-100 reverse stock split, as reflected at the open of trading on the following day. All prior per share and dividend amounts have been restated to reflect this split throughout this document.

Recent Developments

Agreement and Plan of Merger

On March 9, 2012, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with UnionBanCal Corporation, a Delaware corporation (“UBC”). The Merger Agreement provides that, upon the terms and subject to the conditions set forth in the Merger Agreement, Pebble Merger Sub Inc. (“Merger Sub”), a corporation formed in Delaware as a wholly-owned subsidiary of UBC, will merge with and into the Company, with the Company continuing as the surviving corporation and a wholly-owned subsidiary of UBC (the “Merger”). Pursuant to the Merger Agreement, upon consummation of the Merger, each outstanding share of common stock of the Company will be converted into the right to receive $46.00 per share in cash. Consummation of the Merger is subject to certain customary conditions, including, among others, the absence of any injunction or other legal prohibition on the completion of the Merger, regulatory approvals of the Board of Governors of the Federal Reserve System (the “Reserve Board”), the Japan Financial Services Agency and the OCC and expiration of applicable waiting periods. On March 9, 2012, following the execution of the Merger Agreement, SB Acquisition, the holder of 25,000,000 shares of the Company’s common stock, constituting approximately 76% of the outstanding shares of the Company’s common stock, delivered to the Company its action by written consent adopting and approving the Merger Agreement and the Merger. No further approval of the stockholders of the Company is required to approve the Merger Agreement and the Merger.

The Company and UBC have made customary representations, warranties and covenants in the Merger Agreement, including, among others, covenants (i) to use reasonable best efforts to obtain any necessary regulatory approvals; (ii) not to take any actions that would reasonably be expected to materially delay the obtainment of regulatory approvals; and (iii) for the Company to conduct its business in the ordinary course of business during the interim period between the execution of the Merger Agreement and consummation of the Merger. The Merger Agreement provides certain customary termination rights for both UBC and the Company. There is no assurance that the Company, UBC and Merger Sub will complete the Merger.

The foregoing description of the Merger Agreement does not purport to be complete and is qualified in its entirety by reference to the full text of the Merger Agreement, which is filed as Exhibit 2.2 hereto and is incorporated by reference herein.

 

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Termination of Consent Order

On December 30, 2011, the OCC notified the Bank that the Consent Order issued by the OCC on May 11, 2010 (as modified on September 2, 2010) was terminated effective as of December 28, 2011.

Early Redemption of Subordinated Debt

On December 19, 2011, the Company completed the early redemption of all of its outstanding subordinated debentures. The subordinated debentures, which had a $35.0 million principal amount and were scheduled to mature in December 2013, were redeemed at a price equal to 100% of the principal amount, plus accrued interest on the subordinated debentures through December 19, 2011. As a result of this redemption, the Company recognized a pre-tax charge of $4.7 million during the fourth quarter of 2011, related to the non-cash fair valuation of the subordinated debt in connection with the Company’s recapitalization in August 2010. This redemption will reduce interest expense by approximately $1.1 million (pre-tax) in 2012.

End of Deferral Period on Trust Preferred Securities

On December 15, 2011, the Company instructed the trustees for its outstanding trust preferred securities to end the deferral of its obligation to make regularly scheduled interest payments on the trust preferred securities. To end this deferral, the Company deposited an aggregate of $5.6 million with the trustees for the trust preferred securities for the upcoming interest payment dates. The deposits, which were paid by the trustees to the holders of the trust preferred securities, brought the Company’s obligations current under the applicable agreements. The cash payment of the accrued interest had no effect on the results of operations because the Company had accrued the expense of each deferred interest payment at the nominal rate on a compounded basis.

Employees

At December 31, 2011, the Company employed 1,029 full-time equivalent employees. The Company’s employees are not represented by a union or covered by a collective bargaining agreement. Management believes that its employee relations are good. The Company’s definition of Management is the executive team of the Company and its subsidiaries.

Competition

The banking and financial services business is highly competitive. The increasingly competitive environment faced by banks is a result primarily of changes in laws and regulations, changes in technology and product delivery systems, and the continued consolidation among financial services providers. The Company competes for loans, deposits, trust and investment advisory services and clients with other commercial banks, savings and loan associations, securities and brokerage companies, investment advisors, mortgage companies, insurance companies, finance companies, money market funds, credit unions, and other non-bank financial service providers. Many competitors are much larger in total assets and capitalization, have greater access to capital markets, including foreign markets, and/or offer a broader range of financial services.

 

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Economic Conditions and Legislative and Regulatory Developments

The Company’s profitability, like most financial institutions, is primarily dependent on interest rate differentials. These rates are highly sensitive to many factors that are beyond the Company’s control and cannot be predicted, such as inflation, recession and unemployment, and the impact that future changes in domestic and foreign economic conditions might have on the Company. A more detailed discussion of the Company’s interest rate risks and the mitigation of those risks begins on page 87.

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

From time to time, Federal and State legislation is enacted that may have the effect of materially increasing the cost of doing business, limiting or expanding permissible activities, or affecting the competitive balance between banks and other financial services providers. In response to the economic downturn and financial industry instability, legislative and regulatory initiatives were, and are expected to continue to be, introduced and implemented, which substantially increases the regulation of the financial services industry. Moreover, especially in the current economic environment, bank regulatory agencies have responded to concerns and trends identified in examinations, and this has resulted in the increased issuance and continuation of enforcement actions to financial institutions requiring action to address credit quality, liquidity and risk management and capital adequacy, as well as other safety and soundness concerns.

Regulation and Supervision

General

The Company and its subsidiaries are subject to significant regulation and restrictions by Federal and State laws and regulatory agencies. These regulations and restrictions are intended primarily for the protection of depositors and the Deposit Insurance Fund (“DIF”), and secondarily for the stability of the U.S. banking system. They are not intended for the benefit of shareholders of financial institutions. The following discussion of key statutes and regulations is a summary and does not purport to be complete nor does it address all applicable statutes and regulations. This discussion is qualified in its entirety by reference to the statutes and regulations referred to in this discussion.

Regulatory Developments

On September 2, 2010, the Bank entered into the Operating Agreement with the OCC, pursuant to which, among other things, the Bank agreed to maintain total capital at least equal to 12.0% of risk-weighted assets and Tier 1 capital at least equal to 8.0% of adjusted total assets and to not pay any dividend or reduce its capital without the prior non-objection of the OCC and unless at least three years shall have elapsed since the effective date of the Operating Agreement. The Bank believes it is in full compliance with the Operating Agreement.

On May 11, 2010, the Company entered into the Written Agreement with the Federal Reserve Bank of San Francisco (the “Reserve Bank”). The Written Agreement restricts the payment of dividends by the Company, as well as the taking of dividends or any other payment representing a reduction in capital

 

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from the Bank, without the prior approval of the Reserve Bank. The Written Agreement further requires that the Company not incur, increase, or guarantee any debt, repurchase or redeem any shares of its stock, or pay any interest or principal on subordinated debt or trust preferred securities, in each case without the prior approval of the Reserve Bank. The Written Agreement also requires the Company to develop a capital plan, which shall address, among other things, current and future capital requirements, including compliance with the minimum capital ratios, the adequacy of the capital, the source and timing of additional funds, and procedures to notify the Reserve Bank no more than thirty days after the end of any quarter in which the Company’s consolidated capital ratios or the Bank’s capital ratios fall below the required minimums. The Company will also be required to provide notice to the Reserve Bank regarding the appointment of any new director or senior executive officer. Finally, the board of directors of the Company is required to submit written progress reports to the Reserve Bank within thirty days after the end of each calendar quarter. The Company believes it is in full compliance with the Written Agreement.

Until December 28, 2011, the Bank was also subject to a Consent Order issued by the OCC on May 11, 2010 (as modified, the “Consent Order”), which had required the Bank to, among other things, take actions and implement improvement programs with respect to its strategic plan, management, credit policy, consumer mortgage and commercial credit risks, impaired and criticized loans, allowance for loan and lease losses (“ALLL”), funding and liquidity. On December 30, 2011, the Bank was notified by the OCC that the Consent Order was terminated effective as of December 28, 2011.

Bank Holding Company Regulation

As a bank holding company, the Company is subject to regulation and examination by the Reserve Board under the BHCA. Accordingly, the Company is subject to the Reserve Board’s regulations and its authority to:

 

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Require periodic reports and such additional information as the Reserve Board may require;

 

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Require bank holding companies to maintain increased levels of capital;

 

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Require that bank holding companies serve as a source of financial and managerial strength to subsidiary banks and commit resources as necessary to support each subsidiary bank;

 

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Restrict the ability of bank holding companies to declare dividends or obtain dividends or other distributions from their subsidiary banks;

 

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Terminate an activity or terminate control of or liquidate or divest certain subsidiaries, affiliates or investments if the Reserve Board believes the activity or the control of the subsidiary or affiliate constitutes a significant risk to the financial safety, soundness or stability of any bank subsidiary;

 

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Take formal or informal enforcement action or issue other supervisory directives and assess civil money penalties for non-compliance under certain circumstances;

 

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Require the prior approval of senior executive officer or director changes and prohibit golden parachute payments, including change in control agreements, or new employment agreements with such payment terms, which are contingent upon termination;

 

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Regulate provisions of certain bank holding company debt, including the authority to impose interest ceilings and reserve requirements on such debt and require prior approval to purchase or redeem securities in certain situations; and

 

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Approve acquisitions and mergers with banks and consider certain competitive, management, financial or other factors in granting these approvals in addition to similar California or other state banking agency approvals which may also be required.

Subject to prior notice or Reserve Board approval, bank holding companies may generally engage in, or acquire shares of companies engaged in activities determined by the Reserve Board to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. Bank holding

 

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companies which elect and retain “financial holding company” status pursuant to the Gramm-Leach-Bliley Act of 1999 (“GLBA”) may engage in these nonbanking activities and broader securities, insurance, merchant banking and other activities that are determined to be “financial in nature” or are incidental or complementary to activities that are financial in nature without prior Reserve Board approval. Pursuant to GLBA and Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”) in order to elect and retain financial holding company status, a bank holding company and all depository institution subsidiaries of a bank holding company must be well-capitalized and well managed, and, except in limited circumstances, depository subsidiaries must be in satisfactory compliance with the Community Reinvestment Act (“CRA”), which requires banks to help meet the credit needs of the communities in which they operate. Failure to sustain compliance with these requirements or correct any non-compliance within a fixed time period could lead to divestiture of subsidiary banks or require all activities to conform to those permissible for a bank holding company. The Company has not elected financial holding company status and neither the Company nor the Bank has engaged in any activities determined by the Reserve Board to be financial in nature or incidental or complementary to activities that are financial in nature.

It is the Reserve Board’s view 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 financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company’s failure to meet its source-of-strength obligations may constitute an unsafe and unsound practice or a violation of the Reserve Bank regulations, or both. The source of strength doctrine, now required by statute pursuant to Dodd-Frank, most directly affects bank holding companies where a bank holding company’s subsidiary bank fails to maintain adequate capital levels. In such a situation, the subsidiary bank will be required by the bank’s federal regulator to take “prompt corrective action.” See “Prompt Corrective Action Provisions” below.

Bank Regulation

The Bank, as a nationally chartered bank, is subject to primary supervision, periodic examination, and regulation by the OCC. To a lesser extent, the Bank is also subject to certain regulations promulgated by the Reserve Board and the Federal Deposit Insurance Corporation (the “FDIC”), as administrator of the DIF. The federal bank regulatory agencies have extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. The regulatory agencies have adopted guidelines to assist in identifying and addressing potential safety and soundness concerns before an institution’s capital becomes impaired. The guidelines establish operational and managerial standards generally relating to: (1) internal controls, information systems, and internal audit systems; (2) loan documentation; (3) credit underwriting; (4) interest rate exposure; (5) asset growth and asset quality; and (6) compensation, fees, and benefits. Further, the regulatory agencies have adopted safety and soundness guidelines for asset quality and for evaluating and monitoring earnings to ensure that earnings are sufficient for the maintenance of adequate capital and reserves. If, as a result of an examination, the OCC should determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, or other aspects of the Bank’s operations are unsatisfactory or that the Bank or its management is violating or has violated any law or regulation, the OCC, and separately the FDIC as insurer of the Bank’s deposits, have authority to:

 

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Require affirmative action to correct any conditions resulting from any violation or practice;

 

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Direct an increase in capital and the maintenance of higher specific minimum capital ratios, which may preclude the Bank from being deemed well-capitalized and restrict its ability to accept certain brokered deposits;

 

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Restrict the Bank’s payment of dividends;

 

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Restrict the Bank’s growth geographically, by products and services, or by mergers and acquisitions;

 

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Enter into informal or formal enforcement orders, including memoranda of understanding, written agreements and consent or cease and desist orders or prompt corrective action orders to take corrective action and cease unsafe and unsound practices;

 

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Require the prior approval of senior executive officer or director changes and prohibit golden parachute payments, including change in control agreements, or new employment agreements with such payment terms, which are contingent upon termination;

 

  ¡  

Remove officers and directors and assess civil monetary penalties; and

 

  ¡  

Take possession of and close and liquidate the Bank.

The Dodd-Frank Wall Street Reform and Consumer Protection Act

Dodd-Frank significantly revised and expanded the rulemaking, supervisory and enforcement authority of the federal bank regulatory agencies. Dodd-Frank impacts many aspects of the financial industry and, in many cases, will impact larger and smaller financial institutions and community banks differently over time. Many of the following key provisions of Dodd-Frank affecting the financial industry are now either effective or are in the proposed rule or implementation stage:

 

  ¡  

The creation of a Financial Services Oversight Counsel to identify emerging systemic risks and improve interagency cooperation;

 

  ¡  

Expanded FDIC authority to conduct the orderly liquidation of certain systemically significant non-bank financial companies in addition to depository institutions;

 

  ¡  

The establishment of strengthened capital and liquidity requirements for banks and bank holding companies, including minimum leverage and risk-based capital requirements no less than the strictest requirements in effect for depository institutions as of the date of enactment;

 

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The requirement by statute that bank holding companies serve as a source of financial strength for their depository institution subsidiaries;

 

  ¡  

Enhanced regulation of financial markets, including the derivative and securitization markets, and the elimination of certain proprietary trading activities by banks (the “Volcker Rule”);

 

  ¡  

The termination of investments by the U.S. Treasury under the Troubled Asset Relief Program (“TARP”);

 

  ¡  

The elimination and phase out of trust preferred securities from Tier 1 capital with certain exceptions;

 

  ¡  

A permanent increase of the previously implemented temporary increase of FDIC deposit insurance to $250,000 and an extension of federal deposit coverage until January 1, 2013, for the full net amount held by depositors in non-interesting bearing transaction accounts;

 

  ¡  

Authorization for financial institutions to pay interest on business checking accounts;

 

  ¡  

Changes in the calculation of FDIC deposit insurance assessments, such that the assessment base will no longer be the institution’s deposit base, but instead, will be its average consolidated total assets less its average tangible equity;

 

  ¡  

The elimination of remaining barriers to de novo interstate branching by banks;

 

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  ¡  

Expanded restrictions on transactions with affiliates and insiders under Section 23A and 23B of the Federal Reserve Act and lending limits for derivative transactions, repurchase agreements, and securities lending and borrowing transactions;

 

  ¡  

The elimination of the Office of Thrift Supervision and the transfer of oversight of thrift institutions and their holding companies to the OCC or the FDIC and Reserve Board;

 

  ¡  

Provisions that affect corporate governance and executive compensation at most United States publicly traded companies, including (i) stockholder advisory votes on executive compensation, (ii) executive compensation “clawback” requirements for companies listed on national securities exchanges in the event of materially inaccurate statements of earnings, revenues, gains or other criteria, (iii) enhanced independence requirements for compensation committee members, and (iv) giving the Securities and Exchange Commission (“SEC”) authority to adopt proxy access rules which would permit stockholders of publicly traded companies to nominate candidates for election as director and have those nominees included in a company’s proxy statement; and

 

  ¡  

The creation of a Bureau of Consumer Financial Protection, which is authorized to promulgate and enforce consumer protection regulations relating to bank and non-bank financial products and which may examine and enforce its regulations on banks with more than $10 billion in assets.

The numerous rules and regulations that have been promulgated and are yet to be promulgated and finalized under Dodd-Frank are likely to significantly impact the Company’s operations and compliance costs, such as changes in FDIC assessments, the permitted payment of interest on demand deposits and projected enhanced consumer compliance requirements. More stringent capital, liquidity and leverage requirements are expected to impact the Company’s business as Dodd-Frank is fully implemented. The federal agencies have issued many proposed rules pursuant to provisions of Dodd Frank which will apply directly to larger institutions with either more than $50 billion in assets or more than $10 billion in assets, such as proposed regulations for financial institutions deemed systemically significant, proposed rules requiring capital plans and stress tests and the Reserve Board’s proposed rules to implement the Volcker Rule, as well as a final rule for the largest (over $250 billion in assets) and internationally active banks setting a new minimum risk-based capital floor. These and other requirements and policies imposed on larger institutions, such as expected countercyclical requirements for increased capital in times of economic expansion and a decrease in times of contraction, may subsequently become expected “best practices” for smaller institutions. Therefore, as a result of the changes required by Dodd-Frank, the profitability of the Company’s business activities may be impacted and the Company may be required to make changes to certain of its business practices. Such developments and new standards would require the Company to devote even more management attention and resources to evaluate and make any changes necessary to comply with new statutory and regulatory requirements.

Dividends and Other Transfer of Funds

Dividends from the Bank constitute the principal source of income to the Company. The Bank is subject to various statutory and regulatory restrictions on its ability to pay dividends. The Bank is subject first to corporate restrictions on its ability to pay dividends. Prior OCC approval is also required for the Bank to declare a dividend if the total of all dividends (common and preferred), including the proposed dividend, declared by the Bank in any calendar year will exceed its net retained income of that year to date plus the retained net income of the preceding two calendar years. In addition, the banking agencies have the authority under their safety and soundness guidelines and prompt correct action regulations to require their prior approval or to prohibit the Bank from paying dividends, depending upon the Bank’s financial condition, if such payment is deemed to constitute an unsafe or unsound practice. Further, the Bank may not pay a dividend if it would be undercapitalized

 

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after the dividend payment is made. As discussed above in “Regulatory Developments,” as a result of the Written Agreement and Operating Agreement, both OCC and Reserve Board approval is required before the Bank may declare or pay any dividends to the Company.

It is Reserve Board policy that bank holding companies should generally pay dividends on common stock only out of income available over the past year, and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. It is also Reserve Board policy that bank holding companies should not maintain dividend levels that undermine the company’s ability to be a source of strength to its banking subsidiaries. In consideration of the recent financial and economic environment, the Reserve Board has indicated that bank holding companies should carefully review their dividend policy and has discouraged payment ratios that are at maximum allowable levels unless both asset quality and capital are strong. As discussed above in “Regulatory Developments,” as a result of the Written Agreement, Reserve Board approval is required before the Company may declare or pay any dividends to its shareholders.

Capital Requirements

Bank holding companies and banks are subject to various regulatory capital requirements administered by State and Federal banking agencies. Increased capital requirements are expected as a result of expanded authority set forth in Dodd-Frank and the Basel III international supervisory developments discussed below. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weighting, and other factors.

The current risk-based capital guidelines for bank holding companies and banks adopted by the federal banking agencies are expected to provide a measure of capital that reflects the degree of risk associated with a banking organization’s operations for both transactions reported on the balance sheet as assets, such as loans, and those recorded as off-balance sheet items, such as commitments, letters of credit and recourse arrangements. The risk-based capital ratio is determined by classifying assets and certain off-balance sheet financial instruments into weighted categories, with higher levels of capital being required for those categories perceived as representing greater risks and dividing its qualifying capital by its total risk-adjusted assets and off-balance sheet items. Bank holding companies and banks engaged in significant trading activity may also be subject to the market risk capital guidelines and be required to incorporate additional market and interest rate risk components into their risk-based capital standards.

Qualifying capital is classified depending on the type of capital:

 

  ¡  

“Tier 1 capital” currently includes common equity and trust preferred securities, subject to certain criteria and quantitative limits. The capital received from trust preferred offerings also qualifies as Tier 1 capital, subject to the new provisions of Dodd-Frank. Under Dodd-Frank, depository institution holding companies with more than $15 billion in total consolidated assets as of December 31, 2009, will no longer be able to include trust preferred securities as Tier 1 regulatory capital after the end of a three-year phase-out period beginning 2013, and would need to replace any outstanding trust preferred securities issued prior to May 19, 2010, with qualifying Tier 1 regulatory capital during the phase-out period. For institutions with less than $15 billion in total consolidated assets, existing trust preferred capital will still qualify as Tier 1. Small bank holding companies with less than $500 million in assets could issue new trust preferred which could still qualify as Tier 1, however the market for any new trust preferred capital raises is uncertain.

 

13


  ¡  

“Tier 2 capital” includes hybrid capital instruments, other qualifying debt instruments, a limited amount of the ALLL, and a limited amount of unrealized holding gains on equity securities. Following the phase-out period under Dodd-Frank, trust preferred securities will be treated as Tier 2 capital.

 

  ¡  

“Tier 3 capital” consists of qualifying unsecured debt. The sum of Tier 2 and Tier 3 capital may not exceed the amount of Tier I capital.

Under the current capital guidelines, there are three fundamental capital ratios: a Tier 1 leverage ratio, a Tier 1 risk-based capital ratio, and a total risk-based capital ratio. To be deemed “well-capitalized,” a bank must have a Tier 1 leverage ratio, a Tier 1 risk-based capital ratio, and a total risk-based capital ratio of at least 5.0%, 6.0%, and 10.0%, respectively. At December 31, 2011, the respective capital ratios of the Company and the Bank exceeded the minimum percentage requirements to be deemed “well-capitalized.”

In addition to the requirements of Dodd-Frank and Basel III, the federal banking agencies may change existing capital guidelines or adopt new capital guidelines in the future and have required many banks and bank holding companies subject to enforcement actions to maintain capital ratios in excess of the minimum ratios otherwise required to be deemed well-capitalized, in which case institutions may no longer be deemed well-capitalized and may therefore be subject to restrictions on taking brokered deposits.

The Company and the Bank are also required to maintain a leverage capital ratio designed to supplement the risk-based capital guidelines. Banks and bank holding companies that have received the highest rating of the five categories used by regulators to rate banks and that are not anticipating or experiencing any significant growth must maintain a ratio of Tier 1 capital (net of all intangibles) to adjusted total assets of at least 3.0%. All other institutions are required to maintain a leverage ratio of at least 100 to 200 basis points above the 3.0% minimum, for a minimum of 4.0% to 5.0%. Pursuant to federal regulations, banks must maintain capital levels commensurate with the level of risk to which they are exposed, including the volume and severity of problem loans. Federal regulators may, however, set higher capital requirements when a bank’s particular circumstances warrant.

As discussed in “Regulatory Developments,” the Bank is required to maintain a minimum Tier 1 leverage ratio of 8.0% and a minimum total risk-based capital ratio of 12.0% pursuant to the Operating Agreement. However, the Bank is allowed to accept brokered deposits and is qualified to be deemed “well-capitalized.” As of December 31, 2011, the Company’s leverage capital ratio was 12.4%, the Company’s total risk-based capital ratio was 20.2%, and the Company’s Tier 1 risk-based ratio was 19.6%, all ratios exceeding regulatory minimums to be considered well-capitalized. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Capital Resources.”

Basel Accords

The current risk-based capital guidelines which apply to the Company and the Bank are based upon the 1988 capital accord (referred to as “Basel I”) of the International Basel Committee on Banking Supervision (the “Basel Committee”), a committee of central banks and bank supervisors and regulators from the major industrialized countries. The Basel Committee develops broad policy guidelines for use by each country’s supervisors in determining the supervisory policies they apply. A new framework and accord, referred to as Basel II, evolved from 2004 to 2006 out of the efforts to revise capital adequacy standards for internationally active banks. Basel II emphasizes internal assessment of credit, market and operational risk; supervisory assessment and market discipline in determining minimum capital requirements and became mandatory for large or “core” international banks outside the United States in 2008 (total assets of $250 billion or more or consolidated foreign exposures of $10 billion or more). Basel II was optional for others, and if adopted, must first be

 

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complied within a “parallel run” for two years along with the existing Basel I standards. The Company is not required to comply with Basel II and has not elected to apply the Basel II standards.

The United States federal banking agencies issued a proposed rule for banking organizations that do not use the “advanced approaches” under Basel II. While this proposed rule generally parallels the relevant approaches under Basel II, it diverges where United States markets have unique characteristics and risk profiles. A definitive final rule has not yet been issued. The United States banking agencies indicated, however, that they would retain the minimum leverage requirement for all United States banks.

In 2010 and 2011, the Basel Committee finalized proposed reforms on capital and liquidity, generally referred to as Basel III, to reconsider regulatory capital standards, supervisory and risk-management requirements and additional disclosures to further strengthen the Basel II framework in response to the worldwide economic downturn. Although Basel III is intended to be implemented by participating countries for large, internationally active banks, its provisions are likely to be considered by United States banking regulators in developing new regulations applicable to other banks in the United States. Basel III provides for increases in the minimum Tier 1 common equity ratio and the minimum requirement for the Tier 1 capital ratio. Basel III additionally includes a “capital conservation buffer” on top of the minimum requirement designed to absorb losses in periods of financial and economic distress; and an additional required countercyclical buffer percentage to be implemented according to a particular nation’s circumstances. These capital requirements are further supplemented under Basel III by a non-risk-based leverage ratio. Basel III also reaffirms the Basel Committee’s intention to introduce higher capital requirements on securitization and trading activities.

The Basel III liquidity proposals have three main elements: (i) a “liquidity coverage ratio” designed to meet the bank’s liquidity needs over a 30-day time horizon under an acute liquidity stress scenario, (ii) a “net stable funding ratio” designed to promote more medium and long term funding over a one year time horizon, and (iii) a set of monitoring tools that the Basel Committee indicates should be considered as the minimum types of information that banks should report to supervisors.

Implementation of Basel III in the United States will require regulations and guidelines by United States banking regulators, which may differ in significant ways from the recommendations published by the Basel Committee. It is unclear how United States banking regulators will define “well-capitalized” in their implementation of Basel III and to what extent and when smaller banking organizations in the United States will be subject to these regulations and guidelines. Basel III standards, if adopted, would lead to significantly higher capital requirements, higher capital charges and more restrictive leverage and liquidity ratios. The Basel III standards, if adopted, could lead to significantly higher capital requirements, higher capital charges and more restrictive leverage and liquidity ratios. The standards would, among other things:

 

  ¡  

Impose more restrictive eligibility requirements for Tier 1 and Tier 2 capital;

 

  ¡  

Increase the minimum Tier 1 common equity ratio to 4.5%, net of regulatory deductions, and introduce a capital conservation buffer of an additional 2.5% of common equity to risk-weighted assets, raising the target minimum common equity ratio to 7.0%;

 

  ¡  

Increase the minimum Tier 1 capital ratio to 8.5% inclusive of the capital conservation buffer;

 

  ¡  

Increase the minimum total capital ratio to 10.5% inclusive of the capital conservation buffer; and

 

  ¡  

Introduce a countercyclical capital buffer of up to 2.5% of common equity or other fully loss absorbing capital for periods of excess credit growth.

Basel III also introduces a non-risk adjusted Tier 1 leverage ratio of 3.0%, based on a measure of total exposure rather than total assets, and new liquidity standards. The new Basel III capital standards will be phased in from January 1, 2013 until January 1, 2019.

 

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United States banking regulators must also implement Basel III in conjunction with the provisions of Dodd-Frank related to increased capital and liquidity requirements. The regulations ultimately applicable to the Company may be substantially different from the Basel III final framework. Requirements to maintain higher levels of capital or to maintain higher levels of liquid assets could adversely impact the Company’s net income and return on equity.

Prompt Corrective Action Provisions

The Federal Deposit Insurance Act (“FDIA”) provides a framework for regulation of depository institutions and their affiliates, including parent holding companies, by their federal banking regulators. Among other things, it requires the relevant federal banking regulator to take “prompt corrective action” with respect to a depository institution if that institution does not meet certain capital adequacy standards, including requiring the prompt submission of an acceptable capital restoration plan. Supervisory actions by the appropriate federal banking regulator under the prompt corrective action rules generally depend upon an institution’s classification within five capital categories as defined in the regulations. The relevant capital measures are the capital ratio, the Tier 1 capital ratio, and the leverage ratio.

A depository institution’s capital tier under the prompt corrective action regulations will depend upon how its capital levels compare with various relevant capital measures and the other factors established by the regulations. A bank’s prompt corrective action capital category is determined solely for the purpose of applying the prompt corrective action regulations and the capital category may not constitute an accurate representation of the banks’ overall financial condition or prospects for other purposes. A bank will be: (i) “well-capitalized” if the institution has a leverage ratio of 5.0% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and a total risk-based capital ratio of 10.0% or greater, and is not subject to any order or written directive by any such regulatory authority to meet and maintain a specific capital level for any capital measure; (ii) “adequately capitalized” if the institution has a leverage ratio of 4.0% or greater, a Tier 1 risk-based capital ratio of 4.0% or greater, and a total risk-based capital ratio of 8.0% or greater, and is not “well-capitalized”; (iii) “undercapitalized” if the institution has a leverage ratio of less than 4.0%, a Tier 1 risk-based capital ratio of less than 4.0%, or a total risk-based capital ratio that is less than 8.0%; (iv) “significantly undercapitalized” if the institution has a leverage ratio of less than 3.0%, a Tier 1 risk-based capital ratio of less than 3.0%, or a total risk-based capital ratio of less than 6.0%; and (v) “critically undercapitalized” if the institution’s tangible equity is equal to or less than 2.0% of average quarterly tangible assets. An institution may be downgraded to, or deemed to be in, a capital category that is lower than indicated by its capital ratios if it is determined to be in an unsafe or unsound condition or if it receives an unsatisfactory examination rating with respect to certain matters.

The FDIA generally prohibits a depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be “undercapitalized.” “Undercapitalized” institutions are subject to growth limitations and are required to submit a capital restoration plan. The regulatory agencies may not accept such a plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. In addition, for a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee that the institution will comply with such capital restoration plan. The bank holding company must also provide appropriate assurances of performance. The aggregate liability of the parent holding company is limited to the lesser of (i) an amount equal to 5.0% of the depository institution’s total assets at the time it became undercapitalized and (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it is “significantly undercapitalized.”

 

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“Significantly undercapitalized” depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become “adequately capitalized,” requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. “Critically undercapitalized” institutions are subject to the appointment of a receiver or conservator.

The appropriate federal banking agency may, under certain circumstances, reclassify a well-capitalized insured depository institution as adequately capitalized. The FDIA provides that an institution may be reclassified if the appropriate federal banking agency determines (after notice and opportunity for a hearing) that the institution is in an unsafe or unsound condition or deems the institution to be engaging in an unsafe or unsound practice. The appropriate agency is also permitted to require an adequately capitalized or undercapitalized institution to comply with the supervisory provisions as if the institution were in the next lower category (but may not treat a significantly undercapitalized institution as critically undercapitalized) based on supervisory information other than the capital levels of the institution.

Deposit Insurance

The FDIC is an independent federal agency that insures deposits, up to prescribed statutory limits, of federally insured banks and savings institutions and safeguards the safety and soundness of the banking and savings industries. The FDIC insures client deposits through the DIF up to prescribed limits for each depositor. Pursuant to Dodd-Frank, the maximum deposit insurance amount has been permanently increased to $250,000 and all noninterest-bearing transaction accounts are insured through December 31, 2012. The amount of FDIC assessments paid by each DIF member institution is based on its relative risk of default as measured by regulatory capital ratios and other supervisory factors. Due to the greatly increased number of bank failures and losses incurred by DIF, as well as the recent extraordinary programs in which the FDIC has been involved to support the banking industry generally, the DIF was substantially depleted and the FDIC has incurred substantially increased operating costs. In November 2009, the FDIC adopted a requirement for institutions to prepay in 2009 their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011, and 2012.

As required by Dodd-Frank, the FDIC adopted a new DIF restoration plan which became effective on January 1, 2011. Among other things, the plan: (1) raises the minimum designated reserve ratio, which the FDIC is required to set each year, to 1.35% (from the former minimum of 1.15%) and removes the upper limit on the designated reserve ratio (which was formerly capped at 1.5%) and consequently on the size of the fund; (2) requires that the fund reserve ratio reach 1.35% by 2020; (3) eliminates the requirement that the FDIC provide dividends from the fund when the reserve ratio is between 1.35% and 1.5% (4) continues the FDIC’s authority to declare dividends when the reserve ratio at the end of a calendar year is at least 1.5%, but grants the FDIC sole discretion in determining whether to suspend or limit the declaration or payment of dividends. The FDIA continues to require that the FDIC’s Board of Directors consider the appropriate level for the designated reserve ratio annually and, if changing the designated reserve ratio, engage in notice-and-comment rulemaking before the beginning of the calendar year. The FDIC has set a long term goal of getting its reserve ratio up to 2% of insured deposits by 2027.

On February 7, 2011, the FDIC approved a final rule, which was effective for the quarter beginning April 1, 2011, as mandated by Dodd-Frank, changing the deposit insurance assessment system from one that is based on total domestic deposits to one that is based on average consolidated total assets minus average tangible equity. In addition, the final rule creates a scorecard-based assessment system for larger banks (those with more than $10 billion in assets) and suspends dividend payments if the DIF reserve ratio exceeds 1.5%, but provides for decreasing assessment rates when the DIF reserve ratio reaches certain thresholds. Larger insured depository institutions will likely pay higher

 

17


assessments to the DIF than under the old system. Additionally, the final rule includes a new adjustment for depository institution debt whereby an institution would pay an additional premium equal to 50 basis points on every dollar of long term, unsecured debt held as an asset that was issued by another insured depository institution (excluding debt guaranteed under the Temporary Liquidity Guarantee Program (“TLGP”)) to the extent that all such debt exceeds 3% of the other insured depository institution’s Tier 1 capital.

The Bank’s FDIC insurance expense totaled $9.7 million for 2011. FDIC insurance expense includes deposit insurance assessments and Financing Corporation (“FICO”) assessments related to outstanding FICO bonds to fund interest payments on bonds to recapitalize the predecessor to the DIF. These assessments will continue until the FICO bonds mature in 2017. Total FICO assessments for the Company totaled $427,000 for 2011.

The Bank is generally unable to control the amount of premiums that it is required to pay for FDIC insurance. If there are additional bank or financial institution failures or if the FDIC otherwise determines, the Bank may be required to pay even higher FDIC premiums than the recently increased levels. These announced increases and any future increases in FDIC insurance premiums may have a material and adverse affect on the Company’s earnings and could have a material adverse effect on the value of, or market for, the Company’s common stock.

The FDIC may terminate a depository institution’s deposit insurance upon a finding that the institution’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices that pose a risk to the DIF or that may prejudice the interest of the bank’s depositors. The termination of deposit insurance for the Bank would also result in the revocation of the Bank’s charter by the OCC.

Operations and Consumer Compliance Laws

The Bank must comply with numerous federal anti-money laundering, data security, privacy and consumer protection statutes and implementing regulations, including the USA PATRIOT Act of 2001, the Foreign Account Tax Compliance Act (effective 2013), the Bank Secrecy Act, the CRA, the Fair Credit Reporting Act, as amended by the Fair and Accurate Credit Transactions Act, the Equal Credit Opportunity Act, the Truth in Lending Act, the Fair Housing Act, the Home Mortgage Disclosure Act, the Real Estate Settlement Procedures Act, the National Flood Insurance Act and various Federal and State privacy protection laws. Noncompliance with these laws could subject the Bank to lawsuits and could also result in administrative penalties, including, fines and reimbursements. The Bank and the Company are also subject to Federal and State laws prohibiting unfair or fraudulent business practices, untrue or misleading advertising and unfair competition.

These laws and regulations mandate certain disclosure and reporting requirements and regulate the manner in which financial institutions must deal with clients when taking deposits, making loans, collecting loans, and providing other services. Failure to comply with these laws and regulations can subject the Bank to various penalties, including but not limited to enforcement actions, injunctions, fines or criminal penalties, punitive damages to consumers, and the loss of certain contractual rights.

Dodd-Frank provides for the creation of the Bureau of Consumer Financial Protection as an independent entity within the Reserve Board. This bureau is a new regulatory agency for United States banks. It has broad rulemaking, supervisory and enforcement authority over consumer financial products and services, including deposit products, residential mortgages, home-equity loans and credit cards, and contains provisions on mortgage-related matters such as steering incentives, determinations as to a borrower’s ability to repay and prepayment penalties. The bureau’s functions include investigating consumer complaints, conducting market research, rulemaking, supervising and

 

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examining bank’s consumer transactions, and enforcing rules related to consumer financial products and services. Banks with less than $10 billion in assets, such as the Bank, will continue to be examined for compliance by their primary Federal banking agency.

Regulation of Non-bank Subsidiaries

MCM and REWA, operating subsidiaries of the Bank, are registered investment advisors subject to regulation and supervision by the SEC. Further, the banking agencies expect banking organizations in their oversight role over functionally regulated subsidiaries, such as registered investment advisors, to assure appropriate controls are maintained that include:

 

  ¡  

Establishing alternative sources of emergency support from the parent holding company, non-bank affiliates or external third parties prior to seeking support from the Bank;

 

  ¡  

Instituting effective policies and procedures for identifying potential circumstances triggering the need for financial support and the process for obtaining such support;

 

  ¡  

Implementing effective controls, including stress testing and compliance reviews;

 

  ¡  

Implementing policies and procedures to ensure compliance with disclosure and advertising requirements to clearly differentiate the investments in advised funds from obligations of the Bank or insured deposits; and

 

  ¡  

Ensuring proper management, regulatory and financial reporting of contingent liabilities arising out of its investment advisory activities.

Securities Laws

The Company’s common stock is publicly held and listed on NASDAQ Stock Market, and the Company is subject to the periodic reporting, information, proxy solicitation, insider trading, corporate governance and other requirements and restrictions of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and the regulations of the SEC promulgated thereunder as well as listing requirements of NASDAQ. Dodd-Frank includes the following provisions that affect corporate governance and executive compensation at most U.S. publicly traded companies, including the Company: (1) stockholder advisory votes on executive compensation, (2) executive compensation “clawback” requirements for companies listed on national securities exchanges in the event of materially inaccurate statements of earnings, revenues, gains or other criteria, (3) enhanced independence requirements for compensation committee members, and (4) Securities and Exchange Commission (the “SEC”) authority to adopt proxy access rules which would permit shareholders of publicly traded companies to nominate candidates for election as director and have those nominees included in a company’s proxy statement.

The Company is also subject to the accounting oversight and corporate governance requirements of Sarbanes-Oxley Act (“SOX”), including, among other things, required executive certification of financial presentations, requirements for board audit committees and their members, and disclosure of controls and procedures and internal control over financial reporting.

Available Information

The Company maintains an internet website at http://www.pcbancorp.com. The Company makes available its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act and other information related to the Company free of charge, through the Company’s Investor Relations page of this site as soon as reasonably practicable after it electronically files those documents with, or otherwise furnishes them to, the SEC. The Company’s internet website and the information contained therein or connected thereto are not intended to be incorporated into this annual report on Form 10-K.

 

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Segments

The Company had two reportable operating segments at December 31, 2011. These segments are determined based on product line and the types of clients served. The Commercial & Community Banking segment provides loans and deposit products to individuals, commercial enterprises, non-profit organizations, public agencies, and trusts. The Wealth Management segment provides trust and investment advisory services to the same client base. The All Other segment is not considered an operating segment, but includes all corporate administrative support departments such as human resources, legal, finance and accounting, treasury, information technology, internal audit, risk management, facilities management, marketing, and the Bank’s holding company.

As disclosed in Note 23, “Discontinued Operations—RAL and RT Programs” of the Consolidated Financial Statements, the RAL and RT Programs, which had been reported as a separate operating segment in prior years, was sold in January 2010, and is reported now as discontinued operations.

The financial results for each segment are based on products and services provided within each operating segment with various Management assumptions to calculate the indirect credits and charges for funds which also includes an allocation of certain expenses from the All Other segment. The financial results by segment and Management assumptions are explained in Note 24, “Segments” of the Consolidated Financial Statements beginning on page 192.

Commercial & Community Banking

The Commercial & Community Banking segment is the aggregation of client sales and service activities typically found in a bank. This segment includes all lending and deposit products of the Bank. Loan products offered by the Commercial & Community Banking segment include traditional commercial and industrial (“commercial”) and commercial real estate loans, lines of credit, letters of credit, asset based lending, construction loans, land acquisition and development loans to small business and middle market commercial clients. Loan products offered to individual clients include residential real estate loans, home equity lines and loans, and consumer loans.

Residential real estate loans consist of first and second mortgage loans secured by trust deeds on 1 to 4 unit single family homes. The Company has specific underwriting and pricing guidelines based on the credit worthiness of the borrower and the value of the collateral, including credit score, debt-to-income ratio of the borrower and loan-to-value ratio. The Company also sells some loans on the secondary market that may not meet the Company’s underwriting guidelines but do meet the underwriting requirements of Freddie Mac and Fannie Mae. Home equity lines of credit are generally secured by a second trust deed on a single 1 to 4 unit family home. The interest rate on home equity lines is a variable index rate while term residential mortgage loans can have either variable or fixed interest rates.

Consumer loans and lines of credit are extended with or without collateral to provide financing for purposes such as the purchase of recreational vehicles, automobiles, or to provide liquidity. The Company has specific underwriting guidelines which consider the borrower’s credit history, debt-to-income ratio and loan-to-value ratio for secured loans. The consumer loans typically have fixed interest rates.

Commercial loan products are underwritten and customized to meet specific client needs. The Company considers several factors in order to extend the loan including the borrower’s historical loan repayment, company management, current economic conditions, industry specific risks, capital structure, potential collateral, and financial projections. In making commercial real estate secured loan decisions, the Company considers the purpose of the requested loan and nature of the collateral.

 

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Lending policies require loan approval oversight, approval authority limits, and are structured to reduce the risk on the Company’s balance sheet and reduce concentrations of commercial real estate loans. In 2011, a new lending platform was established to produce high quality, low risk loans primarily on multifamily properties located in California. The origination of commercial real estate loans in 2009, and 2010, was limited and closely monitored. Commercial real estate loans which are in Purchased Credit Impaired (“PCI”) Loan Pools are only renewed if they meet the more stringent underwriting criteria. The Company continually evaluates its underwriting standards to ensure that it is effectively managing its credit exposure given changes in collateral values, market conditions, and types of borrowers.

Deposit products offered by the Commercial & Community Banking segment include checking, savings, money market accounts, individual retirement accounts (“IRAs”) and certificates of deposit (“CDs”). The Commercial & Community Banking segment serves clients through traditional banking branches, loan production centers, Automated Teller Machines (“ATM”) through client contact call centers and online banking.

Included in the Commercial & Community Banking segment are the associated administrative departments to support their products and activities such as loan servicing, credit administration, special assets department, research, delinquency management unit, central vault operations, retail banking administration and retail and commercial lending administration departments.

Wealth Management

The Wealth Management segment includes the Bank’s trust department and the investment advisory services division which is comprised of the two registered investment advisors, MCM and REWA, which are subsidiaries of the Bank. The Wealth Management segment provides investment reviews, analysis and customized portfolio management for separately managed accounts, full service brokerage, trust and fiduciary services, equity and fixed income management, and real estate and specialty asset management.

Discontinued Operations

On January 14, 2010, the Company entered into an agreement for the sale of its Refund Anticipation Loan (“RAL”) and Refund Transfer (“RT”) Programs segment. Management determined that the sale of the RAL and RT Programs met the requirements as a discontinued operation for the Company in accordance with the accounting guidance for Impairment and Disposal of Long-Lived Assets. Accordingly, the financial results from the RAL and RT Programs have been reclassified within the Company’s Consolidated Financial Statements and presented separately as discontinued operations.

Foreign Operations

The Company has no foreign operations. However, the Company does provide loans, letters of credit and other trade-related services to a number of domestic businesses that conduct trade activities outside the United States.

Client Concentration

Neither the Company nor either of the reportable segments has any client relationships that individually account for 10% or more of consolidated or segment revenues, respectively.

 

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ITEM 1A. RISK FACTORS

In the course of conducting its business operations, the Company is exposed to a variety of risks, some of which are inherent in the financial services industry and others of which are more specific to its own business. The following discussion addresses some of the key risks that could affect the Company’s business, operations, and financial condition. Other factors that could affect the Company’s financial condition and operations are discussed elsewhere in this Form 10-K and in other documents the Company files with the SEC. The risks identified below are not intended to be a comprehensive list of all risks faced by the Company and additional risks that the Company may currently view as not material may also impair its business, operations and financial condition.

Continued or worsening general economic or business conditions, particularly in California where the Company’s business is concentrated, could have an adverse effect on the Company’s business, results of operations and financial condition.

The Company’s operations, loans and the collateral securing its loan portfolio are concentrated in the State of California. The Company’s success depends upon the business activity, population, income levels, deposits and real estate activity in this market. As a result, the Company may be particularly susceptible to the adverse economic conditions in California and in the eight counties where its business is concentrated.

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

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

While some economic trends have shown signs of improving in recent months, the Company cannot be certain that market and economic conditions will substantially improve in the near future. Recent and ongoing events at the state, national and international levels continue to create uncertainty in the economy and financial markets and could adversely impact economic conditions in the Company’s market area. A worsening of these conditions would likely exacerbate the adverse effects of the recent market and economic conditions on the Company and its customers. As a result, the Company may experience additional increases in foreclosures, delinquencies and customer bankruptcies as well as more restricted access to funds. Any such negative events may have an adverse effect on the Company’s business, financial condition, results of operations and stock price. Moreover, because of the Company’s geographic concentration, it is less able to diversify its credit risks across multiple markets to the same extent as regional or national financial institutions.

The Company and the Bank continue to be subject to certain agreements with their regulators.

The Company remains subject to enhanced supervisory review pursuant to the Written Agreement, and the Bank remains subject to enhanced supervisory review pursuant to the Operating Agreement. See “Regulation and Supervision—Regulatory Developments” for a discussion of the terms of the Written Agreement and Operating Agreement. While the Company and the Bank has made every effort necessary to comply with the requirements of the Written Agreement and Operating Agreement,

 

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there can be no assurance that the Company will be able to comply fully with the provisions of the Written Agreement or that the Bank will be able to comply fully with the provisions of the Operating Agreement, that compliance with the Written Agreement and Operating Agreement will not be more time consuming or more expensive than anticipated, that compliance with the Written Agreement and Operating Agreement will enable the Company and the Bank to sustain profitable operations, or that efforts to comply with the Written Agreement and Operating Agreement will not have adverse effects on the operations and financial condition of the Company or the Bank. In addition, the Company and the Bank cannot determine whether or when the Written Agreement and Operating Agreement will be lifted or terminated. Even if they are lifted or terminated, in whole or in part, the Company and the Bank may remain subject to supervisory enforcement actions that restrict their activities.

The Company and the Bank are subject to extensive regulation.

The financial services industry is extensively regulated. The Bank is subject to extensive regulation, supervision and examination by the OCC and the FDIC. As a bank holding company, the Company is subject to regulation and oversight by the Reserve Board. Federal and State regulation is designed primarily to protect the deposit insurance funds and consumers, and not to benefit the Company’s shareholders. Recent government efforts to strengthen the U.S. financial system have resulted in the imposition of additional regulatory requirements, including expansive financial services regulatory reform legislation in the form of Dodd-Frank. Dodd-Frank will have material implications for the Company and the entire financial services industry. Among other things it will or potentially could:

 

  ¡  

Affect the levels of capital and liquidity with which the Company must operate and how the Company plans capital and liquidity levels;

 

  ¡  

Subject the Company to new and/or higher fees paid to various regulatory entities, including but not limited to deposit insurance fees to the FDIC;

 

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Impact the Company’s ability to invest in certain types of entities or engage in certain activities;

 

  ¡  

Restrict the nature of the Company’s incentive compensation programs for executive officers;

 

  ¡  

Subject the Company to a new Consumer Financial Protection Bureau, with very broad rule-making and enforcement authorities; and

 

  ¡  

Subject the Company to new and different litigation and regulatory enforcement risks.

The full impact of this legislation on the Company and its business strategies and financial performance cannot be known at this time, and may not be known for a number of years. However, these impacts are expected to be substantial and some of them are likely to adversely affect the Company and its financial performance. Other regulations affecting banks and other financial institutions, such as Dodd-Frank, are undergoing continuous review and change frequently; the ultimate effect of such changes cannot be predicted. Because the Company’s business is highly regulated, compliance with such regulations and laws may increase its costs and limit its ability to pursue business opportunities. There can be no assurance that proposed laws, rules and regulations will not be adopted in the future, which could (i) make compliance much more difficult or expensive, (ii) restrict the Company’s ability to originate, broker or sell loans or accept certain deposits, (iii) further limit or restrict the amount of commissions, interest or other charges earned on loans originated or sold by the Company, or (iv) otherwise materially and adversely affect the Company’s business or prospects for business.

The Company may be subject to more stringent capital requirements.

Dodd-Frank requires the federal banking agencies to establish stricter risk-based capital requirements and leverage limits to apply to banks and bank holding companies. In addition, the “Basel III” standards recently announced by the Basel Committee, if adopted, could lead to significantly higher

 

23


capital requirements, higher capital charges and more restrictive leverage and liquidity ratios. The standards would, among other things, impose more restrictive eligibility requirements for Tier 1 and Tier 2 capital; increase the minimum Tier 1 common equity ratio to 4.5%, net of regulatory deductions, and introduce a capital conservation buffer of an additional 2.5% of common equity to risk-weighted assets, raising the target minimum common equity ratio to 7.0%; increase the minimum Tier 1 capital ratio to 8.5% inclusive of the capital conservation buffer; increase the minimum total capital ratio to 10.5% inclusive of the capital buffer; and introduce a countercyclical capital buffer of up to 2.5% of common equity or other fully loss absorbing capital for periods of excess credit growth. Basel III also introduces a non-risk adjusted Tier 1 leverage ratio of 3.0%, based on a measure of total exposure rather than total assets, and new liquidity standards.

The new Basel III capital standards will be phased in from January 1, 2013 until January 1, 2019, and it is not yet known how these standards will be implemented by U.S. regulators generally or how they will be applied to financial institutions of the Company’s size. Implementation of these standards, or any other new regulations, may adversely affect the Company’s ability to pay dividends, or require it to restrict growth or raise capital, including in ways that may adversely affect its results of operations or financial condition.

The Company’s allowance for loan losses may not be adequate to cover actual losses.

A significant source of risk arises from the possibility that the Company could sustain losses because borrowers, guarantors, and related parties may fail to perform in accordance with the terms of their loans. This risk is normally addressed by means of an ALLL in the amount of Management’s estimate of losses inherent in the Company’s loan portfolio. As explained in Note 2, “Business Combinations – Investment Transaction” to the Consolidated Financial Statements, the Company was required under generally accepted accounting principles in the United States (“GAAP”) to estimate the fair value of its loan portfolio as of the close of business on August 31, 2010 (the “Transaction Date”), and write the portfolio down to that estimate. For most loans, this meant computing the net present value of estimated cash flows to be received from borrowers. The ALLL that had been maintained as an estimate of losses inherent in the loan portfolio was eliminated in this accounting. A new ALLL has been established for loans made subsequent to the Transaction Date and for any subsequent lowering of the estimate of cash flows to be received from the PCI loans held.

The estimate of fair value as of the Transaction Date was based on economic conditions at the time and on Management’s projections regarding both future economic conditions and the ability of the Company’s borrowers to continue to repay their loans. However, the estimate of fair value may prove to be overly optimistic and the Company may suffer losses in excess of those estimated as of that date. The ALLL established for new loans or for revised estimates may prove to be inadequate to cover actual losses especially if economic or other conditions worsen.

While Management believes that both the estimate of fair value and the ALLL are adequate to cover current losses, no underwriting and credit monitoring policies and procedures that the Company could adopt to address credit risk could provide complete assurance that there will not be unexpected losses. These losses could have a material adverse effect on the Company’s business, financial condition, results of operations and cash flows. In addition, federal regulators periodically evaluate the adequacy of the Company’s ALLL and may require the Company to increase its provision for loan losses or recognize further loan charge-offs based on judgments different from those of Management.

A substantial portion of the Company’s loan portfolio is comprised of commercial real estate loans and commercial business loans.

At December 31, 2011, $1.59 billion, or 43.4% of the Company’s loan portfolio consisted of commercial real estate loans. These commercial real estate loans constituted a greater percentage of the Company’s

 

24


loan portfolio than any other loan category, including 1 to 4 family residential real estate loans, which totaled $1.04 billion, or 28.4%, of the Company’s loan portfolio, and commercial loans, which totaled $189.2 million, or 5.2%, of the Company’s loan portfolio. Commercial real estate loans and commercial loans generally expose a lender to greater risk of nonpayment and loss than 1 to 4 family loans because repayment of the loans often depends on the successful operation of the property and/or the income stream of the borrower. Commercial loans expose the Company to additional risks since they are generally secured by business assets that may depreciate over time. Such loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to 1 to 4 family loans. Also, many of the Company’s commercial borrowers have more than one loan outstanding with the Company. Consequently, an adverse development with respect to one loan or one credit relationship can expose the Company to a significantly greater risk of loss compared to an adverse development with respect to a 1 to 4 family loan. Changes in economic conditions that are out of the control of the borrower and lender could impact the value of the security for the loan, the future cash flow of the affected property or borrower, or the marketability of a construction project with respect to loans originated for the acquisition and development of property. Additionally, any decline in real estate values may be more pronounced with respect to commercial real estate properties than residential real estate properties.

Liquidity risk could impair the Company’s ability to fund operations and jeopardize its financial condition.

Liquidity is essential to the Company’s business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a material adverse effect on the Company’s liquidity. The Company’s access to funding sources in amounts adequate to finance its activities could be impaired by factors that affect it specifically or the financial services industry in general. Factors that could detrimentally impact the Company’s access to liquidity sources include a decrease in the level of the Company’s business activity due to a market downturn, adverse regulatory action against the Company or the Bank, a reduction in the Company’s credit ratings, an increase in costs of capital in financial capital markets, or a decrease in depositor or investor confidence in the Company. The Company’s ability to acquire deposits or borrow could also be impaired by factors that are not specific to it, such as a severe disruption of the financial markets or negative views and expectations about the prospects for the financial services industry as a whole.

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

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

 

25


Market and other constraints on the Company’s loan origination volumes may lead to continued pressure on its interest and fee income.

Due to the poor economic conditions in the markets in which the Company operates and other factors, the Company expects continued pressure on new loan originations in the near term. If the Company is unable to increase loan volumes, there will be continued pressure on its interest income and fees generated from its lending operations. Unless the Company is able to offset the lower interest income and fees with increased activity in other areas of its operations, its total revenues may decline relative to its total noninterest expenses. The Company expects that it may be difficult to find new revenue sources in the near term.

As a bank holding company, the Company is substantially dependent on its subsidiaries for dividends, distributions and other payments.

Substantially all of the Company’s activities are conducted through the Bank, and, consequently, as the parent company of the Bank, the principal source of funds from which the Company services debt and pays its obligations and dividends is the receipt of dividends from the Bank. Pursuant to the Operating Agreement, the Bank may not pay a dividend or make a capital distribution to the Company until September 2, 2013. From and after September 2, 2013, the Bank may not pay a dividend or make a capital distribution to the Company without the prior written consent of the OCC. The Written Agreement also restricts the Company from taking any dividends or any other payment representing a reduction in capital from the Bank without the prior approval of the Reserve Board.

The Company faces strong competition from financial services companies and other companies that offer banking services.

The Company faces increased competition from financial services companies and other companies that offer banking services. The Company conducts most of its operations in California. Increased competition in its markets may result in a reduction in loans or deposits it may acquire. Ultimately, the Company may not be able to compete successfully against current and future competitors. These competitors include national banks, regional banks and other community banks. The Company also faces competition from many other types of financial institutions, including savings institutions, industrial banks, finance companies, brokerage firms, insurance companies, credit unions, mortgage banks and other financial intermediaries. In particular, the Company’s competitors include major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous locations and mount extensive promotional and advertising campaigns. Areas of competition include interest rates for loans and deposits, efforts to obtain loan and deposit clients and a range in quality of products and services provided, including new technology-driven products and services. If the Company is unable to attract and retain banking clients, it may be unable to continue loan growth and level of deposits.

The actions and commercial soundness of other financial institutions could affect the Company’s ability to engage in routine funding transactions.

Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. The Company has exposure to different industries and counterparties, and executes transactions with various counterparties in the financial industry, including brokers and dealers, commercial banks, investment banks, mutual and hedge funds, and other institutional clients. Defaults by financial services institutions, even rumors or questions about one or more financial services institutions or the financial services industry in general, could lead to market wide liquidity problems and further, could lead to losses or defaults by the Company or by other institutions. Many of these transactions expose the Company to credit risk in the event of default of its counterparty or client. In

 

26


addition, the Company’s credit risk may increase when the presumed value of collateral held by it cannot be realized or can only be liquidated at prices not sufficient to recover the full amount of the loan or derivative exposure due to the Company. Any such losses could materially and adversely affect the Company’s results of operations.

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

The Company faces various operational risks that arise from the potential that inadequate information systems, operational problems, failures in internal controls, breaches of security systems, fraud, the execution of unauthorized transactions by employees, or any number of unforeseen catastrophes could result in unexpected losses. The Company maintains a system of internal controls to mitigate against such occurrences and maintains insurance coverage for such risks, but should such an event occur that is not prevented or detected by the Company’s internal controls, uninsured or in excess of applicable insurance limits, it could have a significant adverse impact on the Company’s business, financial condition or results of operations.

The Company relies on communications, information, operating and financial control systems technology from third party service providers, and it may suffer an interruption in or breach of security of those systems.

The Company relies heavily on third party service providers for much of its communications, information, operating and financial control systems technology, including its internet banking services and data processing systems. Any failure or interruption of these services or systems or breaches in security of these systems could result in failures or interruptions in the Company’s client relationship management, general ledger, deposit, servicing, and/or loan origination systems. The occurrence of any failures or interruptions may require the Company to identify alternative sources of such services. The Company may not be able to negotiate terms that are as favorable to it, or may not be able to obtain services with similar functionality as found in its existing systems without the need to expend substantial resources, if at all. The occurrence of a breach of security of these systems could damage the Company’s reputation, result in a loss of customers or expose the Company to possible financial liability.

The Company is exposed to risk of environmental liabilities with respect to properties to which it takes title.

In the course of its business, the Company may own or foreclose and take title to real estate, and could be subject to environmental liabilities with respect to these properties. The Company may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and cleanup costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances, or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, as the owner or former owner of a contaminated site, the Company may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. If the Company ever became subject to significant environmental liabilities, its business, financial condition, liquidity and results of operations could be materially and adversely affected.

A natural disaster could harm the Company’s business.

Historically, California, in which a substantial portion of the Company’s business is located, has been susceptible to natural disasters, such as earthquakes, floods and wild fires. The nature and level of natural disasters cannot be predicted. These natural disasters could harm the Company’s operations through interference with communications, including the interruption or loss of the Company’s

 

27


computer systems, which could prevent or impede the Company from gathering deposits, originating loans and processing and controlling its flow of business, as well as through the destruction of facilities and the Company’s operational, financial and management information systems. Additionally, natural disasters could negatively impact the values of collateral securing the Company’s loans and interrupt borrowers’ abilities to conduct their business in a manner to support their debt obligations, either of which could result in losses and increased provisions for loan losses.

Managing reputational risk is important to attracting and maintaining clients, investors and employees.

Threats to the Company’s reputation can come from many sources, including adverse sentiment about financial services institutions generally, unethical practices, employee misconduct, breaches of the Company’s information technology security systems, failure to deliver minimum standards of service or quality, compliance deficiencies, and questionable or fraudulent activities of our clients. The Company has policies and procedures in place to protect its reputation and promote ethical conduct, but these policies and procedures may not be fully effective. Negative publicity regarding the Company’s business, employees, or clients, with or without merit, may result in the loss of clients, investors and employees, costly litigation, a decline in revenues and increased governmental regulation.

The Company is dependent on key personnel and the loss of one or more of those key personnel may materially and adversely affect its prospects.

Competition for qualified employees and personnel in the banking industry is intense and there are a limited number of qualified persons with knowledge of, and experience in, the California banking industry. The process of recruiting personnel with the combination of skills and attributes required to carry out the Company’s strategies is often lengthy. In addition, legislation and regulations which impose restrictions on executive compensation may make it more difficult for the Company to retain and recruit key personnel. The Company’s success depends to a significant degree upon its ability to attract and retain qualified management, loan origination, finance, administrative, marketing, and technical personnel, and upon the continued contributions of its management and personnel. In particular, the Company’s success has been and continues to be highly dependent upon the abilities of key executives, including its Chief Executive Officer.

The Company may issue securities that could dilute the ownership of its existing shareholders and may adversely affect the market price of its common stock.

The Company may elect to raise capital in the future to enhance its capital levels, improve its capital ratios, provide capital for acquisitions, increase liquidity available for operations and other opportunities, or for other reasons. If the Company raises funds by issuing equity securities or instruments that are convertible into equity securities, the percentage ownership of its existing shareholders will be reduced, the new equity securities may have rights, preferences and privileges superior to those of its common stock and additional issuances could be at a purchase price that is lower than the available market price for its common stock. The market price of the Company’s common stock could decline as a result of sales of a large number of shares of common stock, preferred stock or similar securities in the market as a result of future sales of common stock or the perception that such sales could occur. The Company may also issue equity securities as consideration for acquisitions that could be dilutive to existing shareholders.

As a “controlled company,” the Company is exempt from certain NASDAQ corporate governance requirements.

The Company’s common stock is currently traded on NASDAQ. NASDAQ generally requires a majority of directors to be independent and requires independent director oversight over the

 

28


nominating and executive compensation functions. However, under the rules applicable to NASDAQ, if another company owns more than 50% of the voting power of a listed company, that company is considered a “controlled company” and is exempt from rules relating to independence of the Board of Directors and the compensation and nominating committees. The Company is a controlled company because SB Acquisition Company LLC, beneficially owns more than 50% of the Company’s outstanding voting stock. Accordingly, the Company is exempt from certain corporate governance requirements and holders of the Company’s common stock may not have all the protections that these rules are intended to provide.

A majority of the Company’s common stock is held by a single shareholder.

SB Acquisition owns approximately 76.0% of the Company’s outstanding common stock and has two representatives on the Board of Directors. Accordingly, SB Acquisition has a controlling influence over the election of directors to the Board of Directors and over corporate policy, including decisions to enter into mergers or other extraordinary transactions. In pursuing its economic interests, SB Acquisition may make decisions with respect to fundamental corporate transactions that may be different from the decisions of other shareholders.

The price of the Company’s common stock may be volatile or may decline.

The trading price of the Company’s common stock may fluctuate significantly as a result of a number of factors, many of which are outside the Company’s control. In addition, the stock market is subject to fluctuations in the share prices and trading volumes that affect the market prices of the shares of many companies. These broad market fluctuations could adversely affect the market price of the Company’s common stock. Among the factors that could affect stock price are:

 

  ¡  

Actual or anticipated quarterly fluctuations in the Company’s operating results and financial condition;

 

  ¡  

Changes in financial estimates or publication of research reports and recommendations by financial analysts with respect to the Company’s common stock or those of other financial institutions;

 

  ¡  

Failure to meet analysts’ loan and deposit volume, revenue, asset quality or earnings expectations;

 

  ¡  

Speculation in the press or investment community generally or relating to the Company’s reputation or the financial services industry;

 

  ¡  

Actions by the Company’s shareholders, including sales of common stock by existing shareholders and/or directors and executive officers;

 

  ¡  

Fluctuations in the stock price and operating results of the Company’s competitors;

 

  ¡  

Future sales of the Company’s equity or equity-related securities;

 

  ¡  

Proposed or adopted regulatory changes or developments;

 

  ¡  

Investigations, proceedings, or litigation that involve or affect the Company;

 

  ¡  

The performance of the national and California economy and the real estate markets in California; or

 

  ¡  

General market conditions and, in particular, developments related to market conditions for the financial services industry.

The trading volume of the Company’s common stock is limited.

The Company’s common stock trades on NASDAQ under the symbol “PCBC” and trading volume is modest. The limited trading market for the Company’s common stock may lead to exaggerated

 

29


fluctuations in market prices and possible market inefficiencies, as compared to a more actively traded stock. It may also make it more difficult to dispose of such common stock at expected prices, especially for holders seeking to dispose of a large number of such stock.

Resales of the Company’s common stock in the public market may cause the market price of the common stock to fall.

The Company has provided customary registration rights to SB Acquisition, which owns approximately 76.0% of the Company’s outstanding common stock, and to the U.S. Treasury, which owns approximately 11.0% of the Company’s outstanding common stock. If either SB Acquisition or the U.S. Treasury elects to sell its shares, such sales or attempted sales could result in significant downward pressure on the market price of the common stock and actual price declines.

The Company’s common stock is equity and therefore is subordinate to the Company’s indebtedness and any preferred stock.

Shares of the Company’s common stock are equity interests in the Company, do not constitute indebtedness, and, therefore, are not insured against loss by the FDIC or by any other public or private entity. Such common stock will rank junior to all indebtedness and other non-equity claims on the Company with respect to assets available to satisfy claims on the Company, including in a liquidation of the Company. Additionally, holders of such common stock are subject to the prior dividend and liquidation rights of any holders of our preferred stock then outstanding.

Anti-takeover provisions could negatively impact the Company’s shareholders.

Various provisions of the Company’s certificate of incorporation and bylaws and certain other actions the Company has taken could delay or prevent a third-party from acquiring control of it even if doing so might be beneficial to its shareholders. These include, among other things, the authorization to issue “blank check” preferred stock by action of the Board of Directors acting alone, thus without obtaining shareholder approval. The BHCA and the Change in Bank Control Act of 1978, as amended, together with federal regulations, require that, depending on the particular circumstances, either regulatory approval must be obtained or notice must be furnished to the appropriate regulatory agencies and not disapproved prior to any person or entity acquiring “control” of a national bank, such as the Bank. These provisions may prevent a merger or acquisition that would be attractive to shareholders and could limit the price investors would be willing to pay in the future for the Company’s common stock.

The Company will be subject to business uncertainties while the Merger with UBC is pending that could adversely affect its financial results. Failure to complete the Merger with UBC could also negatively impact the Company’s stock price and future business and financial results.

On March 12, 2012, the Company announced the execution of a definitive merger agreement with UBC. Uncertainty about the effect of the Merger on employees or customers may have an adverse effect on the Company. Although the Company intends to take steps designed to reduce any adverse effects, these uncertainties may impair its ability to attract, retain and motivate key personnel until the Merger is completed and for a period of time thereafter, and could cause customers and others that deal with the Company to seek to change existing business relationships.

Employee retention and recruitment may be particularly challenging prior to the completion of the Merger, as employees and prospective employees may experience uncertainty about their future roles with the combined company. If, despite the Company’s retention and recruiting efforts, key employees depart or fail to accept employment with the Company because of issues relating to the uncertainty and difficulty of integration or a desire not to remain with the combined company, the Company’s business operations and financial results could be adversely affected.

 

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In addition, the Merger Agreement restricts the Company, without UBC’s consent, from taking certain specified actions, including making certain capital expenditures and investments, entering into new or changing existing lines of business and opening or closing branch offices until the Merger occurs or the Merger Agreement terminates. These restrictions may prevent the Company from making other changes to its business prior to consummation of the Merger or termination of the Merger Agreement even if the Company believes those changes would be advantageous to it.

Termination of the Merger Agreement may negatively affect the Company.

If the Merger Agreement is terminated, the Company may suffer various adverse consequences, including:

 

  ¡  

Its business may have been adversely impacted by the failure to pursue other beneficial opportunities due to the focus of Management on the proposed Merger, without realizing any of the anticipated benefits of completing the Merger;

 

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The market price of its common stock might decline to the extent that the market price prior to termination reflects a market assumption that the proposed Merger will be completed; and

 

  ¡  

The payment of a termination fee, if required under the circumstances, may adversely affect its financial condition and liquidity.

UBC may be unable to obtain the approvals required to complete the Merger with the Company.

The completion of the Merger is subject to numerous customary conditions. Among other things, before the Merger may be completed, UBC and its affiliates must make various filings with the Reserve Board, the Japan Financial Services Agency and the OCC and receive the approvals or non-objections of those agencies. The Company cannot provide assurance as to whether or when UBC will receive the required approvals or non-objections and delays in the receipt of approvals would have the effect of delaying completion of the Merger. In addition, these governmental authorities may impose conditions on their approvals, including restrictions or conditions on the business or operations of UBC after the Merger that could cause UBC to abandon the Merger.

The Company will incur significant transaction costs in connection with the Merger Agreement and the Merger that could materially impact its financial performance and results.

The Company will incur significant merger transaction costs, including legal, accounting, financial advisory and other costs relating to the Merger Agreement and the Merger. The costs, either individually or in combination, could have a material adverse affect on the Company’s financial results.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

 

ITEM 2. PROPERTIES

Both the Company and the Bank are headquartered at 1021 Anacapa Street in Santa Barbara, California. In addition, the Company occupies six administrative offices for support department operations in Santa Barbara, Ventura, Monterey and Los Angeles counties. These offices are reported in the “All Other” segment and include human resources, information technology, bank operations, finance and accounting, and other support functions.

 

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At December 31, 2011, the Bank owned 12 and leased 35 retail branch locations. These 47 offices are located in the Los Angeles, Monterey, San Benito, San Luis Obispo, Santa Barbara, Santa Clara, Santa Cruz, and Ventura counties and are reported in the “Commercial & Community Banking” segment. In addition, the Bank owns two and leased three offices used for a combination of wealth management and loan production. These five offices are located in Santa Barbara, Monterey, Los Angeles, and San Francisco counties.

The “Wealth Management” segment provides service and administrative support to their clients through five locations. These leased offices are located in San Luis Obispo, Santa Barbara and Los Angeles counties in California, and in New York. The Bank’s trust administration department is located in Santa Barbara. In addition, there are several wealth management advisors located within the retail branch locations.

 

ITEM 3. LEGAL PROCEEDINGS

The Company has been named in lawsuits filed by clients and others. These lawsuits are described in Note 17, “Commitments and Contingencies,” of the Consolidated Financial Statements beginning on page 181. The Company does not expect that these suits will have any material impact to its financial condition or operating results.

The Company is involved in various other litigation of a routine nature that is being handled and defended in the ordinary course of the Company’s business. In the opinion of Management, based in part on consultation with legal counsel, the resolution of these litigation matters will not have a material impact to the Company’s financial condition or operating results.

 

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

 

32


PART II

 

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

Market Information

The Company’s common stock trades on the NASDAQ Global Select Market under the symbol “PCBC.” As of February 29, 2012, there were approximately 2,827 holders of record of the Company’s common stock. On December 28, 2010, the Company effected a 1-for-100 reverse stock split, as reflected at the open of trading on the following day. All prior per share and dividend amounts have been restated to reflect this split. The following table presents the high and low sales prices and dividends paid for the Company’s common stock for each quarterly period for the last two years as reported by the NASDAQ Global Select Market:

 

Period Ended

   High      Low      Dividends
Declared
 

2011

        

Successor Company

        

Three Months Ended December 31

   $ 28.44       $ 22.74       $   

Three Months Ended September 30

     31.84         23.76           

Three Months Ended June 30

     32.34         29.30           

Three Months Ended March 31

     31.39         26.38           

2010

        

Three Months Ended December 31

     92.00         22.00           

One Month Ended September 30

     98.00         78.00           
                          

Predecessor Company

        

Two Months Ended August 31

   $ 166.00       $ 62.00       $   

Three Months Ended June 30

     549.00         62.00           

Three Months Ended March 31

     245.00         97.00           

Dividends

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

Under the terms of the Written Agreement, the Company may not pay cash dividends on its common stock without the prior approval of the Reserve Board. For a discussion of additional regulatory restrictions on the payment of dividends, see “Regulation and Supervision—Dividends and Other Transfer of Funds.” In addition, under the terms of the Merger Agreement, the Company may not pay cash dividends on its common stock without the prior approval of UBC.

 

33


The principal source of funds from which the Company may pay dividends is the receipt of dividends from the Bank. The availability of dividends from the Bank is limited by various statutes and regulations. The Bank is subject first to corporate restrictions on its ability to pay dividends. The Bank may not pay a dividend if it would be undercapitalized after the dividend payment is made. Pursuant to the Operating Agreement, the Bank may not pay a dividend or make a capital distribution to the Company without prior approval from the OCC or until September 2, 2013. The Written Agreement also restricts the taking of dividends or any other payment representing a reduction in capital from the Bank, without the prior approval of the Reserve Board. Furthermore, OCC approval is required for the Bank to declare a dividend if the total of all dividends (common and preferred), including the proposed dividend, declared by the Bank in any calendar year will exceed its net retained income of that year to date plus the retained net income of the preceding two calendar years. In addition, the banking agencies have the authority under their safety and soundness guidelines and prompt correct action regulations to require their prior approval or to prohibit the Bank from paying dividends, depending upon the Bank’s financial condition, if such payment is deemed to constitute an unsafe or unsound practice.

Stock Performance

The following graph shows a five year comparison of cumulative total returns for the Company’s common stock, the Standard & Poor’s 500 Stock Index and the NASDAQ Bank Index, each of which assumes an initial value of $100 and reinvestment of dividends.

 

LOGO

 

34


Securities Authorized for Issuance Under Equity Compensation Plans

The following table provides information at December 31, 2011, with respect to shares of Company common stock that may be issued under the Company’s existing equity compensation plans.

 

     December 31, 2011  

Plan category

   Number of securities to
be issued upon exercise
of  outstanding options,
warrants, and rights (a)
     Weighted-average exercise
price of outstanding
options, warrants, and

rights (b)
     Number of securities
remaining available for future
issuance under equity
compensation plans
(excluding securities reflected
in column (a)) (c)
 

Equity compensation plans approved by security holders

     122,657       $ 365.12         1,986,579   

Equity compensation plans not approved by security holders

                       
  

 

 

    

 

 

    

 

 

 

Total

     122,657       $ 365.12         1,986,579   
  

 

 

    

 

 

    

 

 

 

 

(a)

Included in column (a) are unexercised stock options and restricted stock units granted to directors and employees through current and expired option plans as of December 31, 2011. This amount excludes 15,120 warrants issued to the U.S. Treasury since they are not compensatory.

(b)

This does not include restricted stock or restricted stock units, because they do not have an exercise price.

(c)

Securities remaining available for issuance are from the 2010 Equity Incentive Plan.

 

35


ITEM 6. SELECTED FINANCIAL DATA

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

 

    Successor Company          Predecessor Company  

(dollars and shares in thousands,

except per share amounts)

  At or
Twelve Months
Ended
December 31,
2011
    At or
Four Months
Ended
December 31,
2010
         At or
Eight
Months
Ended
August 31,
2010
    At  or
Twelve
Months
Ended
December 31,
2009
 

Results of Operations:

           

Interest income

  $ 271,294      $ 84,740          $ 189,700      $ 353,272   

Interest expense

    43,950        12,568            80,328        153,641   
 

 

 

   

 

 

       

 

 

   

 

 

 

Net interest income

    227,344        72,172            109,372        199,631   

Provision for loan losses

    5,555        590            171,583        352,398   

Noninterest income

    50,818        20,072            35,797        57,561   

Noninterest expense

    202,559        65,884            149,963        380,241   
 

 

 

   

 

 

       

 

 

   

 

 

 

Income/(loss) before income tax benefit

    70,048        25,770            (176,377     (475,447

Income tax benefit

    (474)                   (4,742     (18,823
 

 

 

   

 

 

       

 

 

   

 

 

 

Net income/(loss) from continuing operations

    70,522        25,770            (171,635     (456,624
 

 

 

   

 

 

       

 

 

   

 

 

 

(Expense)/income from discontinued operations, net

           (26)            6,731        35,363   
 

 

 

   

 

 

       

 

 

   

 

 

 

Net income/(loss)

    70,522        25,744            (164,904     (421,261

Dividends and accretion on preferred stock

                      6,938        9,996   
 

 

 

   

 

 

       

 

 

   

 

 

 

Net income/(loss) applicable to common shareholders

  $ 70,522      $ 25,744          $ (171,842   $ (431,257
 

 

 

   

 

 

       

 

 

   

 

 

 

Earnings/(loss) per share from continuing operations:

           

Basic

  $ 2.14      $ 1.02          $ (359.07   $ (977.78

Diluted (1)

  $ 2.14      $ 0.86          $ (359.07   $ (977.78

Earnings per share from discontinued operations:

           

Basic

  $      $          $ 14.08      $ 75.72   

Diluted

  $      $          $ 14.08      $ 75.72   

Earnings/(loss) per share applicable to common shareholders:

           

Basic

  $ 2.14      $ 1.02          $ (359.50   $ (923.46

Diluted (1)

  $ 2.14      $ 0.85          $ (359.50   $ (923.46

Book value per common share

  $ 23.16      $ 19.53          $ 20.11      $ 402.27   
 

Weighted average number of common shares outstanding:

           

Basic

    32,904        25,331            478        467   

Diluted

    32,913        30,126            478        467   

 

(1)

Loss per diluted common shares for the periods ended August 31, 2010, and December 31, 2010, 2009, and 2008, is calculated using basic weighted average shares outstanding.

(continued on next page)

 

36


ITEM 6. SELECTED FINANCIAL DATA—CONTINUED

 

    Successor Company           Predecessor Company  

(dollars and shares in thousands,

except per share amounts)

  At or
Twelve  Months
Ended
December  31,
2011
     At or
Four Months
Ended
December  31,
2010
          At or
Eight  Months
Ended
August  31,
2010
     At or
Twelve  Months
Ended
December  31,
2009
 

Balance Sheet:

              

Loans held for investment

  $ 3,660,961       $ 3,761,517           $ 4,016,126       $ 5,166,431   

Total assets

  $ 5,850,022       $ 6,085,548           $ 7,215,476       $ 7,542,255   

Total deposits

  $ 4,617,040       $ 4,906,788           $ 5,190,223       $ 5,373,819   

Long term debt & other borrowings (2)

  $ 66,524       $ 125,755           $ 1,000,932       $ 1,311,828   

Total shareholders’ equity

  $ 761,970       $ 642,683           $ 581,913       $ 364,603   

Operating and Capital Ratios:

              

Return on average assets

    1.2%         1.2%             n/a         n/a   

Return on average shareholders’ equity

    10.0%         12.8%             n/a         n/a   

Tier 1 leverage ratio

    12.4%         10.3%             n/a         5.3%   

Tier 1 risk-based capital ratio

    19.6%         16.1%             n/a         7.8%   

Total risk-based capital ratio

    20.2%         16.4%             n/a         10.4%   

Dividend payout ratio

    n/a         n/a             n/a         n/a   
 

Preferred stock

  $       $           $ 527,167       $ 176,742   

Average total assets

  $ 5,896,365       $ 6,282,969           $ 7,377,931       $ 8,593,630   

Average total equity

  $ 707,276       $ 603,958           $ 288,642       $ 599,998   

Ending common shares outstanding

    32,905         32,901             2,722         467   

Cash dividends declared

  $       $           $       $ 11.00   

 

(2)

Includes obligations under capital lease.

(continued on next page)

 

37


ITEM 6. SELECTED FINANCIAL DATA—CONTINUED

 

     Predecessor Company  

(dollars and shares in thousands,

except per share amounts)

   At or
Twelve  Months
Ended
December 31,
2008
    At or
Twelve  Months
Ended
December 31,
2007
 
    
    
    
    

Results of Operations:

    

Interest income

   $ 411,148      $ 468,795   

Interest expense

     171,107        212,117   
  

 

 

   

 

 

 

Net interest income

     240,041        256,678   

Provision for loan losses

     196,567        21,314   

Noninterest income

     56,557        86,146   

Noninterest expense

     254,135        205,335   
  

 

 

   

 

 

 

(Loss)/income before income tax (benefit)/expense

     (154,104     116,175   

Income tax (benefit)/expense

     (65,996     38,987   
  

 

 

   

 

 

 

Net (loss)/income from continuing operations

     (88,108     77,188   
  

 

 

   

 

 

 

Income from discontinued operations, net

     65,358        23,700   
  

 

 

   

 

 

 

Net (loss)/income

     (22,750     100,888   

Dividends and accretion on preferred stock

     1,094          
  

 

 

   

 

 

 

Net (loss)/income applicable to common shareholders

   $ (23,844   $ 100,888   
  

 

 

   

 

 

 

(Loss)/earnings per share from continuing operations:

    

Basic

   $ (190.30   $ 164.93   

Diluted (1)

   $ (190.30   $ 163.88   

Earnings per share from discontinued operations:

    

Basic

   $ 141.16      $ 50.64   

Diluted

   $ 141.16      $ 50.32   

(Loss)/earnings per share applicable to common shareholders:

    

Basic

   $ (51.50   $ 215.57   

Diluted (1)

   $ (51.50   $ 214.20   

Book value per common share

   $ 1,314.44      $ 1,449.80   

Weighted average number of common shares outstanding:

    

Basic

     463        468   

Diluted

     463        471   

 

(1)

Loss per diluted common shares for the periods ended August 31, 2010, and December 31, 2010, 2009, and 2008, is calculated using basic weighted average shares outstanding.

(continued on next page)

 

38


ITEM 6. SELECTED FINANCIAL DATA – CONTINUED

 

 

     Predecessor Company  

(dollars and shares in thousands,

except per share amounts)

   At or
Twelve  Months
Ended
December 31,
2008
     At or
Twelve  Months
Ended
December 31,
2007
 
     
     
     
     

Balance Sheet:

     

Loans held for investment

   $ 5,764,856       $ 5,359,155   

Total assets

   $ 9,573,020       $ 7,374,115   

Total deposits

   $ 5,266,725       $ 4,737,238   

Long term debt & other borrowings (2)

   $ 1,510,240       $ 1,405,602   

Total shareholders’ equity

   $ 788,437       $ 668,356   

Operating and Capital Ratios:

     

Return on average assets

     n/a         1.4%   

Return on average shareholders’ equity

     n/a         15.3%   

Tier 1 leverage ratio

     8.8%         8.0%   

Tier 1 risk-based capital ratio

     11.8%         9.7%   

Total risk-based capital ratio

     14.6%         12.3%   

Dividend payout ratio

     n/a         41.1%   

Preferred stock

   $ 175,907       $   

Average total assets

   $ 7,870,804       $ 7,491,946   

Average total equity

   $ 727,298       $ 657,667   

Ending common shares outstanding

     466         461   

Cash dividends declared

   $ 88.00       $ 88.00   

 

(2)

Includes obligations under capital lease.

 

39


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

The Company provides a wide range of banking, investment advisory and trust services to its clients primarily through its wholly-owned subsidiary, SBB&T, and its subsidiaries. For over 50 years, the Bank has served clients through relationship banking. The Bank combines the breadth of financial products typically associated with a larger financial institution with the type of individual client service that is found in a community bank. The Bank provides full service banking, including all aspects of checking and savings, private and commercial lending, investment advisory services, trust, and other banking products and services. Products and services are offered through retail branch offices, commercial and wealth management centers and other distribution channels to consumers and businesses operating throughout the Central Coast of California, in eight contiguous counties including Santa Barbara, Ventura, Monterey, Santa Cruz, Santa Clara, San Benito, San Luis Obispo and Los Angeles. The Company is headquartered in Santa Barbara, California.

On the “Transaction Date” pursuant to the terms of an Investment Agreement dated April 29, 2010 (the “Investment Agreement”), between the Company, the Bank and SB Acquisition, the Company issued shares to SB Acquisition (“Investment Transaction”). The aggregate consideration paid to the Company by SB Acquisition for these securities was $500 million in cash for 98.1% of the Company’s voting securities. As a result of the Investment Transaction, pursuant to which SB Acquisition acquired and controlled 98.1% of the voting securities of the Company, the Company followed the acquisition or purchase method of accounting as required by the Business Combinations Topic of the Accounting Standards Codification (“ASC”) Topic 805, Business Combinations (“ASC 805”).

As a result of the Investment Transaction and the application of purchase accounting, the Company’s balance sheets and results of operations from periods prior to the Transaction Date are labeled as “Predecessor Company” and are not comparable to balances and results of operations from periods subsequent to the Transaction Date, which are labeled as “Successor Company.” The lack of comparability arises from the assets and liabilities having a new accounting basis as a result of recording them at their fair values as of the Transaction Date rather than at their historical cost basis recorded in the predecessor period. To call attention to this lack of comparability and as required by the accounting and reporting guidance, the Company has placed a heavy black line between the Successor Company and Predecessor Company columns in the Consolidated Financial Statements and in the tables in the notes to the Consolidated Financial Statements and in this MD&A discussion.

The following discussion and analysis should be read in conjunction with the Company’s Consolidated Financial Statements and notes, herein referred to as “the Consolidated Financial Statements” included and incorporated by reference herein. “Bancorp” or “the Bank’s holding company” will be used in this discussion when referring only to the holding company as distinct from the consolidated company which is referred to as “PCBC” or “the Company” and “the Bank” or “SBB&T” will be used when referring to Santa Barbara Bank & Trust, N.A.

FINANCIAL HIGHLIGHTS OF 2011

Successor Company

Net income for the twelve months ended December 31, 2011, was $70.5 million, or $2.14 per diluted share.

The significant factors impacting the Company’s net income for the twelve months ended December 31, 2011, were:

 

  ¡  

Financial results continued to be positively effected by purchase accounting adjustments related to the Recapitalization Transaction;

 

  ¡  

Improved net interest margin to 4.17% for the twelve months ended December 31, 2011, compared to 3.75% for the four months ended December 31, 2010;

 

40


  ¡  

Provision for loan losses remained low as a result of the purchase accounting adjustments made in conjunction with the Recapitalization Transaction;

 

  ¡  

Eliminated $1.2 billion in wholesale funding since the Investment Transaction which reduced interest expense; and

 

  ¡  

Incurred additional expense to support improvement in technology and operational infrastructure enhancements.

Recent Developments

On March 9, 2012, the Company entered into Merger Agreement with UBC. The Merger Agreement provides that, upon the terms and subject to the conditions set forth in the Merger Agreement, Merger Sub will merge with and into the Company, with the Company continuing as the surviving corporation and a wholly owned subsidiary of UBC. Pursuant to the Merger Agreement, upon consummation of the Merger, each outstanding share of common stock of the Company will be converted into the right to receive $46.00 per share in cash. Consummation of the Merger is subject to certain customary conditions, including, among others, the absence of any injunction or other legal prohibition on the completion of the Merger, regulatory approvals of the Reserve Board, the Japan Financial Services Agency and the OCC and expiration of applicable waiting periods. On March 9, 2012, following the execution of the Merger Agreement, SB Acquisition, the holder of 25,000,000 shares of the Company’s common stock, constituting approximately 76% of the outstanding shares of the Company’s common stock, delivered to the Company its action by written consent adopting and approving the Merger Agreement and the Merger. No further approval of the stockholders of the Company is required to approve the Merger Agreement and the Merger. For more information regarding the Merger Agreement and the Merger, see “Item 1. Business—Recent Developments.”

FINANCIAL HIGHLIGHTS OF 2010 AND 2009

Successor Company

Net income applicable to common shareholders for the four months ended December 31, 2010, was $25.7 million, or $0.85 per diluted share. Income from continuing operations for the four months ended December 31, 2010 was $25.8 million, or $0.86 per diluted share.

The significant factors impacting the Company’s net income applicable to common shareholders for the four months ended December 31, 2010 were:

 

  ¡  

Financial results were significantly improved after the application of purchase accounting due to the Recapitalization Transactions as described in more detail below;

 

  ¡  

Provision for loan losses related only to loans originated after the Transaction Date as a result of the purchase accounting adjustments explained in detail in the section below;

 

  ¡  

Interest expense on CDs was reduced relative to the amount that would otherwise have been recognized by the application of purchase accounting. The fair value of these deposits was higher than their recorded amount resulting in a premium being recognized for these deposits. This premium is amortized against interest expense, reducing it to an amount lower than the nominal interest rate for these deposits; and

 

  ¡  

Overall interest expense decreased substantially as the result of the prepayment of $802.4 million of Federal Home Loan Bank (“FHLB”) advances in the first week of September 2010.

 

41


The Impacts of the Investment Transaction on the Company’s Financial Condition and Results of Operations

Impacts on Capital and Liquidity

The $500 million paid by SB Acquisition in the Investment Transaction provided new capital to the Company. Almost all of this capital was contributed to the Bank to meet the enhanced regulatory minimum capital ratios required by the Operating Agreement. Additionally, the Company was able to repay a significant amount of its debt immediately following the Investment Transaction.

Impacts on Financial Condition and Results of Operations from Purchase Accounting

Because of the high proportion of voting securities in the Company acquired by SB Acquisition, the Investment Transaction is considered an acquisition for accounting purposes and must be accounted for in the financial statements of the acquirer by using “acquisition” or “purchase” accounting. With the purchase accounting pushed down from SB Acquisition to the Company, the Company’s assets and liabilities are reported in the Company’s Consolidated Financial Statements at their fair value at the transaction date. Based on the purchase price of $500 million and the $478.3 million of fair value of net assets acquired, the transaction resulted in initial goodwill of $21.7 million. The methodology used in determining the fair values of each of the major categories of assets and liabilities and the amounts of the adjustments as of the Transaction Date are described in detail in Note 2, “Business Combination – Investment Transaction” of the Consolidated Financial Statements.

The most significant fair value adjustments resulting from the application of the purchase accounting were made to loans. ASC 805 requires that all loans held by the Company on the Transaction Date be recorded at their fair value. Rather than provide an ALLL to recognize the uncertainty of receiving the full amount of the contractual payments from borrowers, as is normally done for loans held for investment, this uncertainty is instead considered in estimating the fair value of the loans. Therefore, stating loans at their fair value results in no ALLL being provided for acquired loans as of the date they are acquired.

At the Transaction Date, loans held by the Bank had shown evidence of credit deterioration since origination, and it was probable that not all contractually required principal and interest payments would be collected. Such impaired loans identified at the time of the acquisition were accounted for using the measurement provision for PCI loans, per ASC 310-30, Receivables, Loans and Debt Securities Acquired with Deteriorated Credit Quality (“ASC 310-30”) herein referred to as “PCI Term Pools.” The special accounting for PCI loans not only requires that they are recorded at fair value at the date of acquisition and that any related ALLL may not be carried forward past the Transaction Date, but it also governs how interest income will be recognized on these loans and how any further deterioration in credit quality after the Transaction Date will be recognized and reported.

Management has elected to have PCI loans aggregated into several pools based on common risk characteristics as allowed under accounting guidance of ASC 310-30. Each pool is accounted for as a single asset with a single composite discount rate and an aggregate expectation of cash flows. Both the accretion of interest income and the comparison of actual cash flows to expected cash flows are completed at the pool level rather than by individual loans. Once loans are placed into pools, the integrity of the pool must be maintained. Therefore, all activity such as payments, charge-offs, recoveries, and prepayments received must be applied to the loan pool in which the loan was placed at the Transaction Date. Payments which are in excess of expectations in one pool may not be applied to other pools to avoid the recognition of impairment for deficient payments within another pool. Loans may not be removed from a pool, added to a pool, or moved from one pool to another. Only the disposal of a loan, which may include sales of loans to third parties, receipt of payments in full or in part by the borrower, foreclosure of the collateral, or charge-off will result in the removal of a loan from a loan pool. When a loan is removed from a pool, it is removed at its carrying amount.

 

42


Quarterly, the Company compares actual cash flows to expected cash flows for PCI Term Pools to determine whether such cash flows are substantially the same as was expected at the time the loan’s expected cash flow were last estimated. A significant decrease in the actual cash flows as compared to expected cash flows may require Management to revise its expectations for future cash flows. If, based on Management’s evaluation, estimates for future cash flows are less than previously expected, the Company may establish an ALLL through a charge to the provision for loan losses. A significant increase in actual cash flows as compared to expected cash flows will first result in the reduction of any allowance that had previously been established for a pool, and then an increase to interest income through the adjustment of the accretable yield.

Some loans that otherwise meet the definition of credit impaired, such as revolving lines of credit, are specifically excluded from the scope of the accounting guidance in ASC 310-30 and are accounted for using ASC 310-20, Receivables, Nonrefundable Fees and Other Costs (“ASC 310-20”) herein will refer to these loans as “PCI Revolving Pools.” PCI Revolving Pools were also required to be fair valued with the application of purchase accounting and were acquired at a discount. Management also considers these revolving lines of credit to be credit impaired and has pooled these revolving lines of credit purchased through the Investment Transaction.

Because PCI loans are written down at acquisition to an amount estimated to be collectible and aggregated into pools, the classification and disclosures are at a pool level regardless of the underlying individual loan performance. Loans within PCI Term Pools are not reported as delinquent, nonaccrual, impaired or troubled debt restructured (“TDRs”), since the pools are evaluated as single units of account, even though some of the underlying loans may be contractually past due, placed on nonaccrual, impaired or TDRs. Loans within PCI Revolving Pools are required by accounting guidance to be reported as delinquent, nonaccrual, impaired or TDRs despite being evaluated as a pool at the Transaction Date.

While the most significant adjustments from purchase accounting related to loans, other balances and results of operations were impacted as well. The effect of the purchase accounting adjustments on these other balances and results of operations are described within each section of this discussion and analysis.

Predecessor Company

Net loss applicable to common shareholders for the eight months ended August 31, 2010, and the twelve months ended December 31, 2009, was $171.8 million or $359.50 per diluted share and $431.3 million or $923.46 per diluted share, respectively.

For the eight months ended August 31, 2010, and for the twelve months ending December 31, 2009, the differences between the net loss applicable to common shareholders and the net loss from continuing operations is attributable to the operating results from the discontinued operations, the accrual of dividends on the Company’s Series B Fixed Rate Cumulative Perpetual Preferred Stock (the “Series B Preferred Stock”) and the accretion of the warrants issued with the Series B Preferred Stock.

The significant factors impacting the Company’s net loss applicable to common shareholders for the eight months ended August 31, 2010, were:

 

  ¡  

Provision for loan losses for continuing operations was $171.6 million for the period compared to $352.4 million for 2009, as the Company began to experience a lower rate of growth in credit problems;

 

  ¡  

The continuing decline in outstanding loan balances due to payments, prepayments, charge-offs, and the Company’s decision to reduce loan originations reduced interest income;

 

  ¡  

The Company’s decision to maintain over $1.0 billion in cash to mitigate uncertainty to depositors generated a significant amount of negative interest spread related to the difference between interest earned on cash balances and interest paid on borrowings;

 

43


  ¡  

The Company sold securities realizing a gain of $5.7 million;

 

  ¡  

Other expense was impacted by the transaction costs to execute the Investment Transaction, including investment banker, attorney, and consulting fees; and

 

  ¡  

The Company sold its RAL and RT Programs in January 2010 for a net gain of $8.2 million.

The impact to the Company from these items will be discussed in more detail throughout the analysis sections of the MD&A section of this Form 10-K.

RESULTS OF OPERATIONS

INTEREST INCOME

The Company’s primary source of revenue is interest income. The discussion below concerning interest income from loans for the various periods presented relate to the Commercial & Community Banking segment, while the discussion below concerning interest income from investment securities, trading assets and other interest income all pertain to the Company’s treasury department activities, and are included in the All Other segment. The Wealth Management segment does not earn interest income. The accounting for interest income for loans and securities is explained in detail in Note 1, “Summary of Significant Accounting Policies” of the Consolidated Financial Statements.

 

44


The following table presents a summary of interest income for the periods indicated:

 

(dollars in thousands)   Successor Company          Predecessor Company  
  Twelve  Months
Ended
December  31,
2011
    Four Months
Ended
December  31,
2010
      Eight  Months
Ended
August  31,
2010
    Twelve  Months
Ended
December  31,
2009
 
         
         
         

Interest income

           

Loans:

           

Commercial

  $ 25,251      $ 7,655          $ 24,034      $ 49,778   

Real estate—commercial

    150,350        46,812            90,159        158,558   

Real estate—residential 1 to 4 family

    59,446        20,860            33,438        62,798   

Consumer loans

    6,006        1,551            18,950        31,923   
 

 

 

   

 

 

       

 

 

   

 

 

 

Total

    241,053        76,878            166,581        303,057   

Investment securities available for sale:

           

U.S. Treasury securities

           3            219        530   

U.S. Agency securities

    1,363        618            5,626        16,362   

Asset-backed securities

    73        81            92        139   

Collateralized mortgage obligations and mortgage-backed securities

    17,922        3,274            6,388        10,937   

State and municipal securities

    8,628        2,896            7,727        14,791   
 

 

 

   

 

 

       

 

 

   

 

 

 

Total

    27,986        6,872            20,052        42,759   

Trading assets

                      143        5,131   

Other

    2,255        990            2,924        2,325   
 

 

 

   

 

 

       

 

 

   

 

 

 

Total interest income

  $ 271,294      $ 84,740          $ 189,700      $ 353,272   
 

 

 

   

 

 

       

 

 

   

 

 

 

Successor Company

Interest income was $271.3 million and $84.7 million for the twelve months ended December 31, 2011, and four months ended December 31, 2010, respectively. Interest income from loans was positively impacted by the application of purchase accounting adjustments, while interest income from securities was negatively impacted.

At the Transaction Date, loans were placed into pools with similar risk characteristics and each pool was fair valued as described in “Financial Highlights of 2010 and 2009” at the beginning of the MD&A and in Note 1, “Summary of Significant Accounting Policies.” Fair value was determined by estimating the principal and interest cash flows expected to be collected after discounting at the prevailing market rate of interest. Interest income is recognized for PCI Term Pools based on the discount rate for each pool over the remaining life of the PCI Loan Pools using the effective interest method. The cash flows for the PCI Term Loans have been performing better than expected and, therefore the majority of the discount rates for PCI Term Pools increased resulting in improved interest income during 2011. For PCI Revolving Pools and loans originated or purchased since the Transaction Date, interest income is being recognized based on the terms of the loans. PCI Revolving Pools were valued at a discount on the Transaction Date. Accounting guidance does not allow the accretion of a discount if such accretion would bring the net carrying amount above the net realizable value. When it is significantly probable the net realizable value of a PCI Revolving Pool is greater than the carrying amount of the pool, the discount will begin to accrete into interest income over the remaining life of the pool using the effective interest method.

In contrast, the fair value at the Transaction Date for the investment securities portfolio was higher than the carrying value and a premium was recognized because market interest rates had declined since most of the securities had been purchased. The premium is amortized against interest income over the terms of the various securities, reducing interest income. During 2011, $549.0 million of

 

45


investment securities were purchased which increased the average balance to $1.37 billion at a rate of 2.04% for the twelve months ended December 31, 2011, from $1.04 billion at a rate of 1.98% for the four months ended December 31, 2010.

Predecessor Company

Interest income for the eight months ended August 31, 2010, was $189.7 million and $353.3 million for the twelve months ended December 31, 2009. Interest income from both loans and securities gradually decreased during the periods as overall interest rates continued to decline and average balances declined. Loan balances were reduced by loan sales and charge-offs. The Company also restricted lending activity to maintain the Company’s capital ratios which resulted in a decline in loan balances as maturing loans were not matched by new originations.

Interest income from trading and available for sale (“AFS”) securities decreased as a result of selling a majority of the trading securities during the third quarter of 2009, and from sales, calls and maturities of securities from the AFS portfolio. During the eight months ended August 31, 2010, and twelve months ended December 31, 2009, $347.0 million and $701.6 million, respectively of investment securities were called or sold. The investment securities called were mostly U.S. Agency securities while investment securities sold were mostly mortgage backed securities (“MBS”). At the same time, the interest rate for some of the adjustable rate investment securities was reduced due to the decrease in long term interest rates. The Company’s decision to maintain a substantial amount of liquidity to mitigate uncertainty to depositors rather than to redeploy these funds into higher yielding assets also contributed to the decline in interest income.

INTEREST EXPENSE

The Company incurs interest expense from interest payments made to depositors and for other borrowings. Interest expense from deposits pertain to the Commercial & Community Banking operating segment, while interest expense from borrowings or debt almost all pertain to the Company’s treasury department related activity and therefore are included in the All Other segment. Wealth Management incurs interest expense only for the capital lease on the building occupied by the Company’s trust department. For more information regarding leases, refer to the section titled “Leases” in Note 1, “Summary of Significant Accounting Policies” of the Consolidated Financial Statements for an explanation of the accounting for a capital lease.

The following table presents a summary of interest expense for the periods indicated:

 

(dollars in thousands)   Successor Company    

 

  Predecessor Company  
  Twelve  Months
Ended
December  31,
2011
    Four Months
Ended
December  31,
2010
      Eight  Months
Ended
August  31,
2010
    Twelve  Months
Ended
December  31,
2009
 
         
         
         

Interest expense

           

Deposits:

           

NOW accounts

  $ 1,636      $ 640          $ 1,702      $ 6,015   

Money market deposit accounts

    1,665        569            1,499        4,932   

Savings deposits

    1,758        612            1,406        2,842   

Time certificates of deposit

    20,251        4,933            41,903        69,840   
 

 

 

   

 

 

   

 

 

 

 

   

 

 

 

Total

    25,310        6,754            46,510        83,629   

Securities sold under agreements to

           

repurchase and Federal funds purchased

    9,585        1,771            5,392        10,127   

Other borrowings:

           

FHLB advances and other long term debt

    8,249        3,680            27,709        58,722   

Other borrowings

    806        363            717        1,163   
 

 

 

   

 

 

   

 

 

 

 

   

 

 

 

Total

    9,055        4,043            28,426        59,885   
 

 

 

   

 

 

   

 

 

 

 

   

 

 

 

Total interest expense

  $ 43,950      $ 12,568          $ 80,328      $ 153,641   
 

 

 

   

 

 

   

 

 

 

 

   

 

 

 

 

46


Successor Company

Each of the categories of interest expense was significantly impacted by the application of purchase accounting adjustments. At the Transaction Date, market interest rates had declined from what they were when a large proportion of the Company’s fixed rate time CDs and repurchase agreements were issued. The decline in interest rates caused the carrying value of these liabilities to decrease and premiums were recognized for these liabilities to record them at their fair value. These premiums are being amortized over the terms of the related liabilities, reducing interest expense since the Transaction Date. During 2011, the average balance of interest-bearing deposits declined $413.0 million due to maturing client and broker CDs which originally had high interest rates but, due to the amortization of the premium from the purchase accounting adjustments, interest expense was reduced to market interest rates. As the amortization of the premium decreases, new CDs are originated at interest rates above the purchased accounting adjusted interest rates, increasing the average interest rate for deposits to 71 basis points for the twelve month period ended December 31, 2011, compared to 51 basis points for the four month period ended December 31, 2010.

For the twelve months ended December 31, 2011, the average balance of other borrowings decreased to $108.8 million from $145.6 million for the four months ended December 31, 2010. This decrease is attributable to the maturity and redemption of $53.0 million of subordinated debt during 2011. At December 31, 2011, there are no borrowings outstanding with the FHLB since all of borrowings from the FHLB were either prepaid in September 2010, or matured in the fourth quarter of 2010. The Investment Transaction provided excess liquidity which enabled the Company to reduce outstanding debt in 2010, and reduce future borrowing expense. The Company also repurchased $68.0 million of its subordinated debt at the Transaction Date contributing further to the year over year decline in interest expense. The remaining subordinated debt and the Company’s trust preferred securities had a fair value less than their face values resulting in accretable discounts, which has increased interest expense since the Transaction Date.

The securities sold under agreements to repurchase had a fair value in excess of their principal amount resulting in a premium; the amortization of which reduced interest expense to less than the amount paid to creditors. Despite the market trend of declining interest rates, the average rates on repurchase agreements increased due to the change in the interest rates for a $100.0 million repurchase agreement from a floating rate of 3 month London Inter-Bank Offered Rate (“LIBOR”) less 25 basis points to a fixed rate of 4.12%. This interest rate reset occurred in February 2011.

Predecessor Company

Interest expense for the eight months ended August 31, 2010, was substantially lower than the twelve months ended December 31, 2009, as more of the Company’s fixed rate liabilities, CDs and FHLB advances, matured. They were replaced by liabilities that were priced at lower current market rates.

NET INTEREST MARGIN

An important measure of a financial institution’s earning capacity is its net interest margin. This measure is computed by dividing the difference between interest income and interest expense, or net interest income, by average earning assets. As a financial intermediary, a bank earns money by borrowing from depositors and debt-holders and lending some of those funds to loan clients and by purchasing investments. By combining the average yield earned on interest earning assets with the average interest cost to hold those assets, the net interest margin measures both the institution’s ability to earn its desired yield on its assets and its efficiency in obtaining the funding that supports those assets. The net interest margin differs from, and is lower than the net interest spread, which is the difference between the average yield earned on interest bearing assets and the average rate paid on interest bearing liabilities, because a portion of the Company’s interest earning assets are funded by noninterest bearing liabilities.

 

47


The net interest margin is improved by higher yields earned on interest earning assets, lower rates paid on interest bearing liabilities, funding a larger proportion of earning assets with noninterest bearing liabilities, and by lowering the amount of nonearning assets that must be funded. Yields earned on assets and paid on liabilities tend to move in tandem with each other as the market interest rate environment changes, but it is generally harder to improve the net interest margin in a low interest rate environment because there is a point beyond which deposit rates cannot be reduced, and still retain clients, while yields on assets may continue to decline. Conversely, as market interest rates rise, deposit rates will generally not rise as fast or as much and the net interest margin may thereby be improved.

The following tables set forth average balances, interest income and interest expense for the twelve months ended December 31, 2011, the four months ended December 31, 2010, the eight months ended August 31, 2010, and for the twelve months ended December 31, 2009.

 

    Successor Company  
    For the Twelve Months Ended
December 31, 2011
 
    Average
Balance
    Interest/
Expense (3)
     Yield/
Rate (3)
 
    (dollars in thousands)  

Assets

      

Interest bearing demand deposits in other financial institutions

  $ 322,830      $ 771         0.24

Securities:

      

Investment securities available for sale:

      

Taxable

    1,163,380        19,358         1.66

Non taxable

    203,877        8,628         4.23
 

 

 

   

 

 

    

 

 

 

Total securities

    1,367,257        27,986         2.04

Loans: (1)

      

Commercial

    239,803        25,251         10.53

Real estate—commercial (2)

    2,199,472        150,350         6.84

Real estate—residential 1 to 4 family

    1,187,783        59,446         5.00

Consumer loans

    58,104        6,006         10.34
 

 

 

   

 

 

    

 

 

 

Total loans, gross

    3,685,162        241,053         6.54

Other interest earning assets

    81,716        1,484         1.82
 

 

 

   

 

 

    

 

 

 

Total interest earning assets

    5,456,965        271,294         4.97

Noninterest earning assets

    439,400        
 

 

 

      

Total assets

  $ 5,896,365        
 

 

 

      

Liabilities and shareholders’ equity

      

Interest bearing deposits:

      

Savings and interest bearing transaction accounts

  $ 1,759,912        5,059         0.29

Time certificates of deposit

    1,812,543        20,251         1.12
 

 

 

   

 

 

    

 

 

 

Total interest bearing deposits

    3,572,455        25,310         0.71

Borrowed funds:

      

Securities sold under agreements to repurchase

    319,088        9,585         3.00

Other borrowings

    108,838        9,055         8.32
 

 

 

   

 

 

    

 

 

 

Total borrowed funds

    427,926        18,640         4.35
 

 

 

   

 

 

    

 

 

 

Total interest bearing liabilities

    4,000,381        43,950         1.10

Noninterest bearing demand deposits

    1,101,214        

Other noninterest bearing liabilities

    87,494        

Shareholders’ equity

    707,276        
 

 

 

      

Total liabilities and shareholders’ equity

  $ 5,896,365        
 

 

 

      

 

 

 

Net interest spread

         3.87
   

 

 

    

 

 

 

Net interest income/margin

    $ 227,344         4.17
   

 

 

    

 

 

 

 

(1)

Nonaccrual loans are included in loan balances. Interest income includes related net deferred fee income.

(2)

Commercial real estate loans include multifamily residential real estate loans.

(3)

Includes impact of accretion or amortization of discounts and premiums.

 

48


    Successor Company          Predecessor Company  
    For the Four Months Ended
December 31, 2010
         For the Eight Months Ended
August 31, 2010
 
    Average
Balance
    Interest/
Expense (3)
    Yield/
Rate (3)
         Average
Balance
    Interest/
Expense (3)
    Yield/
Rate (3)
 
(dollars in thousands)                                         

Assets

               

Interest bearing demand deposits in other financial institutions

  $ 740,199      $ 599        0.24       $ 1,030,268      $ 2,241        0.33

Securities:

               

Trading assets

                          4,998        143        4.30

Investment securities available for sale:

               

Taxable

    825,991        3,976        1.44         737,155        12,325        2.51

Non taxable

    214,987        2,896        4.04         238,375        7,727        4.86
 

 

 

   

 

 

   

 

 

       

 

 

   

 

 

   

 

 

 

Total securities

    1,040,978        6,872        1.98         980,528        20,195        3.09

Loans: (1)

               

Commercial

    502,178        7,655        4.56         820,380        24,034        4.40

Real estate—commercial (2)

    2,114,524        46,812        6.64         2,511,673        90,159        5.38

Real estate—residential 1 to 4 family

    1,202,298        20,860        5.21         935,245        33,438        5.36

Consumer loans

    80,345        1,551        5.78         574,519        18,950        4.95
 

 

 

   

 

 

   

 

 

       

 

 

   

 

 

   

 

 

 

Total loans, gross

    3,899,345        76,878        5.91         4,841,817        166,581        5.16

Other interest earning assets

    81,636        391        1.43         83,364        683        1.23
 

 

 

   

 

 

   

 

 

       

 

 

   

 

 

   

 

 

 

Total interest earning assets

    5,762,158        84,740        4.41         6,935,977        189,700        4.10

Noninterest earning assets

    520,811                216,057       

Total assets from discontinued operations

                   225,897       
 

 

 

           

 

 

     

Total assets

  $ 6,282,969              $ 7,377,931       
 

 

 

           

 

 

     

Liabilities and shareholders’ equity

               

Interest bearing deposits:

               

Savings and interest bearing transaction accounts

  $ 1,605,435        1,821        0.34       $ 1,591,632        4,607        0.43

Time certificates of deposit

    2,379,972        4,933        0.62         2,706,043        41,903        2.33
 

 

 

   

 

 

   

 

 

       

 

 

   

 

 

   

 

 

 

Total interest bearing deposits

    3,985,407        6,754        0.51         4,297,675        46,510        1.63

Borrowed funds:

               

Securities sold under agreements to repurchase

    325,442        1,771        1.63         314,009        5,392        2.58

Other borrowings

    145,611        4,043        8.31         1,127,676        28,426        3.79
 

 

 

   

 

 

   

 

 

       

 

 

   

 

 

   

 

 

 

Total borrowed funds

    471,053        5,814        3.69         1,441,685        33,818        3.53
 

 

 

   

 

 

   

 

 

       

 

 

   

 

 

   

 

 

 

Total interest bearing liabilities

    4,456,460        12,568        0.85         5,739,360        80,328        2.11

Noninterest bearing demand deposits

    1,112,944                1,020,775       

Other noninterest bearing liabilities

    109,607                103,257       

Total liabilities from discontinued operations

                   225,897       

Shareholders’ equity

    603,958                288,642       
 

 

 

           

 

 

     

Total liabilities and shareholders’ equity

  $ 6,282,969              $ 7,377,931       
 

 

 

     

 

 

       

 

 

     

 

 

 

Net interest spread

        3.56             1.99
   

 

 

   

 

 

         

 

 

   

 

 

 

Net interest income/margin

    $ 72,172        3.75         $ 109,372        2.37
   

 

 

   

 

 

         

 

 

   

 

 

 

 

(1)

Nonaccrual loans are included in loan balances. Interest income includes related net deferred fee income.

(2)

Commercial real estate loans include multifamily residential real estate loans.

(3)

Includes impact of accretion or amortization of discounts and premiums.

 

49


    Predecessor Company  
    For the Twelve Months Ended
December 31, 2009
 
    Average
Balance
    Interest/
Expense (3)
     Yield/
Rate (3)
 
    (dollars in thousands)  

Assets

      

Interest bearing demand deposits in other financial institutions

  $ 603,223      $ 1,635         0.27

Federal funds sold

    329        1         0.30

Securities:

      

Trading assets

    106,623        5,131         4.81

Investment securities available for sale:

      

Taxable

    854,005        27,968         3.27

Non taxable

    306,547        14,791         4.83
 

 

 

   

 

 

    

 

 

 

Total securities

    1,267,175        47,890         3.78

Loans: (1)

      

Commercial

    1,088,847        49,778         4.57

Real estate—commercial (2)

    2,785,416        158,558         5.69

Real estate—residential 1 to 4 family

    1,086,122        62,798         5.78

Consumer loans

    632,350        31,923         5.05
 

 

 

   

 

 

    

 

 

 

Total loans, gross

    5,592,735        303,057         5.42

Other interest earning assets

    80,382        689         0.86
 

 

 

   

 

 

    

 

 

 

Total interest earning assets

    7,543,844        353,272         4.68

Noninterest earning assets

    381,358        

Total assets from discontinued operations

    668,428        
 

 

 

      

Total assets

  $ 8,593,630        
 

 

 

      

Liabilities and shareholders’ equity

      

Interest bearing deposits:

      

Savings and interest bearing transaction accounts

  $ 1,849,045        13,788         0.75

Time certificates of deposit

    2,580,600        69,841         2.71
 

 

 

   

 

 

    

 

 

 

Total interest bearing deposits

    4,429,645        83,629         1.89

Borrowed funds:

      

Securities sold under agreements to repurchase and Federal funds purchased

    336,434        10,127         3.01

Other borrowings

    1,441,866        59,885         4.15
 

 

 

   

 

 

    

 

 

 

Total borrowed funds

    1,778,300        70,012         3.93
 

 

 

   

 

 

    

 

 

 

Total interest bearing liabilities

    6,207,945        153,641         2.47

Noninterest bearing demand deposits

    1,003,647        

Other noninterest bearing liabilities

    113,612        

Total liabilities from discontinued operations

    668,428        

Shareholders’ equity

    599,998        
 

 

 

      

Total liabilities and shareholders’ equity

  $ 8,593,630        
 

 

 

      

 

 

 

Net interest spread

         2.21
   

 

 

    

 

 

 

Net interest income/margin

    $ 199,631         2.65
   

 

 

    

 

 

 

 

(1)

Nonaccrual loans are included in loan balances. Interest income includes related net deferred fee income.

(2)

Commercial real estate loans include multifamily residential real estate loans.

(3)

Includes impact of accretion or amortization of discounts and premiums.

 

50


The impacts from changes in interest rates and from the purchase accounting adjustments on interest income and interest expense during these periods are discussed above under “Interest Income,” and “Interest Expense” of this discussion and analysis. The net interest margin is usually adversely impacted by nonperforming loans, with the exception of PCI Term Pools, because the Company generally ceases the accrual of interest on nonperforming loans, while those balances continue to be included in the average balances for loans. Interest income recognized on PCI Term Pools is based on an expected cash flows model; therefore regardless of the performance classification of individual loans within these pools, the Company recognizes accretion based on expectations of future cash flows, and whether or not those cash flows can be reasonably estimated.

Successor Company

The net interest margin was impacted during 2011, primarily by higher yields on interest earning assets, driven in part by increased yields on PCI Term Pools and from additional purchases of investment securities, as the Company made efforts to further deploy additional liquidity. Interest bearing liabilities were positively impacted by higher rate deposits maturing.

Rate and volume variance analyses allocate the change in interest income and expense between the portions which are due to changes in the yield earned or rate paid for specific categories of assets and liabilities and the portion which is due to changes in the average balance between the two periods. The Company is unable to provide a rate and volume variance for 2011, and 2010, because these periods are not comparable as a result of purchase accounting requirements as explained at the beginning of this discussion.

PROVISION FOR LOAN LOSSES

Quarterly, the Company determines the amount of ALLL that is adequate to provide for losses inherent in the Company’s loan portfolio. The provision for loan losses is determined by the net change in the ALLL from one period to another for loans originated or purchased since the Transaction Date. The Company may establish an additional ALLL for PCI Term Pools through a charge to the provision for loan losses when impairment is determined due to lower than expected cash flows. If, through the Company’s quarterly evaluation of expected cash flows, it determines there has been a significant and probable increase in expected cash flows, the Company may reverse any previously established allowance for PCI Term Pools through an adjustment to the provision for loan losses, to the extent that any previous allowance has been established.

For PCI Revolving Pools, quarterly the Company evaluates credit performance to determine if there has been a further deterioration in the credit quality of the underlying loans beyond the purchase discount. To the extent that the credit performance is worse than previously expected, the Company may establish an allowance for PCI Revolving Pools through a provision for loan losses. If credit performance is better than previously expected, the Company may begin to accrete the purchase discount for PCI Revolving Pools into interest income. Since the Transaction Date, the Company has not established an allowance for PCI Revolving Pools, nor did the Company accrete any portion of the purchase discount.

For a detailed discussion of the Company’s ALLL, refer to the Allowance for Loan and Lease Loss section of this document, the “Critical Accounting Policies” section starting on page 83 of the MD&A, Note 1, “Summary of Significant Accounting Policies,” and Note 7, “Allowance for Loan and Lease Losses” within the Consolidated Financial Statements of this Form 10-K. All of the provision for loan losses is reported in the Commercial & Community Banking operating segment.

 

51


A summary of the provision for loan losses is as follows:

 

     Successor Company           Predecessor Company  
(dollars in thousands)    Twelve Months
Ended
December 31,
2011
     Four Months
Ended
December 31,
2010
          Eight Months
Ended
August 31,
2010
     Twelve Months
Ended
December 31,
2009
 

Provision for loan losses

   $ 5,555       $ 590           $ 171,583       $ 352,398   

Successor Company

The provision for loan losses was $5.6 million and $590,000 for the twelve months ended December 31, 2011, and for the four months ended December 31, 2010, respectively. The increase in the provision for loan losses was mostly attributable to the origination of new loans and loan purchases. During 2011, the Company originated new loans with a carrying value of $273.0 million at December 31, 2011, and purchased loans with a carrying value of $315.0 million. In addition, as part of the Company’s quarterly assessment of expected cash flows for PCI Term Pools, an allowance of $867,000 was established for one of the PCI Term Pools which had re-forecasted cash flows below previous expectations.

The provision for loan losses was significantly impacted by purchase accounting adjustments. As a result of the Investment Transaction and the application of the accounting guidance for business combinations, the ALLL for the loans purchased was required to be eliminated and the purchased loans were recorded at their fair value at the Transaction Date as described in Note 1, “Summary of Significant Accounting Policies” of the Consolidated Financial Statements. Consequently, no ALLL is provided for PCI Loan Pools at the Transaction Date. The provision for loan losses for the four months ended December 31, 2010, of $590,000 related to newly originated loans during the period following the Investment Transaction, with a carrying balance of $16.4 million as of December 31, 2010.

Predecessor Company

Provision for loan losses for the eight months ended August 31, 2010 and twelve months ended December 31, 2009 was $171.6 million and $352.4 million, respectively. The decrease in the provision for loan losses relates to reduction in outstanding balance of loans resulting from a reduction in loan originations and the high level of charge-offs in the prior year as well as a slowdown in rate of credit deterioration of the overall loan portfolio.

The increase in the provision for loan losses for 2009, reflects the impact from the change in the ALLL model methodology.

NONINTEREST INCOME

Noninterest income primarily consists of fee income received from the operations of the Bank and gains or losses from sales of assets. Fee income is generated by servicing deposit relationships, trust and investment advisory fees, and fees and commissions earned on certain transactions from Bank operations. The service charges and fees and gains and losses on asset sales relate to the Community & Commercial Banking segment while the trust and investment advisory fees are from the Wealth Management segment. Gains and losses from the sales of securities are from the treasury department’s management of the investment securities and is reflected in the All Other segment.

 

52


The following table presents a summary of noninterest income for the periods presented.

 

     Successor Company           Predecessor Company  
(dollars in thousands)    Twelve Months
Ended
December 31,
2011
    Four Months
Ended
December 31,
2010
          Eight Months
Ended
August 31,
2010
     Twelve Months
Ended
December 31,
2009
 

Noninterest income

              

Service charges and fees

   $ 23,583      $ 7,579           $ 14,901       $ 24,884   

Trust and investment advisory fees

     21,014        6,743             14,035         21,247   

(Loss)/gain on securities, net

     (251     (32          5,667         10,970   

Other

     6,472        5,782             1,194         460   
  

 

 

   

 

 

        

 

 

    

 

 

 

Total noninterest income

   $ 50,818      $ 20,072           $ 35,797       $ 57,561   
  

 

 

   

 

 

        

 

 

    

 

 

 

Successor Company

Noninterest income was $50.8 million for the twelve months ended December 31, 2011, and $20.1 million for the four months ended December 31, 2010. The largest portions of noninterest income are from service charges and fees and trust and investment advisory fees. Service charges and fees consist of service charges on deposit and loan accounts. These fees are generated from the Commercial & Community Banking segment. For the twelve and four month periods ended December 31, 2011, and December 31, 2010, service charges and fees from deposit accounts were $13.1 million and $4.0 million, respectively. Other service charges and fees include charges for a wide range of services provided to clients such as ATMs, safe deposit boxes, bank card fees, loan servicing fees, late charges for loans and wire transfer fees. These fees have remained relatively steady during the reported periods.

Trust and investment advisory fees are primarily from the management of client’s assets and are included in the Wealth Management segment. As the balance and the value of the assets increase, fees increase. In the latter part of 2011, assets under management increased as new client accounts were opened and the overall values of assets under management increased.

There was little or no effect on the components of noninterest income resulting from purchase accounting for the Investment Transaction, except for the gain or loss on securities. In accordance with GAAP, AFS securities were already reported at fair value before the Investment Transaction, the excess of fair value over the amortized cost having been previously recognized in Other Comprehensive Income (“OCI”) as an unrealized gain net of tax. With the elimination of OCI as of the Transaction Date, this gain has effectively been realized in the form of a premium which is amortized as a reduction of interest income. Consequently, any sales after the Transaction Date of securities that were held in the portfolio at the Transaction Date will result in a smaller gain or a larger loss because of the increased basis from the purchase accounting adjustment. As the premiums are amortized over the remaining lives of the securities, the impact of the increased basis will be less.

Predecessor Company

The largest portion of service charges and fees consists of service charges on deposit accounts. For the eight month period ended August 31, 2010, and the twelve month period ended December 31, 2009, service charges on deposits were $9.1 million and $15.3 million, respectively. The declining trend in service charges over the respective periods related primarily to the increase in waivers of such fees in order to retain clients as the financial condition of the Company deteriorated.

For the eight months ended August 31, 2010, the Company recognized a net gain on securities of $5.7 million. This amount resulted primarily from a $4.5 million gain on the sale of $48.6 million of MBS

 

53


and municipal securities and the call of $143.2 million of U.S. Agency and municipal securities from the AFS portfolio during the first quarter of 2010. For the twelve months ended December 31, 2009, there was a net gain on securities of $11.0 million, primarily resulting from the sale of U.S. Agency securities and municipal securities during the fourth quarter of 2009 in which gains of $3.9 million and $6.9 million were realized, respectively. Additional discussion regarding the activity in the investment securities portfolio is disclosed in the “Investment Securities” section of the MD&A and in Note 4, “Investment Securities” of the Consolidated Financial Statements.

Other Noninterest Income

The table below discloses the largest items included in other noninterest income.

 

     Successor Company           Predecessor Company  
(dollars in thousands)    Twelve Months
Ended
December 31,
2011
    Four Months
Ended
December 31,
2010
          Eight Months
Ended
August 31,
2010
    Twelve Months
Ended
December 31,
2009
 

Other Income:

             

Life insurance income (1)

   $ 2,798      $ 967           $ 2,074      $ 3,154   

Gain/(loss) on asset sales (2)

     775        4,598             1,188        (4,814

Net loss on LIHTCP (3)

     (2,846     (1,554          (4,416     (3,680

Other

     5,745        1,771             2,348        5,800   
  

 

 

   

 

 

        

 

 

   

 

 

 

Total

   $ 6,472      $ 5,782           $ 1,194      $ 460   
  

 

 

   

 

 

        

 

 

   

 

 

 

 

(1)

Derived from increase in cash surrender value of insurance policies.

(2)

Represents gains/losses from loan sales and OREO sales and valuation.

(3)

Losses derived from LIHTCP sales and operations.

Successor Company

Other noninterest income was $6.5 million and $5.8 million for the twelve months ended December 31, 2011, and for the four months ended December 31, 2010, respectively. The decrease in other noninterest income for the twelve months ended December 31, 2011, was primarily attributable the decrease in gain on asset sales. For the twelve months ended December 31, 2011, gain on sale of loans was $1.1 million, gain on sale of LIHTCPs of $962,000 and a net loss on other real estate owned (“OREO”) activity of $205,000. For the four months ended December 31, 2010, gains from the sale of loans was $1.6 million and a net gain from OREO activity of $3.0 million was recorded. Gains or losses on securities, life insurance income, and monthly losses from the Bank’s investment in LIHTCP are recorded in the All Other segment.

 

54


NONINTEREST EXPENSE

The following table presents a summary of noninterest expense for the periods presented.

 

     Successor Company            Predecessor Company  
(dollars in thousands)    Twelve Months
Ended
December 31,
2011
     Four Months
Ended
December 31,
2010
           Eight Months
Ended
August 31,
2010
     Twelve Months
Ended
December 31,
2009
 

Noninterest expense

                

Salaries and employee benefits

   $ 97,042       $ 28,128            $ 58,816       $ 103,228   

Net occupancy expense

     23,011         7,711              15,494         26,214   

Goodwill impairment

                                  128,710   

Other

     82,506         30,045              75,653         122,089   
  

 

 

    

 

 

         

 

 

    

 

 

 

Total noninterest expense

   $ 202,559       $ 65,884            $ 149,963       $ 380,241   
  

 

 

    

 

 

         

 

 

    

 

 

 

Successor Company

Salaries and benefits were not impacted by any of the purchase accounting adjustments from the Investment Transaction but has increased as the Company hired additional staff to support the enhancement of the Company’s operating platform and to support the anticipated growth in 2012.

Net occupancy expense for the twelve months and four months ended December 31, 2011, and 2010, was impacted by purchase accounting resulting in decreased lease expense and increased depreciation expense on owned buildings. The Company had entered into long term leases when the economy was stronger and demand was higher for commercial space. These lease payments are higher than current market rates. The revaluation of the leases resulted in the recognition of a liability for unfavorable lease payments. This amount is amortized as a reduction of lease expense over the contractual lease terms. The fair value of the Company’s owned properties was higher than the amortized cost as of the Transaction Date because these buildings were acquired many years ago when commercial properties had lower prices.

Predecessor Company

The Company significantly scaled back lending activities and sold businesses to respond to a significant reduction in net revenues and capital due to the economic slowdown and the related deterioration of credit quality of its loan portfolio. Accordingly, salaries and benefits continued to trend lower as the Company reduced staff through lay-offs and hiring freezes, and reduced the benefits, and bonuses for employees. Net occupancy expense also declined in the first eight months of 2010, from 2009, as the Company consolidated locations to reduce overall expenses.

In the second quarter of 2009, Management concluded that the entire balance of goodwill for all reporting units was impaired and recorded a $128.7 million impairment charge. The impairment of goodwill occurred due to the increasingly uncertain economic environment, significant continued decline in the Company’s market capitalization, and continued elevated credit losses. Additional information regarding the determination to impair the Company’s goodwill is in Note 9, “Goodwill and Intangible Assets” of the Consolidated Financial Statements.

 

55


Other Noninterest Expense

The table below summarizes the significant items included in other noninterest expense from continuing operations.

 

     Successor Company            Predecessor Company  
(dollars in thousands)    Twelve Months
Ended
December 31,
2011
    Four Months
Ended
December 31,
2010
           Eight Months
Ended
August 31,
2010
     Twelve Months
Ended
December 31,
2009
 

Other Expense:

               

Professional services

   $ 14,472      $ 4,633            $ 10,782       $ 22,882   

Regulatory assessments

     11,962        6,305              13,094         18,988   

Other intangible expense

     8,580        2,982              621         1,184   

Software expense

     7,361        3,876              8,660         15,383   

Customer deposit service and support

     6,777        2,344              4,961         8,271   

Furniture, fixtures and equipment, net

     4,954        1,344              3,488         7,147   

Acceleration of discount on redemption of subordinated debt

     4,741                               

Loan servicing expense

     4,343        1,970              2,369         5,526   

Earnout liability

     3,917                               

Supplies and postage

     3,747        1,344              2,740         5,135   

Telephone and data

     3,058        889              2,288         4,380   

Marketing

     2,785        1,181              1,349         3,096   

Other real estate owned expense

     2,402        1,566              2,643         1,884   

FHLB advance prepayment penalties

                         864         3,798   

LIHTCP impairment

                                 8,958   

Ford investment transaction expense

                         13,063           

Reserve for off-balance sheet commitments

     (2,847     32              1,886         8,245   

Other

     6,254        1,579              6,845         7,212   
  

 

 

   

 

 

         

 

 

    

 

 

 

Total

   $ 82,506      $ 30,045            $ 75,653       $ 122,089   
  

 

 

   

 

 

         

 

 

    

 

 

 

Successor Company

Other noninterest expense decreased when comparing the twelve months ended December 31, 2011 to the annualized four months ended December 31, 2010. This decrease is mostly attributable to a decrease in regulatory assessments due to the Bank’s improved financial condition. Also contributing to the decrease in other noninterest expense was a reduction in the reserve for off-balance sheet commitments related to a decrease in unfunded loan commitments, reduced loan servicing expense, telephone and data expense and OREO expense. These decreases were offset by a one-time, non-cash charge of $4.7 million related to the early redemption of $35.0 million of subordinated debt and a $3.9 million increase in the estimated earnout liability associated with the final payments for the purchase of the Bank’s two registered investment advisors.

 

56


PROVISION FOR INCOME TAXES

The benefit for income taxes were as follows:

 

     Successor Company      Predecessor Company  
(dollars in thousands)    Twelve
Months
Ended
December 31,
2011
    Four
Months
Ended
December 31,
2010
     Eight
Months
Ended
August 31,
2010
    Twelve
Months
Ended
December 31,
2009
 

Total tax benefit on continuing operations

   $ (474   $  —       $ (4,741   $ (18,823

Successor Company

As required by GAAP, the Company uses the asset and liability method for reporting its income tax provision expense or benefit. Under this method, income tax expense is recorded for events that increase the Company’s tax liabilities and benefit is recorded for events that decrease them. The primary impact for income tax expense is the Company’s annual taxable income or loss. There are also items within income and expense that, due to tax regulations, are recognized in different periods for tax return purposes than for financial reporting purposes. These items, which are defined in terms of assets or liabilities having different bases for income tax and financial reporting, represent “temporary differences.” The Company is required to provide in its financial statements for the eventual liability or deduction in its tax return for these temporary differences until the item of income or expense has been recognized for financial reporting and for taxes resulting in the basis being the same for both. The provision is recorded in the form of deferred tax expense or benefit as the temporary basis differences arise, with the accumulated amount recognized as a deferred tax liability or asset. Deferred tax assets represent future deductions in the Company’s income tax return, while deferred tax liabilities represent future payments to tax authorities.

The most significant deferred tax asset relates to the valuation of loans and the ALLL. For tax purposes, the purchase accounting valuation adjustment is not recognized. Also, since the loan loss provision expense is deductible for income taxes only to the extent a bank has actually had to charge-off its loans, most banks have significant deferred tax assets. There is a lower basis in loans for financial reporting because the basis of the loans has effectively been partially written down by the amount of the provision expense. If a loan is charged-off, the income tax basis will be lowered to equal the financial reporting basis and a tax deduction will be taken. If the loan is instead repaid, the basis for financial reporting will be written up to the income tax basis through a reduction in provision for loan losses and the deferred tax asset will be reduced because there will not be future tax deductions for a loss.

As a result of the Investment Transaction, the Company incurred an ownership change under Section 382 of the Internal Revenue Code. The ownership change may limit the amount of certain items of the net deferred tax asset including net operating losses and credit carryforwards.

Management’s determination of the realization of net deferred tax assets is based upon Management’s judgment of various future events and uncertainties, including the timing and amount of future income, as well as the implementation of various tax planning strategies to maximize realization of the deferred tax assets. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. The Company currently has a valuation allowance of $248.3 million against net deferred tax assets of $249.8 million (excluding the deferred tax liability related to the indefinite-lived trade name intangible of $5.2 million). Management continues to assess the impact of the Company’s performance and the economic climate on the realizability of its deferred

 

57


tax asset on a quarterly basis. The amount of deferred tax assets considered realizable is subject to adjustment in future periods. Management will continue to monitor all available evidence related to the Company’s ability to utilize its deferred tax assets. The income tax expense or benefit in future periods will be reduced or increased to the extent of offsetting decreases or increases to the deferred tax asset valuation allowance.

The $474,000 tax benefit for the twelve months ended December 31, 2011, primarily consists of; (1) a current state tax expense of $1.6 million related to the pre-tax income of $70.0 million offset by a release of the valuation allowance of $1.5 million, and (2) a tax benefit of $604,000 for favorable settlements with state tax authorities concerning prior amended tax returns and carryback claims.

Predecessor Company

In the second quarter of 2009, the Company determined that the only tax benefits that were more likely-than-not to be realized were those that could be carried back against the income taxes paid for prior years. Consequently, at June 30, 2009, a valuation allowance was established through a noncash charge offsetting the entire net deferred tax asset, the realization of which was not assured through a carryback of losses against taxes already paid. The $18.8 million tax benefit for the twelve months ended December 31, 2009, primarily consist of; (1) a tax benefit of $159.1 million related to the pre-tax loss of $475.4 million offset by a valuation allowance of $133.6 million, (2) the creation of a valuation allowance of $10.8 million relating to existing deferred balances and (3) a tax benefit of $4.1 million for amended tax returns filed for tax years 2005 through 2007.

The Company still had a valuation allowance substantially offsetting its deferred tax assets, but the deferred tax asset decreased in the eight months ended August 31, 2010. One component of the deferred tax asset is the temporary difference related to unrealized gains and losses on AFS securities. As disclosed in Note 4, “Investment Securities” of the Consolidated Financial Statements, as interest rates decreased during 2010, unrealized gains increased and unrealized losses decreased. The tax effect of these changes is to increase the deferred tax liability or decrease the deferred tax asset. With these changes the valuation allowance needed to be reduced so as not to exceed the net deferred tax asset related to the AFS securities. This reduction of the valuation allowance was recorded through the income tax benefit for the eight months ended August 31, 2010. There was also an adjustment to the deferred tax asset and valuation allowance as the Company changed its estimate of the amount of past taxes it could claim through carryback.

For additional information related to the Company’s provision for income taxes, refer to Note 11, “Deferred Tax Asset and Tax Provision” of the Consolidated Financial Statements and the discussion of income taxes and deferred tax assets in the “Critical Accounting Policies” section of this Form 10-K.

BALANCE SHEET ANALYSIS

CASH AND CASH EQUIVALENTS

Successor Company

The Company’s cash and cash equivalents decreased by $273.1 million or 55.1% since December 31, 2010, to $222.7 million at December 31, 2011. The decrease in cash and cash equivalents was primarily due to the purchase of $315.0 million of loans, the purchase of $549.0 million of investment securities, and the repayment of $53.0 million of long term subordinated debt during the twelve months ended December 31, 2011. These were offset by $365.8 million from the sale, call, maturity, and principle pay-downs of investment securities, a decrease of deposits of $289.7 million due to the maturity of high interest rate client and broker CDs, and by a payment from the Internal Revenue Service (“IRS”) of $50.1 million for a tax receivable related to the re-filing of previous years tax returns.

 

58


INVESTMENT SECURITIES

The Company’s security portfolio is utilized as collateral for borrowings, required collateral for public agencies and trust clients deposits, CRA support, and to manage liquidity, capital and interest rate risk.

At December 31, 2011, 2010, and 2009, the Company held the following investment securities.

 

     Successor
Company
          Predecessor
Company
 
     December 31,      December 31,           December 31,  
(dollars in thousands)    2011      2010           2009  

Trading:

            

Mortgage-backed securities

   $       $           $ 5,403   
  

 

 

    

 

 

        

 

 

 

Total trading securities

                         5,403   
 

Available for sale:

            

U.S. Treasury securities

                         11,432   

U.S. Agency securities

     114,906         268,443             607,930   

Mortgage-backed securities

     237,044         197,912             169,058   

Collateralized mortgage obligations

     938,964         608,425             113,934   

Asset-backed securities

             1,754             1,271   

State and municipal securities

     212,511         201,566             250,062   
  

 

 

    

 

 

        

 

 

 

Total available for sale securities

     1,503,425         1,278,100             1,153,687   
  

 

 

    

 

 

        

 

 

 

Total securities

   $ 1,503,425       $ 1,278,100           $ 1,159,090   
  

 

 

    

 

 

        

 

 

 

Successor Company

Trading securities

In the revaluation conducted for the Investment Transaction, the Company eliminated the trading portfolio, since there were no immediate plans to sell these securities. Because trading securities are always carried at their fair value with any offsetting changes recorded already to income, no purchase adjustment was necessary in the revaluation.

Available for sale securities

The balance of AFS securities was $1.50 billion and $1.28 billion at December 31, 2011, and December 31, 2010, respectively. The increase of $225.3 million is attributable primarily to the purchase of $477.6 million of Collateralized Mortgage Obligation (“CMO”) securities, offset by $161.9 million of principal payments on CMO securities, and the maturity of $90.0 million of U.S. Agency securities.

 

59


The table below summarizes the maturity distribution of the securities portfolio at December 31, 2011.

 

     Successor Company  
     December 31, 2011  
     One year
or less
    After one
year to five
years
    After five
years to
ten years
    After
ten years
    Total  
     (dollars in thousands)  

Maturity distribution:

  

Available for sale:

          

U.S. Agency securities

   $ 76,241      $ 38,665      $      $      $ 114,906   

Mortgage-backed securities and collateralized mortgage obligations

     2,286        1,011,235        145,526        16,961        1,176,008   

State and municipal securities

     5,366        22,479        49,224        135,442        212,511   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total securities

   $ 83,893      $ 1,072,379      $ 194,750      $ 152,403      $ 1,503,425   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average yield:

          

Available for sale:

          

U.S. Agency securities

     0.81     0.96                   0.86

Mortgage-backed securities and collateralized mortgage obligations

     1.13     1.73     2.84     3.14     1.89

State and municipal securities

     1.39     2.00     3.74     4.65     4.08
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Overall weighted average

     0.86     1.71     3.07     4.48     2.12
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The timing of the payments for MBS and CMO securities in the above table is based on the contractual terms of the underlying loans adjusted for estimated prepayments. Issuers of certain investment securities have retained the right to call these securities before contractual maturity.

For additional information on impairment of investment securities and credit ratings of investment securities refer to Note 4, “Investment Securities” of the Consolidated Financial Statements.

LOAN PORTFOLIO

The Company offers a full range of lending products and banking services to households, professionals, and businesses, including commercial and residential real estate loans, commercial and industrial loans, and consumer loans. All assets, income, and expenses related to these activities are reported in the Commercial & Community Banking operating segment.

 

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The table below summarizes the distribution of the carrying value of the Company’s loans held for investment:

 

     Successor Company            Predecessor Company  
(dollars in thousands)    December 31,
2011
     December 31,
2010
           December 31,
2009
     December 31,
2008
     December 31,
2007
 

Real estate:

                   

Residential—1 to 4 family

   $ 1,040,126       $ 897,478            $ 1,097,172       $ 1,267,818       $ 1,257,306   

Multifamily

     344,643         254,511              275,069         273,644         278,935   

Commercial

     1,588,852         1,745,589              2,018,039         2,126,654         1,727,138   

Construction and land

     185,400         234,837              501,934         670,834         758,041   

Revolving—1 to 4 family

     249,857         280,753              360,113         328,325         268,763   

Commercial loans

     189,226         266,702              726,225         871,761         873,292   

Consumer loans

     49,977         60,713              113,008         144,216         155,288   

Other loans

     12,880         20,934              74,871         81,604         40,392   
  

 

 

    

 

 

         

 

 

    

 

 

    

 

 

 

Total loans held for investment

   $ 3,660,961       $ 3,761,517            $ 5,166,431       $ 5,764,856       $ 5,359,155   
  

 

 

    

 

 

         

 

 

    

 

 

    

 

 

 

Percent of loans to total loans

                   

Real estate:

                   

Residential—1 to 4 family

     28.4%         23.9%              21.2%         22.0%         23.5%   

Multifamily

     9.4%         6.8%              5.3%         4.7%         5.2%   

Commercial

     43.4%         46.3%              39.1%         36.9%         32.2%   

Construction and land

     5.1%         6.2%              9.7%         11.6%         14.1%   

Revolving—1 to 4 family

     6.8%         7.5%              7.0%         5.7%         5.0%   

Commercial loans

     5.2%         7.1%              14.1%         15.2%         16.3%   

Consumer loans

     1.4%         1.6%              2.2%         2.5%         2.9%   

Other loans

     0.3%         0.6%              1.4%         1.4%         0.8%   
  

 

 

    

 

 

         

 

 

    

 

 

    

 

 

 

Total loans held for investment

     100.0%         100.0%              100.0%         100.0%         100.0%   
  

 

 

    

 

 

         

 

 

    

 

 

    

 

 

 

Successor Company

The loans in the table above include PCI Loan Pools, and loans originated or purchased since the Transaction Date. Included in the PCI Loan Pools are purchase accounting adjustments, as more fully discussed in the Critical Accounting Policies of the MD&A and in Note 1 “Summary of Significant Accounting Policies” of the Consolidated Financial Statements. At the Transaction Date, all of the loans in the Company’s loan portfolio were aggregated into pools of loans, and recorded at their fair values, which significantly impacted the carrying amounts for the Company’s loans. Additionally, the amounts presented above include deferred loan origination fees and costs, extension fees, and commitment fees.

As described in the Critical Accounting Policies of the MD&A and Note 1, “Summary of Significant Accounting Policies” of the Consolidated Financial Statements, the Company has elected an accounting policy based on expected cash flows in the accounting for term loans subsequent to the Transaction Date in accordance with ASC 310-30, and push-down accounting requirements for loan portfolios acquired in a business combination, and such loans are referred herein as “PCI Term Pools.” Some loans that otherwise meet the definition as credit impaired, such as revolving lines of credit, are specifically excluded from the PCI Term Pools as per accounting guidance in ASC 310-30, and are referred to as “PCI Revolving Pools.” PCI term and revolving loans have been pooled based on similar risk characteristics, and are accounted for as a single asset. The accounting for PCI Term and PCI Revolving Pools is significantly different from the accounting for loans originated after the Transaction Date. At December 31, 2011, and 2010, a majority of loans included in “Loans Held for Investment” are PCI Term and PCI Revolving Pools.

 

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To assist the reader with understanding of the PCI Term and PCI Revolving Pools versus the loans originated or purchased after the Transaction Date, the following table provides a summary of the carrying balance and unpaid principal balance of the loans held for investment at December 31, 2011, and 2010.

 

     Successor Company  
     December 31, 2011  
     Originated  or
Purchased Since
Transaction Date
     PCI Term
Pools
     PCI Revolving
Pools
     Total  
     (dollars in thousands)  

Real estate:

           

Residential—1 to 4 family

   $ 296,257       $ 679,282       $ 64,587       $ 1,040,126   

Multifamily loans

     151,417         191,850         1,376         344,643   

Commercial

     114,307         1,454,837         19,708         1,588,852   

Construction

     1,793         179,646         3,961         185,400   

Revolving—1 to 4 family

     3,890         5,949         240,018         249,857   

Commercial loans

     11,622         56,806         120,798         189,226   

Consumer loans

     6,404         22,342         21,231         49,977   

Other loans

     2,335         5,838         4,707         12,880   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total loans held for investment

   $ 588,025       $ 2,596,550       $ 476,386       $ 3,660,961   
  

 

 

    

 

 

    

 

 

    

 

 

 
           

Total unpaid principal balance

   $ 594,386       $ 2,841,625       $ 557,023       $ 3,993,034   
  

 

 

    

 

 

    

 

 

    

 

 

 
     Successor Company  
     December 31, 2010  
     Originated After
the Transaction
Date
     PCI Term
Pools
     PCI Revolving
Pools
     Total  
     (dollars in thousands)  

Real estate:

           

Residential—1 to 4 family

   $ 7,652       $ 814,770       $ 75,056       $ 897,478   

Multifamily loans

             252,379         2,132         254,511   

Commercial

             1,718,029         27,560         1,745,589   

Construction

             227,424         7,413         234,837   

Revolving—1 to 4 family

     1,237         5,451         274,065         280,753   

Commercial loans

     2,553         115,799         148,350         266,702   

Consumer loans

     1,155         34,491         25,067         60,713   

Other loans

     3,807         9,458         7,669         20,934   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total loans held for investment

   $ 16,404       $ 3,177,801       $ 567,312       $ 3,761,517   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total unpaid principal balance

   $ 16,376       $ 3,494,683       $ 668,988       $ 4,180,047   
  

 

 

    

 

 

    

 

 

    

 

 

 

Successor Company

At December 31, 2011, loans held for investment were $100.6 million lower than that reported at December 31, 2010. The majority of the decline can be attributed to declines in the PCI Term and Revolving Loan Pools, which is primarily reflective of pay-downs and pay-offs within those loan pools. Declines in PCI Loan Pools were offset by a $571.6 million increase in loans originated or purchased after the Transaction Date, of which $315.0 million can be attributed to loan purchases during 2011. For additional information concerning loans the Company purchased during the twelve months ended December 31, 2011, see Note 5, “Loans” of the Consolidated Financial Statements.

 

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Predecessor Company

2009 Compared to 2008

The loan portfolio at December 31, 2009, was $5.17 billion compared to $5.76 billion at December 31, 2008, a decrease of $598.4 million. This decrease was mostly due to the reclassification of loans held for investment to loans held for sale of $170.6 million and charge-offs of $228.3 million. The loan sales were comprised of $77.3 million of residential loans, $87.2 million of commercial real estate loans and $6.1 million of commercial loans. Due to the high concentration of commercial real estate loans, the Company began to reduce its concentrations in commercial real estate loans during 2009.

2008 Compared to 2007

The loan portfolio at December 31, 2008, was $5.76 billion, an increase of $405.7 million from December 31, 2007. A majority of this increase occurred in the commercial real estate loan portfolio which increased $399.5 million during 2008. This increase was partially offset by a decrease in the construction portfolio of $87.2 million. During 2008, the Company sold Small Business Administration (“SBA”) loans for a gain on sale of $1.2 million, residential real estate loans for a gain on sale of $774,000 and various other types of loans in conjunction with the sale of two branches in October 2008.

Discussion regarding the amounts and reasons for charge-offs during the years mentioned above is included in the section below titled “Loan Losses.”

Loan Balances by Maturity

The following table provides a maturity distribution for loans held for investment, and summarizes the balances by interest rate type for each loan category.

 

     Successor Company  
     December 31, 2011  
     Due in
one year
or less
     Due after
one year to
five years
     Due after
five years
     Total  
     (dollars in thousands)  

Real Estate:

           

Residential—1 to 4 family

           

Floating rate

   $ 4,964       $ 5,852       $ 332,785       $ 343,601   

Fixed rate

     5,450         7,181         683,894         696,525   

Multifamily

           

Floating rate

     2,878         24,171         291,549         318,598   

Fixed rate

     743         11,837         13,465         26,045   

Commercial

           

Floating rate

     35,028         508,838         625,013         1,168,879   

Fixed rate

     43,992         237,960         138,021         419,973   

Construction

           

Floating rate

     57,867         40,120         11,756         109,743   

Fixed rate

     49,375         22,610         3,672         75,657   

Revolving—1 to 4 family

           

Floating rate

     13,809         132,582         102,094         248,485   

Fixed rate

     539         698         135         1,372   

Commercial loans

           

Floating rate

     60,514         37,638         62,250         160,402   

Fixed rate

     6,370         19,678         2,776         28,824   

Consumer loans

           

Floating rate

     4,544         1,109         20,054         25,707   

Fixed rate

     1,111         6,397         16,762         24,270   

Other

           

Floating rate

     5,076         2,286         326         7,688   

Fixed rate

     1,134         2,560         1,498         5,192   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total loans held for investment

   $ 293,394       $ 1,061,517       $ 2,306,050       $ 3,660,961   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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Of the total for loans held for investment in the above table, 65.1% have some variability in interest rates. Some of the loans reset immediately with a short term index such as LIBOR or Prime, or they may be fixed for a period of time after origination and then reset periodically until maturity.

ALLOWANCE FOR LOAN AND LEASE LOSSES

The Company has established an ALLL, representing Management’s best estimate of probable credit losses inherent in the loan portfolio as of the date of the balance sheet. The ALLL is increased by charges made to current period earnings and recoveries on previously charged-off loans, and is reduced by charge-offs related to loan balances deemed by Management to be uncollectable.

The table below summarizes the estimated Allowance for Loan and Lease Losses by loan type.

 

     Successor Company           Predecessor Company  
(dollars in thousands)    December 31,
2011
     December 31,
2010
          December 31,
2009
     December 31,
2008
     December 31,
2007
 

Real estate:

                  

Residential—1 to 4 family

   $ 1,952       $ 120           $ 23,523       $ 16,294       $ 3,180   

Multifamily

     783                     5,867         3,184         890   

Commercial

     722       &nb