ITEM 1. BUSINESS
Forward-Looking Statements
In addition to historical information, this discussion and analysis includes certain forward-looking statements that are subject to risks and uncertainties and include information about possible or assumed future results of operations. Many possible events or factors could affect the future financial results and performance of the Company. This could cause results or performance to differ materially from those expressed in our forward-looking statements. Words such as “expects”, “anticipates”, “believes”, “estimates”, “intends”, “plans”, “assumes”, “projects”, “predicts”, “forecasts”, variations of such words and other similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in, or implied by, such forward-looking statements.
Readers of the Company’s Annual Report and Form 10-K should not rely solely on forward looking statements and should consider all uncertainties and risks discussed throughout this report. These statements are representative only on the date hereof, and the Company undertakes no obligation to update any forward-looking statements made. Some possible events or factors that could occur that may cause differences from expected results include the following: the Company’s loan growth is dependent on economic conditions, as well as various discretionary factors, such as decisions to sell, or purchase certain loans or loan portfolios; or sell or buy participations of loans; the quality and adequacy of management of the borrower, developments in the industry the borrower is involved in, product and geographic concentrations and the mix of the loan portfolio. The rate of charge-offs and provision expense can be affected by local, regional and international economic and market conditions, concentrations of borrowers, industries, products and geographical conditions, the mix of the loan portfolio and management’s judgements regarding the collectibility of loans. Liquidity requirements may change as a result of fluctuations in assets and liabilities and off-balance sheet exposures, which will impact the capital and debt financing needs of the Company and the mix of funding sources. Decisions to purchase, hold, or sell securities are also dependent on liquidity requirements and market volatility, as well as on and off-balance sheet positions. Factors that may impact interest rate risk include local, regional and international economic conditions, levels, mix, maturities, yields or rates of assets and liabilities and the wholesale and retail funding sources of the Company. The Company is also exposed to the potential of losses arising from adverse changes in market rates and prices which can adversely impact the value of financial products, including securities, loans, and deposits. In addition, the banking industry in general is subject to various monetary and fiscal policies and regulations, which include those determined by the Federal Reserve Board, the Federal Deposit Insurance Corporation and state regulators, whose policies and regulations could affect the Company’s results.
Other factors that may cause actual results to differ from the forward-looking statements include the following: competition with other local and regional banks, savings and loan associations, credit unions and other non-bank financial institutions, such as investment banking firms, investment advisory firms, brokerage firms, mutual funds and insurance companies, as well as other entities which offer financial services; interest rate, market and monetary fluctuations; inflation; market volatility; general economic conditions; introduction and acceptance of new banking-related products, services and enhancements; fee pricing strategies, mergers and acquisitions and their integration into the Company; civil disturbances or terrorist threats or acts, or apprehension about the possible future occurrences or acts of this type; outbreak or escalation of hostilities in which the United States is involved, any declaration of war by the U.S. Congress or any other national or international calamity, crisis or emergency; changes in laws and regulations; recently issued accounting pronouncements; government policies, regulations, and their enforcement (including Bank Secrecy Act-related matters, taxing statutes and regulations); restrictions on dividends that our subsidiaries are allowed to pay to us; the ability to satisfy requirements related to the Sarbanes-Oxley Act and other regulation on internal control; and management’s ability to manage these and other risks.
General Development of the Company
General
Capital Corp of the West (the “Company”) is a bank holding company incorporated under the laws of the State of California on April 26, 1995. On November 1, 1995, the Company became registered as a bank holding company
and is the holder of all of the capital stock of County Bank (the “Bank”). During 1999, Town and Country Finance and Thrift (the “Thrift”) was merged into County Bank. The Company’s primary asset is the Bank and the Bank is the Company’s primary source of income. As of February 1, 2005, the Company had outstanding 5,807,382 shares of Common Stock, no par value, held by approximately 1,700 shareholders. There were no preferred shares outstanding at February 1, 2005. The Company has one wholly-owned inactive nonbank subsidiary, Capital West Group (“CWG”) at December 31, 2004. The Bank has three wholly-owned subsidiaries, Merced Area Investment & Development, Inc. (“MAID”), County Asset Advisors (“CAA”) and County Investment Trust (“REIT”). CAA is currently inactive. All references herein to the Company includes direct subsidiaries of the Company as well as the Bank and the Bank’s subsidiaries, unless the context otherwise requires.
Information about Commercial Banking & General Business of the Company and its Subsidiaries
The Bank was organized on August 1, 1977, as County Bank of Merced, a California state banking corporation. The Bank commenced operations in 1977. In November 1992, the Bank changed its legal name to County Bank. The Bank’s deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”), up to applicable limits. The Bank is a member of the Federal Reserve System.
Industry & Market Area
The Bank engages in general commercial banking business primarily in Fresno, Madera, Mariposa, Merced, San Francisco, San Joaquin, Stanislaus, and Tuolomne counties. The Bank has twenty full service branch offices; two of which are located in Merced with the branch located in downtown Merced currently serving as both a branch and as administrative headquarters. There are offices in Atwater, Hilmar, Los Banos, Sonora, Stockton, two offices in Modesto and two offices in Turlock. In 1997, the Bank also opened an office in Madera and purchased three branch offices from Bank of America in Livingston, Dos Palos and Mariposa. During 1999, the Bank opened its first office in Fresno, and in 2000 expanded its presence in Fresno by adding an additional office. On January 18, 2001 the Bank opened a loan production office in San Francisco that during 2001 was converted into a full service branch. During 2003 and 2004, the Bank added one full service branch facility in Fresno each year. The Bank’s administrative headquarters also provides accommodations for the activities of MAID, the Bank’s wholly-owned real estate subsidiary. (See “ITEM 2.
ITEM 2. PROPERTIES
The Bank
Capital Corp of the West/County Bank is a community service bank with operations located mainly in the San Joaquin Valley of Central California. The corporate headquarters and main branch facility are located at 550 West Main Street, Merced, California in a three-story building with a two-story, attached parking garage and is approximately 29,000 square feet. In addition to this facility, there are three support centers in downtown Merced with an additional square footage of 33,000 square feet.
The Bank currently has 19 branch operations located in the central valley and 1 branch operation located in San Francisco. The central valley operations include branches located in: Merced (2), Atwater, Los Banos, Hilmar, Sonora, Turlock (2), Modesto (2), Dos Palos, Livingston, Mariposa, Madera, Fresno (4) and Stockton. The Bank owns eight of these branch facilities and the remaining twelve facilities are leased. The Management of the Bank believes that the facilities will be adequate to accommodate operations for the foreseeable future.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
As of December 31, 2004, the Company, is not a party to, nor is any of its properties the subject of, any material pending legal proceedings, nor are any such proceedings known to be contemplated by government authorities.
The Company is, however, exposed to certain potential claims encountered in the normal course of business. In the opinion of Management, the resolution of these matters will not have a material adverse effect on the Company’s consolidated financial position or results of operations in the foreseeable future.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company did not submit any matters to a vote of security holders in the quarter ended December 31, 2004.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
For information concerning the market for the Company’s common stock and related shareholder matters, see page 48 of the Company’s 2004 Annual Report to Shareholders incorporated herein by reference.
For information concerning the Company’s dividend policy, see the “Capital Resources” discussion on page 47 of the Company’s 2004 Annual Report to Shareholders incorporated herein by reference.
Market for Company’s Common Stock and Related Stock Matters
The Company’s stock is included for quotation on the Nasdaq National Market System with a stock quotation symbol of CCOW. The following table indicates the range of high and low bid prices for the period shown, based upon information provided by the Nasdaq National Market System. There were approximately 1,700 CCOW shareholders as of December 31, 2004.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
For selected consolidated financial data concerning the Company, see page 35 of the Company’s 2004 Annual Report to Shareholders incorporated herein by reference.
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
For management’s discussion and analysis of financial condition and results of operations, see pages 36 through 48 of the Company’s 2004 Annual Report to Shareholders incorporated herein by reference.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
For management’s discussion and analysis of market risk and interest rate risk management, see pages 45 through 47 of the Company’s 2004 Annual Report to Shareholders incorporated herein by reference.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Audited Consolidated Balance Sheets as of December 31, 2004 and 2003 and Audited Consolidated Statements of Income and Comprehensive Income, Shareholders’ Equity and Cash Flows for the fiscal years ended December 31, 2004, 2003, and 2002 appear on pages 52 through 55 of the Company’s 2004 Annual Report to Shareholders incorporated herein by reference. Notes to the Consolidated Financial Statements appear on pages 56 through 80 of the Company’s 2004 Annual Report to Shareholders incorporated herein by reference. The Independent Auditors’ Report appears on page 51 of the Company’s 2004 Annual Report to Shareholders incorporated herein by reference.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There were no changes in and there were no disagreements with accountants on accounting and financial disclosure during 2004.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
Under the supervision and with the participation of the Company’s management, including its chief executive officer and chief financial officer, the Company’s management conducted an evaluation of the effectiveness of the design and operation of its disclosure controls and procedures as defined by Rules 13a-15(c) and 15d-15(c)) under the Securities Exchange Act of 1934.
Based on the evaluation, the chief executive officer and chief financial officer concluded that as of December 31, 2004, the end of the period covered by this report, the disclosure controls and procedures were adequate and effective, and that the material information required to be included in this report, including information from the Company’s consolidated subsidiaries, was made known to the chief executive officer and chief financial officer by others within the Company in a timely manner, particularly during the period when this annual report on Form 10-K was being prepared.
Management’s Report on Internal Control over Financial Reporting.
Based on their evaluation as of December 31, 2004, our Chief Executive Officer and Chief Financial Officer, have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended) were sufficiently effective to ensure that the information required to be disclosed by us in this Annual Report on Form 10-K was recorded, processed, summarized and reported within the time periods specified within the SEC’s rules and instructions for Form 10-K.
Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended). Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2004. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework. Our management has concluded that, as of December 31, 2004, our internal control over financial reporting is effective based on these criteria. Our independent registered public accounting firm, KPMG LLP, has issued an audit report on our assessment of our internal control over financial reporting, which is included herein.
None
PART III
ITEM 10.
ITEM 10.
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
As permitted by the Securities and Exchange Commission’s rules relating to Form 10-K, the information called for by this item is incorporated by reference from the section of the Company’s 2004 Proxy Statement titled “Election of Directors,” which is to be filed on or about March 11, 2005.
As permitted by the Securities and Exchange Commission, the information called for by this item is incorporated by reference from the section of the Company’s 2004 Proxy Statement titled “Information Pertaining to Election of Directors,” which is to be filed on or about March 11, 2005.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
As permitted by the Securities and Exchange Commission’s rules relating to Form 10-K, the information called for by this item is incorporated by reference from the sections of the Company’s 2004 Proxy Statement, titled “Beneficial Ownership of Management” and “Principal Shareholders” which is to be filed on or about March 11, 2005.
Securities authorized for issuance under equity compensation plans.
(a)
The information in the following table is provided as of the end of the fiscal year ended December 2004 with respect to compensation plans (including individual compensation arrangements) under which equity securities are issuable:
Equity Compensation Plan Information
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
As permitted by the Securities and Exchange Commission’s rules relating to Form 10-K, the information called for by this item is incorporated by reference from the Company’s Proxy Statement, which was filed on or about March 11, 2005.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTING FEES AND SERVICES
As permitted by the Securities and Exchange Commission, the information called for by this item is incorporated by reference from the section of the Company’s 2004 Proxy Statement titled “Auditor Fees,” which is to be filed on or about March 11, 2005.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a)
Financial Statements and Schedules
An index of all financial statements and schedules filed as part of this Form 10-K appears below and the material which begins on the pages of the Company’s Annual Report to Shareholders for the year ended December 31, 2004 listed, are incorporated herein by reference in response to Item 8 of this report.
The Exhibit Index is located on the final page of this report on Form 10-K.
(c)
Financial Statement Schedules
All other supporting schedules are omitted because they are not applicable, not required, or the information required to be set forth therein is included in the financial statements or notes thereto incorporated herein by reference.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 11th day of March, 2005.
CAPITAL CORP OF THE WEST
Date: March 11, 2005
By:
/s/ Thomas T. Hawker
THOMAS T. HAWKER
President and Chief Executive Officer
(Principal Executive Officer)
Date: March 11, 2005
By:
/s/ R. Dale McKinney
R. DALE MCKINNEY
Executive Vice President and
Chief Financial Officer and Principal
Accounting Officer
(Principal Financial and Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Exhibit Index
The following is a list of all exhibits required by Item 601 of Regulation S-K to be filed as part of this 10-K:
*
Denotes management contract or compensatory plan arrangement.
Capital Corp of the West
Selected Financial Data
(1)
Nonperforming loans consist of loans on nonaccrual, loans past due 90 days or more and restructured loans.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis is designed to provide a better understanding of the significant changes and trends related to Capital Corp of the West (the “Company”). The following discussion should be read in conjunction with the consolidated financial statements of the Company and the notes thereto. The consolidated financial statements of the Company include its subsidiaries, County Bank (the “Bank”), and Capital West Group (“CWG”). It also includes the Bank’s subsidiaries, Merced Area Investment Development, Inc. (“MAID”), County Asset Advisor, Inc. (“CAA”) and County Investment Trust (“REIT”). Regency Investment Advisors (“RIA”) was a wholly owned subsidiary of the Company from from its purchase date in June, 2002 until it was sold in October, 2004.
Forward-Looking Statements
In addition to historical information, this discussion and analysis includes certain forward-looking statements that are subject to risks and uncertainties and include information about possible or assumed future results of operations. Many possible events or factors could affect the future financial results and performance of the Company. This could cause results or performance to differ materially from those expressed in our forward-looking statements. Words such as “expects,” “anticipates,” “believes,” “estimates,” “intends,” “plans,” “assumes,” “projects,” “predicts,” “forecasts,” variations of such words and other similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in, or implied by, such forward-looking statements.
Readers of the Company’s Annual Report and Form 10-K should not rely solely on forward looking statements and should consider all uncertainties and risks discussed throughout this report. These statements are representative only on the date hereof, and the Company undertakes no obligation to update any forward-looking statements made. Some possible events or factors that could occur that may cause differences from expected results include the following: the Company’s loan growth is dependent on economic conditions, as well as various discretionary factors, such as decisions to sell, or purchase certain loans or loan portfolios; or sell or buy participations of loans; the quality and adequacy of management of the borrower; developments in the industry the borrower is involved in, product and geographic concentrations and the mix of the loan portfolio. The rate of charge-offs and provision expense can be affected by local, regional and international economic and market conditions, concentrations of borrowers, industries, products and geographical conditions, the mix of the loan portfolio and management’s judgments regarding the collectibility of loans. Liquidity requirements may change as a result of fluctuations in assets and liabilities and off-balance sheet exposures, which will impact the capital and debt financing needs of the Company and the mix of funding sources. Decisions to purchase, hold, or sell securities are also dependent on liquidity requirements and market volatility, as well as on and off-balance sheet positions. Factors that may impact interest rate risk include local, regional and international economic conditions, levels, mix, maturities, yields or rates of assets and liabilities and the wholesale and retail funding sources of the Company. The Company is also exposed to the potential of losses arising from adverse changes in market rates and prices which can adversely impact the value of financial products, including securities, loans, and deposits. In addition, the banking industry in general is subject to various monetary and fiscal policies and regulations, which include those determined by the Federal Reserve Board, the Federal Deposit Insurance Corporation and state regulators, whose policies and regulations could affect the Company’s results.
Other factors that may cause actual results to differ from the forward-looking statements include the following: competition with other local and regional banks, savings and loan associations, credit unions and other non-bank financial institutions, such as investment banking firms, investment advisory firms, brokerage firms, mutual funds and insurance companies, as well as other entities which offer financial services; interest rate, market and monetary fluctuations; inflation; market volatility; general economic conditions; introduction and acceptance of new banking-related products, services and enhancements; fee pricing strategies, mergers and acquisitions and their integration into the Company; civil disturbances or terrorist threats or acts, or apprehension about the possible future occurrences or acts of this type, outbreak or escalation of hostilities in which the United States is involved, any declaration of war by the U. S. Congress or any other national or international calamity, crisis or emergency; changes in laws and regulations; recently issued accounting pronouncements; government policies, regulations, and their
enforcement (including Bank Secrecy Act-related matters, taxing statutes and regulations); restrictions on dividends that our subsidiaries are allowed to pay to us; the ability to satisfy requirements related to the Sarbanes-Oxley Act and other regulation on internal control; and management’s ability to manage these and other risks.
Critical Accounting Policies and Estimates
The Company’s discussion and analysis of its financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates, including those related to the adequacy of the allowance for loan losses, investments, and intangible assets. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
The Allowance for Loan Losses represents management’s estimate of the amount of inherent losses in the loan portfolio that can be reasonably estimated as of the balance sheet date. Determining the amount of the Allowance for Loan Losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends, uncertainties and conditions, all of which may be susceptible to significant change. The politics related to the adequacy of the allowance for loan losses can be found in Note 1, the section titled “Allowance for Loan Losses” as well as in Note 3, titled “Loans” in this report.
A decline in the fair value of any securities that is considered other than temporarily impaired is recorded in our consolidated statements of income in the period the impairment occurs. The cost basis of the underlying security is written down to fair value as a new cost basis. We consider our other than temporary impairment accounting policies to be critical, as the timing and amount of income, if any, from these instruments typically depend upon factors beyond our control. These factors include the general condition of the public equity markets, levels of mergers and acquisitions activity, fluctuations in the market prices of the underlying common stock of these companies, and legal and contractual restrictions on our ability to sell the underlying securities. The policies related to the valuation of the investment securities can be found in Note 1, the section titled “Investment Securities” in this report as well as Note 2 “Investment Securities”.
Goodwill, which arises from the purchase price exceeding the assigned value of the net assets of an acquired business, represents the value attributable to intangible elements being acquired. The value of this goodwill is supported ultimately by revenue from the acquired businesses. A decline in earnings could lead to impairment, which would be recorded as a write-down in our consolidated statements of income. Events that may indicate goodwill impairment include significant or adverse changes in results of operations of the business, economic or political climate; an adverse action or assessment by a regulator; unanticipated competition; and a more likely-than-not expectation that a reporting unit will be sold or disposed of. The policies related to the adequacy of the goodwill and other intangible assets can be found in Note 1, the section titled “Goodwill”, “Other Intangibles”, and “Impairment of Long-Lived assets and Long-Lived Assets to be Disposed Of” in this report.
Overview
During 2004, earnings decreased $1,317,000 or 10% to $12,323,000, which compares to earnings of $13,640,000 and $10,428,000 achieved in 2003 and 2002. Basic earnings per share were $2.15 in 2004 compared to $2.43 and $1.88 in 2003 and 2002. Diluted earnings per share were $2.06 in 2004 compared to $2.34 and $1.83 in 2003 and 2002. The Company’s return on average total assets was 0.94% in 2004 compared with 1.23% and 1.09% in 2003 and 2002. The $1,317,000 earnings decrease in 2004 was primarily the result of an other-than-temporary impairment charge of $3,709,000, the write-off of tax benefits related to the Company’s REIT consent dividend tax benefit of $1,229,000 which lead to a higher effective tax rate, and increases in general and
administrative expenses of $2,350,000 which were partially offset by an increase in net interest income of $7,314,000. The effective tax rate in 2004 was 37% as compared to an effective tax rate of 26% in 2003. The Company achieved strong asset growth in 2004, reaching total assets at December 31, 2004 of $1,447,768,000 up $213,226,000 or 17% from $1,234,542,000 at December 31, 2003. The growth in assets was primarily funded through increases in the deposit portfolio as well as increased borrowings. Net loans grew to $870,809,000 at December 31, 2004, an increase of $119,820,000 or 16% from the $750,989,000 outstanding at December 31, 2003. Loan growth was obtained primarily from increased loan production within our existing branch network. Deposits grew to $1,154,157,000 at December 31, 2004, an increase of $125,349,000 or 12% over the $1,028,808,000 outstanding as of December 31, 2003. The increase in deposits was obtained primarily from increased deposit gathering within our existing branch network. Total shareholders’ equity grew to $103,481,000 at December 31, 2004, an increase of $13,996,000 or 16% over the December 31, 2003 total of $89,485,000. The Company continues to be well capitalized by regulatory definitions. The Company’s return on average equity was 13%, 16%, and 15% in 2004, 2003, and 2002 respectively.
Results of Operations
Capital Corp of the West’s earnings were $12,323,000 during 2004, driven primarily by an increase in interest income of $8,158,000 or 13% to $70,571,000 during 2004 which compares with $62,413,000 achieved during 2003. During 2003, there was an increase of $3,602,000 or 6% to $62,413,000 which compares to $58,811,000 achieved in 2002. During 2004, interest expense increased by $844,000 or 5%, leaving an interest expense to interest income ratio of 24% in 2004 which compares to 26% and 32% in 2003 and 2002. The improvement in net interest income in 2004 was partially offset by a higher effective tax provision of $7,150,000 in 2004 when compared to $4,857,000 the year ended December 31, 2003. Net interest income increased by $7,314,000, or 16%, to $53,474,000 during 2004 which compares to an increase in net interest income of $6,203,000 in 2003 over 2002 levels. The improvement in interest income and net interest income during 2004 compared to 2003 was driven primarily by an increase in average earning asset balances.
The Company’s primary source of revenue is net interest income, which is the difference between interest income and fees derived from earning assets and interest paid on liabilities obtained to fund those assets. The level of interest income is affected by changes in the volume and the rates earned on interest-earning assets. During 2004, the increase in interest income was due to increases in average earning assets partially offset by lower yields on those assets. Average interest-earning assets in 2004 were $1,212,314,000 as compared with $1,032,700,000 in 2003, an increase of $179,614,000 or 17%. The average rate earned on interest-earning assets was 5.89% in 2004, a decrease of 21 basis points from the 6.10% earned in 2003. The primary cause for the decrease in rate on interest-earning assets was lower prevailing market interest rates that were available for reinvestments in 2004 in comparison to 2003 for new investments in earning assets.
Interest expense is a function of the volume and rates paid for interest-bearing liabilities. Interest-bearing liabilities consist primarily of certain deposits and borrowed funds. Average interest-bearing liabilities in 2004 were $993,486,000 as compared with $858,665,000 in 2003, an increase of $134,821,000 or 16%. The increase in volume was primarily attributable to increased market penetration within the Bank’s our existing branch network. Total interest expense increased $844,000 or 5% to $17,097,000 in 2004 as compared to $16,253,000 for 2003. Total interest expense in 2002 totaled $18,854,000. The weighted average total cost of interest-bearing funds were 1.72%, 1.89%, and 2.52% in 2004, 2003, and 2002. If the current rate environment remains unchanged during 2005, it is anticipated that the average interest paid on certificates of deposit should stay about the same as maturing accounts reprice at their maturities to an anticipated current equivalent interest rate level. If interest rates increase in 2005, then it is anticipated that the average interest paid on certificates of deposit should increase in 2005 as maturing accounts reprice at their maturities to an anticipated higher equivalent interest rate level.
The Company’s net interest margin, the ratio of net interest income to average interest-earning assets for 2004 was 4.49%. This is a decrease of four basis points compared to the 2003 margin of 4.53%. The decrease in net interest margin during 2004 was primarily the result of falling short term interest rates during most of 2004. If the current interest rate environment continues throughout 2005, it is anticipated the Company’s overall net interest margin should be in the 4.30% to 4.50% range. A modest increase in rates should cause the Company’s net interest margin to slightly decrease. The net interest margin decrease of five basis points during 2003 from the 4.58%
achieved in 2002 was primarily the result of an overall decline in prevailing interest rates during the period. In 2004, loans comprised 67% of average interest-earning assets as compared with 67% and 65% in 2003 and 2002. Securities comprised 32% of average interest-earning in 2004 compared with 31% and 32% in 2003 and 2002.
The Company’s net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities. It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds. The changes due to both rate and volume have been allocated to rate and volume in proportion to the relationship of the absolute dollar amount of the change in each.
The increase in taxable equivalent interest income of $8,441,000 in 2004 is comprised of a $9,150,000 volume increase attributable to an increase in interest-earning assets of $179,614,000 between 2004 and 2003 that was partially offset by a $709,000 rate decrease during this same period. The increase in total interest expense of $844,000 in 2004 related to a $1,519,000 volume increase attributable to an increase in average interest-bearing liabilities of $134,821,000 during 2004 when compared to 2003 that was partially offset by a $675,000 rate decrease during this same period. Interest rates declines were greater for interest earning assets than interest bearing liabilities during 2004.
The increase in taxable equivalent interest income of $3,624,000 in 2003 is comprised of a $9,661,000 volume increase primarily attributable to an increase in interest-earning assets of $147,815,000 between 2003 and 2002 that was partially offset by a $6,037,000 rate decrease during this same period. The decrease in total interest expense of $2,601,000 in 2003 related to a $1,709,000 volume increase attributable to an increase in average interest-bearing liabilities of $109,157,000 during 2003 when compared to 2002 that was partially offset by a $4,310,000 rate decrease during this same period. Interest rate declines were greater for interest earning assets than interest bearing liabilities during this time period.
Provision for Loan Losses
The Company maintains an allowance for loan losses at a level considered by management to be adequate to cover probable losses inherent in its loan portfolio. The provision for loan losses is charged against income and increases the allowance for loan losses. The provision for loan losses for the year ended December 31, 2004 was $2,671,000 compared to $2,455,000 in 2003 and $4,151,000 in 2002. The increased level of provision for loan losses in 2004 when compared to 2003 was primarily the result of increased loan balances and loan volume. The decreased level for 2003 as compared to 2002 was attributable to low charge-off levels helped by a strong commercial real estate market. The methodology used to determine the level of provision for loan losses includes an analysis of relevant risk factors within the entire loan portfolio, including nonperforming loans. The methodology is based, in part, on management’s use of a loan grading and classification system. The Bank’s management grades its loans through internal reviews and periodically subjects loans to external reviews. These external reviews are presented to and assessed by the Bank’s audit committee. Credit reviews are performed quarterly and the quality grading process occurs on a monthly basis. The level of provision for loan losses in 2004, 2003, and 2002 also supports the general loan growth of the Company, as gross loans increased 16% in 2004 and 21% in 2003.
Noninterest Income
The following table summarizes noninterest income for the years ended December 31,
Total noninterest income decreased by $3,772,000 or 37% to $6,405,000 in 2004, which compares with $10,177,000 and $8,164,000 earned in 2003 and 2002. This decrease was caused primarily by an increase in other than temporary impairment of investment securities that was recorded in the fourth quarter of 2004. The 2004 decrease in noninterest income when compared to 2003 results was also negatively affected by the fact there were no real estate sales in 2004. Deposit service charges increased by $654,000 or 12% during 2004. The steadily increasing deposit service charges in 2004, 2003 and 2002 was primarily the result of an increase in demand deposit and NOW accounts in each of these years. Loan packaging fees fell by $140,000 or 26% primarily due to a slower mortgage market and increased competition. Retail investment income fell by $41,000 or 4% primarily due to the October 15, 2004 divestiture of Regency Investment Advisors (“RIA”). Other income increased by $10,000 or 1% to $1,348,000 in 2004, compared to $1,338,000 and $996,000 in 2003 and 2002. Other income included letters of credit commitment fees which were $90,000, $108,000 and $65,000 in 2004, 2003, and 2002, respectively. That represents a 17% decrease from 2003 to 2004 and a 66% increase from 2002 to 2003. Other income also includes operating recoveries which amounted to $166,000, $16,000, and $24,000 in 2004, 2003, and 2002, respectively. This represents a 904% increase between 2003 and 2004 and a 33% decrease from 2002 to 2003. Miscellaneous income represented $85,000, $78,000, and $51,000 in 2004, 2003, and 2002, respectively. This represents a 9% increase from 2003 to 2004 and a 53% increase from 2002 to 2003. ATM fee income represented $103,000, $94,000, and $91,000 in 2004, 2003, and 2002, respectively. This represents a 10% increase from 2003 to 2004 and a 3% increase from 2002 to 2003.
Noninterest Expense
The following table summarizes noninterest income for the years ended December 31,
Total noninterest expense increased $2,350,000 or 7% to $37,735,000 in 2004 as compared with an increase of $4,298,000 or 14% to $35,385,000 in 2003. Noninterest expense totaled $31,087,000 in 2002.
Salaries and related benefits increased by $1,626,000 or 9% to $20,697,000 in 2004, compared with an increase of $2,397,000 or 14% to $19,071,000 in 2003. Salaries and related benefits totaled $16,674,000 in 2002. The salary increases were primarily due to staff additions to support growth and normal salary progression.
Premises and occupancy expenses increased $500,000 or 17% to $3,446,000 in 2004 compared with an increase of $420,000 or 17% to $2,946,000 in 2003. Premises and occupancy expense totaled $2,526,000 in 2002. The increases in 2004 and 2003 were caused primarily by the addition of new branch facilities, an operations center, and improvements in existing branch facilities.
Equipment expenses decreased $149,000 or 4% to $3,186,000 in 2004 compared with an increase of $381,000 or 13% to $3,335,000 in 2003. Equipment expenses were $2,954,000 in 2002. The decrease in 2004 was primarily due to the retirement of assets and reduced equipment costs within the branch network. The increase in 2003 and 2002 was primarily due to equipment purchases relating to branch expansion and general growth of the Company.
The Company’s professional fees include legal, consulting, audit and accounting fees. Total professional fees increased by $9,000 or 1% to $1,671,000 in 2004 as compared with an increase of $485,000 or 41% to $1,662,000 in 2003. Total professional fees were $1,177,000 in 2002. Consulting and auditing fees increased $81,000 in 2004 when compared to 2003 levels and were directly related to increased costs associated with the cost of documenting compliance with the Sarbanes Oxley Act of 2002. Consulting expenses related to systems improvement and new product development decreased $88,000 in 2004 in comparison to 2003.
Supplies increased by $79,000 or 10% to $873,000 in 2004 as compared with an increase of $14,000 or 2% to $794,000 in 2003. Supplies expense totaled $780,000 in 2002. The supplies expense has increased for the last three years in relation to branch office growth, changes in regulations and product disclosures, and with paper transaction volumes. Supply expense increases were partially offset by decreases due to an ongoing transition from paper-based to electronic deposit transactions. Generally, as more banking transactions are delivered electronically, paper costs are reduced.
Marketing expenses increased by $99,000 or 10% to $1,062,000 in 2004 as compared with an increase of $63,000 or 7% to $963,000 in 2003. Marketing expenses totaled $900,000 in 2002. Marketing expenses have increased slowly over the past few years as the Company has actively promoted various deposit and loan products using television, newspaper, and other media sources to assist in attracting new and retaining existing customers.
Other expenses increased $207,000 or 3% to $6,145,000 in 2004. During 2003, other expenses increased $542,000 or 10% to $5,938,000. Other expenses were $5,396,000 in 2002. These expense increases are generally the result of Company growth. Other expenses include postage which cost $437,000 in 2004. This was an increase of 3% over 2003. 2003 postage cost was $426,000 which was a 6% increase over 2002 which were $402,000. Other expenses also include corresponding bank charges whose cost was $348,000 in 2004, $321,000 in 2003, and $257,000 in 2002. This represents an increase of 8% from 2003 to 2004 and a 25% increase from 2002 to 2003. Telephone also contributed expenses of $649,000, $613,000, and $588,000 in 2004, 2003, and 2002, respectively. This represents an increase of 6% from 2003 to 2004 and 4% from 2002 to 2003. Travel added expenses of $461,000, $417,000, and $308,000 in 2004, 2003, and 2002, respectively. This represents an increase of 11% from 2003 to 2004 and 35% from 2002 to 2003. The housing tax credit writedown also contributed to expenses by $589,000, $386,000, and $336,000 in 2004, 2003, and 2002, respectively. This represents an increase of 53% from 2003 to 2004 and an increase of 15% from 2002 to 2003.
Provision for Income Taxes
The Company’s provision for income taxes was $7,150,000 in 2004 compared to a provision for income taxes of $4,857,000 and $2,455,000 in 2003 and 2002. The effective income tax rates (computed as income taxes as a percentage of income before income taxes) were 37%, 26%, and 19% for 2004, 2003, and 2002. During 2002, the effective tax rate was lowered by the implementation of a certain capital raising strategy that had the effect of reducing state income taxes. This strategy lowered taxable state income by approximately $16,000,000 in 2002. During 2003 and 2002, the tax rate was lower than the statutory rate due also in part, to tax credits earned from the investment in low-income housing partnerships that qualify for housing tax credits under internal revenue code section 42. In 2004, the tax rate was in excess of the statutory rate due primarily to the payment of $2,411,000 in state income taxes in conjunction with the State of California’s Voluntary Compliance Initiative in April of 2004. Total housing tax credits for 2004, 2003, and 2002 were approximately $1,028,000, $975,000, and $750,000. In addition, during 2004, 2003, and 2002, the Company realized tax benefits of $726,000, $442,000, and $407,000 from nontaxable interest income received from bank qualified municipal securities.
During 2003, California enacted tax legislation that added new penalties for taxpayers that engaged in strategies and transactions that the Franchise Tax Board defined as abusive tax shelters. The new tax shelter regulations gave taxpayers until April 30, 2004 to take advantage of an amnesty period that would allow taxpayers to amend prior year tax filings without being subject to the new tax shelter penalties. The Company utilized a Real Estate Investment Trust (“REIT”) which had generated tax savings and has been classified by the California Franchise Tax Board as an abusive tax shelter. Company management believes the strategy used was lawful and defensible, and intends to defend the tax positions taken. The Company generated a cumulative total of $1,229,000 in recorded tax benefits from the REIT from January 1, 2001 through December 31, 2002 that were completely expensed in 2004.
Financial Condition
Total assets increased $213,226,000 or 17% to $1,447,768,000 at December 31, 2004, compared to $1,234,542,000 at December 31, 2003. Net loans increased to $870,809,000 at December 31, 2004, a 16% increase from the balance of $750,989,000 at December 31, 2003. Deposits grew by $125,349,000 or 12% in 2004 to $1,154,157,000 which compares to $1,028,808,000 at December 31, 2003. Growth in assets has been achieved
primarily through the growth in deposits obtained through our retail branch offices which has funded increased investment in loans and investment securities. The Company uses its retail branch system and outside calling officers to attract new deposit and loan customers.
Securities
The following table sets forth the carrying amount (fair value) of available for sale securities at December 31,
The following table sets forth the carrying amount (amortized cost) and fair value of held to maturity securities at December 31,
Available for sale securities decreased $6,214,000 or 2% to $269,189,000 at December 31, 2004 compared with a balance of $275,403,000 at December 31, 2003. Held to maturity securities increased $70,375,000 or 73% to $166,987,000 at December 31, 2004 compared to $96,612,000 outstanding at December 31, 2003. The increase achieved within the held to maturity segment of the securities portfolio were made possible by increased deposit liabilities and increased borrowings that were used to fund increased purchases of investment securities. The decrease in the available for sale segment of the securities portfolio is attributable to maturities, calls, and selling of U.S. Treasury and governments securities. During 2004, $10,000,000, $10,000,000, and $9,000,000 in U.S. Treasury and governments were matured, sold, and called respectively. The single largest component of the Company’s investment portfolio during the last three years has been mortgage-backed securities, which generally provide a higher yielding investment return, but contain a longer maturity than the other types of securities contained with the investment portfolios. At December 31, 2004 and 2003 the Company did not hold any structured notes. See Note 1 and 2 to the Company’s Consolidated Financial Statements for further information concerning the securities portfolio.
Loans
Total loans increased $120,841,000 or 16% to $885,093,000 at December 31, 2004, compared to the $764,252,000 outstanding at December 31, 2003 due to increased penetration into existing geographic markets.
The Company concentrates its lending activities in five principal areas: commercial, agricultural, real estate construction, real estate mortgage, and consumer loans. Interest rates charged for loans made by the Company vary with the degree of risk, the size and term of the loan, and borrowers’ depository relationships with the Company and prevailing market rates.
As a result of the Company’s loan portfolio mix, the future quality of these assets could be affected by adverse trends in its region or in the broader community. These trends are beyond the control of the Company.
Credit Risk Management and Asset Quality
The Company closely monitors the markets in which it conducts its lending operations and adjusts its strategy to control exposure to loans with higher credit risk. Asset reviews are performed using grading standards and criteria similar to those employed by bank regulatory agencies. Assets receiving lesser grades become “classified assets” which include all nonperforming assets and potential problem loans and receive an elevated level of attention to improve the likelihood of collection. The policy of the Company is to review each loan in the portfolio to identify problem credits. There are three classifications for problem loans: “substandard,” “doubtful” and “loss.” Substandard loans have one or more defined weaknesses and are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. Doubtful loans have the weaknesses of substandard loans with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. A loan classified as loss is considered uncollectible and its continuance as an asset is not warranted. The level of nonperforming loans and real estate acquired through foreclosure are two indicators of asset quality. Nonperforming loans are those in which the borrower fails to perform under the original terms of the obligation and are categorized as loans past due 90 days or more but still accruing, loans on nonaccrual status and restructured loans. Loans are generally placed on nonaccrual status and accrued but unpaid interest is reversed against current year income when interest or principal payments become 90 days past due unless the outstanding principal and interest is adequately secured and, in the opinion of management, are deemed to be in the process of collection. Loans that are not 90 days past due may also be placed on nonaccrual status if management reasonably believes the borrower will not be able to comply with the contractual loan repayment terms and the collection of principal or interest is in question.
Management defines impaired loans as those loans, regardless of past due status, in which principal and interest are not expected to be collected under the original contractual loan repayment terms. An impaired loan is charged off at the time management believes the collection of principal and interest process has been exhausted. Partial charge-offs are recorded when portions of impaired loans are deemed uncollectable. At December 31, 2004 and 2003, impaired loans were measured based upon the present value of future cash flows discounted at the loan’s effective rate, the loan’s observable market price, or the fair value of collateral if the loan is collateral dependent.
The Company had impaired loans at December 31, 2004 of $4,394,000 as compared with $3,987,000 at December 31, 2003. The Company recorded $704,000 in specific allowance for loan losses against impaired loans at December 31, 2004 as compared to $598,000 at December 31, 2003. Other forms of collateral, such as inventory, chattel, and equipment secure the remaining nonperforming loans as of each date.
At December 31, 2004 and 2003 the Bank had $60,000 of real estate acquired through foreclosure, which consisted of one residential foreclosure property.
Allowance for Loan Losses
In determining the adequacy of the allowance for loan losses, management takes into consideration the growth trend in the portfolio, examinations by financial institution supervisory authorities, internal and external credit reviews, prior loan loss experience of the Company, concentrations of credit risk, delinquency trends, general economic conditions and the interest rate environment. The allowance for loan losses is based on estimates and ultimate future losses may vary from current estimates. It is always possible that future economic or other factors may adversely affect the Company’s borrowers, and thereby cause loan losses to exceed the current allowance for loan losses.
The balance in the allowance for loan losses was affected by the amounts provided from operations, amounts charged-off and recoveries of loans previously charged off. The Company had provisions to the allowance in 2004 of $2,671,000 as compared to $2,455,000 and $4,151,000 in 2003 and 2002. See “Results of Operations - Provision for Loan Losses.”
The following table summarizes the loan loss experience of the Company for the years ended December 31,
The Company’s charge-offs, net of recoveries, was $1,650,000 in 2004 as compared with $1,326,000 and $1,760,000 in 2003 and 2002. This represents loan loss experience ratios of 0.20%, 0.19%, and 0.31% in those respective years stated as a percentage of average loans outstanding for each year. The increase in net charge-offs in 2004 in comparison to 2003 is primarily the result of an increase in the size of the loan portfolio. The decrease in net charge-offs in 2003 when compared to 2002 is due to decreased net charge offs within the consumer portfolio as well as the commercial and agricultural portfolios. As of December 31, 2004 the allowance for loan losses was $14,284,000 or 1.61% of total loans outstanding. This compares with an allowance for loan losses of $13,263,000 or 1.74% in 2003 and $12,134,000 or 1.91% in 2002. The decrease in net charge-offs in 2002 compared to 2001 was due to decreased net charge-offs within the consumer portfolio.
Liquidity
To maintain adequate liquidity requires that sufficient resources be available at all times to meet cash flow requirements of the Company. The need for liquidity in a banking institution arises principally to provide for deposit withdrawals, the credit needs of its customers and to take advantage of investment opportunities as they arise. The Company may achieve desired liquidity from both assets and liabilities. The Company considers cash and deposits held in other banks, federal funds sold, other short term investments, maturing loans and investments, receipts of principal and interest on loans, available for sale investments and potential loan sales as sources of asset liquidity. Deposit growth and access to credit lines established with correspondent banks and market sources of funds are considered by the Company as sources of liquidity. The Company is the sole shareholder of the Bank, and derives its primary source of liquidity from its ability to receive dividends from the Bank. Dividends from the Bank are subject to certain regulatory limitations.
Recent accounting rule changes have resulted in the variable interest entities used for trust preferred offerings no longer being treated as consolidated subsidiaries of trust preferred issuers. The FRB has indicated that trust preferred securities will continue to constitute Tier 1 capital until further notice. However, there could be a change to the regulatory capital treatment of preferred securities issued by bank holding companies, such as a conclusion
being reached by the FRB that preferred securities should no longer be treated as Tier 1 regulatory capital. In addition, the SEC staff has concluded that all banks and bank holding companies must deconsolidate the trusts used for trust preferred offerings as of December 31, 2003.
The Company reviews its liquidity position on a regular basis based upon its current position and expected trends of loans and deposits. Management believes that the Company maintains adequate amounts of liquid assets to meet its liquidity needs. These assets include cash, demand and time deposits in other banks, available for sale securities and federal funds sold. The Company’s liquid assets totaled $330,358,000 and $321,235,000 at December 31, 2004 and 2003 and were 23% and 26% of total assets on December 31, 2004 and 2003. Cash and noninterest-bearing deposits in other banks decreased $3,838,000 or 9% to $40,454,000 at December 31, 2004, compared to $44,292,000 at December 31, 2003. The decrease in the 2004 cash position when compared to 2003 was the result of decreased cash letters at the end of December 2004 when compared to the same period in 2003. Liquidity is also affected by collateral requirements of the Bank’s public agency deposits and certain borrowings. Total pledged securities were $321,688,000 and $295,204,000 at December 31, 2004 and 2003.
Although the Company’s primary sources of liquidity include liquid assets and a stable deposit base, the Company maintains lines of credit with certain correspondent banks, the Federal Reserve Bank, and the Federal Home Loan Bank aggregating $217,832,000 of which $155,326,000 was outstanding as of December 31, 2004. This compares with lines of credit of $174,313,000 of which $83,346,000 was outstanding as of December 31, 2003.
The following table sets forth known contractual obligations of the Company at December 31, 2004:
Contractual Obligations
Borrowings, junior subordinated debentures and operating lease obligations are discussed in the consolidated financial statements at Notes 5, 6, and 9, respectively. The purchase obligation consists of one contract to build a retail branch office in Fresno, California.
Market and Interest Rate Risk Management
In the normal course of business, the Company is exposed to market risk which includes both price and liquidity risk. Price risk is created from fluctuations in interest rates and the mismatch in repricing characteristics of assets, liabilities, and off-balance sheet instruments at a specified point in time. Mismatches in interest rate repricing among assets and liabilities arise primarily through the interaction of the various types of loans versus the types of deposits that are maintained as well as from management’s discretionary investment and funds gathering activities. Liquidity risk arises from the possibility that the Company may not be able to satisfy current and future financial commitments or that the Company may not be able to liquidate financial instruments at market prices. Risk management policies and procedures have been established and are utilized to manage the Company’s exposure to market risk. Quarterly testing of the Company’s assets and liabilities under both increasing and decreasing interest rate environments are performed to insure the Company does not assume a magnitude of risk that is outside approved policy limits.
The Company’s success is largely dependent upon its ability to manage interest rate risk. Interest rate risk can be defined as the exposure of the Company’s net interest income to adverse movements in interest rates. Although the Company manages other risks, such as credit and liquidity risk in the normal course of its business, management considers interest rate risk to be its most significant market risk and could potentially have the largest material effect on the Company’s financial condition and results of operations. Correspondingly, the overall strategy of the Company is to manage interest rate risk, primarily through balance sheet structure, to be interest rate neutral. The Company does use derivative instruments to control interest rate risk. During the second quarter of 2001, the
Company entered into a $20,000,000 hedge transaction exchanging a fixed interest rate for a variable rate tied to the prime rate. This hedge transaction was designed to give some interest income protection in a falling rate environment. This type of hedging activity is permitted subject to the approval of the Board of Directors. The hedge expired on August 23, 2004.
The Company’s interest rate risk management is the responsibility of the Asset/Liability Management Committee (ALCO), which reports to the Board of Directors. ALCO establishes policies that monitor and coordinate the Company’s sources, uses and pricing of funds. ALCO is also involved in formulating the economic projections for the Company’s budget and strategic plan. ALCO sets specific rate sensitivity limits for the Company. ALCO monitors and adjusts the Company’s exposure to changes in interest rates to achieve predetermined risk targets that it believes are consistent with current and expected market conditions. Balance sheet management personnel monitor the asset and liability changes on an ongoing basis and provide report information and recommendations to the ALCO committee in regards to those changes.
Earnings Sensitivity
The Company’s net income is dependent on its net interest income. Net interest income is susceptible to interest rate risk to the degree that interest-bearing liabilities mature or reprice on a different basis than interest-earning assets. When interest-bearing liabilities mature or reprice more quickly than interest-earning assets in a given period, a significant increase in market rates of interest could adversely affect net interest income. Similarly, when interest-earning assets mature or reprice more quickly than interest-bearing liabilities, falling interest rates could result in a decrease in net interest income.
The primary analytical tool used by the Company to gauge interest rate sensitivity is a net interest income simulation model used by many other financial institutions. The model, which is updated quarterly, incorporates all of the Company’s assets and liabilities and off-balance sheet funding commitments, together with assumptions that reflect the current interest rate environment. The Company does utilize off-balance sheet derivative financial instruments such as interest rate swaps, futures contracts, or other financial hedging instruments in managing interest rate risk. The model projects changes in cash flow of the various interest-earning assets and interest-bearing liabilities in both rising and falling interest rate environments. Based on the current portfolio mix, this model is used to estimate the effects of changes in market rates on the Company’s net interest income under interest rate conditions that simulate an immediate and sustained shift in the yield curve of up 2 percent and down 1 percent, as well as the effect of immediate and sustained flattening or steepening of the yield curve. This model’s estimate of interest rate sensitivity takes into account the differing time intervals and differing rate change increments of each type of interest sensitive asset and liability.
The estimated impact of immediate changes in interest rates at the specified levels at December 31, 2004 and 2003 is presented in the following tables:
December 31, 2004
(1)
The amount in this column represents the change in net interest income for 12 months in a stable interest rate environment versus the net interest income in the various rate scenarios.
December 31, 2003
(1)
The amount in this column represents the change in net interest income for 12 months in a stable interest rate environment versus the net interest income in the various rate scenarios.
It should be emphasized that the results are dependent on material assumptions such as those discussed above. For instance, asymmetrical interest rate behavior can have a material impact on the simulation results.
The Company’s primary objective in managing interest rate risk is to minimize the adverse impact of changes in interest rates on the Company’s net interest income and capital, while structuring the Company’s asset-liability structure to obtain the maximum yield-cost spread on that structure. The Company relies primarily on its asset-liability structure to control interest rate risk.
Based upon the December 31, 2004 mix of interest sensitive assets and liabilities, given a parallel shift up in the yield curve of 2%, this model estimated the Company’s cumulative net interest income over the next year would increase by $536,000. This compares with a cumulative one year expected increase in net interest income of $173,000 as of December 31, 2003. If prevailing market interest rates sustained a parallel decrease of 1.0% at December 31, 2004, this model estimated the Company’s cumulative one year expected decrease in net interest income would be $1,002,000. This compares with an expected cumulative one year decrease in net interest income of $1,257,000 as of December 31, 2003. The model shows that at December 31, 2004 if interest rates increase or decrease, the Company has similar interest rate risk exposure as compared to December 31, 2003, with slightly more negative results in a decreasing rate environment. As the total measure of interest rate risk indicates, the Company is modestly asset sensitive.
Off-Balance Sheet Arrangements
During 2001, the Company entered into an interest rate exchange agreement with the Federal Home Loan Bank (“FHLB”) of San Francisco that was recorded as a cash flow hedge transaction. The notional amount of the swap was $20 million with a term of 3 years which expired on August 23, 2004. For more information regarding this swap transaction, see Note 1, the section titled “Derivative Instruments and Hedging Activities” in the Company’s 2004 annual report.
The Bank has also extended firm lending commitments in the form of unused credit lines to loan customers. These commitments may or may not ever be drawn upon, depending on the credit needs of the Bank’s loan customers. For more information regarding these loan commitments, See Footnote 9, titled “Commitments and Financial Instruments With Off-Balance Sheet Credit Risk” in the Company’s 2004 annual report.
Capital Resources
The Company is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate mandatory and possibly additional discretionary actions by the regulators that, if undertaken, could have a material effect on the Company’s financial statements. Management believes, as of December 31, 2004, that the Company and the Bank meet all capital requirements to which they are subject. The Company’s leverage capital ratio at December 31, 2004 was 8.46% as compared with 8.55% as of December 31, 2003. The Company’s total risk-based capital ratio at December 31, 2004 was 11.55% as compared to 11.57% as of December 31, 2003.
Capital ratios are reviewed on a regular basis to ensure that capital exceeds the prescribed regulatory minimums and is adequate to meet the Company’s future needs. All ratios are in excess of the regulatory definitions of “well capitalized”. Management believes that, under the current regulations, the Company will continue to meet its minimum capital requirements in the foreseeable future.
The Company has a formal dividend policy, and dividends are issued solely at the discretion of the Company’s Board of Directors, subject to compliance with regulatory requirements. In order to pay any cash dividend, the Company must receive payments of dividends or management fees from the Bank. There are certain legal and regulatory limitations on the payment of cash dividends by banks. Notwithstanding regulatory restrictions, in order for the Bank to maintain a 10% risk weighted capital ratio, the Company had the ability to pay cash dividends at December 31, 2004 of $17,635,000. The Bank had the ability to pay cash dividends to the Company at December 31, 2004 of $5,402,000.
Impact of Inflation
The primary impact of inflation on the Company is its effect on interest rates. The Company’s primary source of income is net interest income which is affected by changes in interest rates. The Company attempts to limit inflation’s impact on its net interest margin through management of rate-sensitive assets and liabilities and the
analysis of interest rate sensitivity. The effect of inflation on premises and equipment, as well as noninterest expenses, has not been significant for the periods covered in this report.
Market for Company’s Common Stock and Related Stock Matters
The Company’s stock is included for quotation on the NASDAQ National Market System with a stock quotation symbol of CCOW.
The following table indicates the range of high and low sales prices for the period shown, based upon information provided by the NASDAQ National Market System.
Generally, the Company has retained earnings to support the growth of the Company and did not pay regular cash dividends prior to 2004. The Company began paying dividends in the first quarter of 2004. Any future dividends will depend on the Company’s performance, the judgment of the Board as to the appropriateness of declaring a dividend, and compliance with various legal and regulatory provisions which restrict the amount of dividends which the Company may declare. (See “Capital Resources” above).
CAPITAL CORP OF THE WEST AND SUBSIDIARIES
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management of Capital Corp of the West and subsidiaries (the “Company”) is responsible for establishing and maintaining effective internal control over financial reporting. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles.
Under the supervision and with the participation of management, including the principal executive officer and principal financial officer, the Company conducted an evaluation of the effectiveness of internal control over financial reporting based on the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation under the framework in Internal Control-Integrated Framework, management of the Company has concluded the Company maintained effective internal control over financial reporting, as such term is defined in Securities Exchange Act of 1934 Rules 13a-15(f), as of December 31, 2004.
Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting can also be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk.
Management is also responsible for the preparation and fair presentation of the consolidated financial statements and other financial information contained in this report. The accompanying consolidated financial statements were prepared in conformity with U.S. generally accepted accounting principles and include, as necessary, best estimates and judgments by management.
KPMG LLP, an independent registered public accounting firm, has audited the Company’s consolidated financial statements as of and for the year ended December 31, 2004, and the Company’s assertion as to the effectiveness of internal control over financial reporting as of December 31, 2004, as stated in their reports, which are included herein.
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of
Capital Corp of the West:
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that Capital Corp of the West and subsidiaries (the Company) maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principals, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Capital Corp of the West and subsidiaries maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Capital Corp of the West and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Capital Corp of the West and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of income and comprehensive income, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2004, and our report dated March 11, 2005 expressed an unqualified opinion on those consolidated financial statements.
/s/ KPMG LLP
Sacramento, California
March 11, 2005
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
Capital Corp of the West:
We have audited the accompanying consolidated balance sheets of Capital Corp of the West and subsidiaries (the Company) as of December 31, 2004 and 2003, and the related consolidated statements of income and comprehensive income, shareholders’ equity, and cash flows for each of the years in the three year period ended December 31, 2004. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Capital Corp of the West and subsidiaries as of December 31, 2004 and 2003 and the results of their operations and their cash flows for each of the years in the three year period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the internal control over financial reporting of Capital Corp of the West as of December 31, 2004, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 11, 2005 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
/s/ KPMG LLP
Sacramento, California
March 11, 2005
CAPITAL CORP OF THE WEST
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements.
CAPITAL CORP OF THE WEST
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
See accompanying notes to consolidated financial statements.
CAPITAL CORP OF THE WEST
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
See accompanying notes to consolidated financial statements.
CAPITAL CORP OF THE WEST
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements.
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. Summary of Significant Accounting Policies
Capital Corp of the West (the “Company”) is a registered bank holding company, which provides a full range of banking services to individual and business customers primarily in the Central San Joaquin Valley, through its subsidiaries. The following is a description of the more significant policies.
Principles of Consolidation: The consolidated financial statements of Capital Corp of the West include its subsidiaries: County Bank (the “Bank”), Capital West Group (“CWG”), Regency Investment Advisors (“RIA”), and the subsidiaries of County Bank which include County Asset Advisor, Inc. (“CAA”), Merced Area Investment Development, Inc. (“MAID”), and County Investment Trust (“REIT”). CWG, a subsidiary formed in 1996, became inactive in 1997. Regency Investment Advisors was acquired in June 2002 and divested in October 2004. All significant intercompany balances and transactions are eliminated.
The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period. Actual results could differ from those estimates applied in the preparation of the consolidated financial statements. A material estimate that is particularly susceptible to change in the near term relates to the determination of the allowance for loan losses.
Cash and Cash Equivalents: The Company maintains deposit balances with various banks which are necessary for check collection and account activity charges. Cash in excess of immediate requirements is invested in federal funds sold or other short-term investments. Generally, federal funds are sold for periods from one to thirty days. Cash, noninterest-bearing deposits in other banks and federal funds sold are considered to be cash and cash equivalents for the purposes of the consolidated statements of cash flows. Banks are required to maintain minimum average reserve balances with the Federal Reserve Bank. The amount of those reserve balances was approximately $25,000 at December 31, 2004 and $25,000 in 2003.
Investment Securities: Investment securities consist of U.S. treasury, federal agencies, state and county municipal securities, corporate bonds, mortgage-backed securities, collateralized mortgage obligations, agency preferred stock, trust preferred stock and equity securities. Investment securities are classified into one of three categories. These categories include trading, available for sale, and held to maturity. The category of each security is determined based on the Company’s investment objectives, operational needs and intent. The Company has not purchased securities with the intent of actively trading them.
Securities available for sale may be sold prior to maturity and are available for future liquidity requirements. These securities are carried at fair value. Unrealized gains and losses on securities available for sale are excluded from earnings and reported net of tax as a separate component of shareholders’ equity until realized.
Securities held to maturity are classified as such where the Company has the ability and positive intent to hold them to maturity. These securities are carried at cost, adjusted for amortization of premiums and accretion of discounts.
Premiums and discounts are amortized or accreted over the life of the related investment security as an adjustment to yield using the effective interest method. Dividend and interest income are recognized when earned. Realized gains and losses for securities classified as available for sale or held to maturity are included in earnings and are derived using the specific identification method for determining the cost of securities sold. Unrealized losses due to fluctuations in fair value of securities held to maturity or available for sale are recognized through earnings when it is determined that there is other than temporary impairment and a new cost basis is established for the security.
Loans: Loans are carried at the principal amount outstanding, net of unearned income, including deferred loan origination fees and costs. Nonrefundable loan origination and commitment fees and the direct costs associated
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
with originating or acquiring the loans are deferred and amortized as an adjustment to interest income over the life of the related loan using a method that approximates the level yield method.
Interest income on loans is accrued based on contract interest rates and principal amounts outstanding. Loans which are more than 90 days delinquent, with respect to interest or principal, are placed on non-accrual status, unless the outstanding principal and interest is adequately secured and, in the opinion of management, remains collectable. Uncollected accrued interest is reversed against interest income, and interest is subsequently recognized only as received until the loan is returned to accrual status. Interest accruals are resumed when such loans are brought fully current with respect to interest and principal and when, in the judgment of management, the loans are estimated to be fully collectable as to both principal and interest.
A loan is considered impaired, if it is probable that the Company will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Any allowance for loan losses on impaired loans is measured based upon the present value of future cash flows discounted at the loan’s effective rate, the loan’s observable market price, or the fair value of collateral if the loan is collateral dependent. Interest on impaired loans is recognized on a cash basis. In general, these statements are not applicable to large groups of small balance homogenous loans that are collectively evaluated for impairment, such as residential mortgage and consumer installment loans. Income recognition on impaired loans conforms to the method the Company uses for income recognition on nonaccrual loans. Interest income on nonaccrual loans is recorded on a cash basis. Payments may be treated as interest income or return of principal depending upon management’s opinion of the ultimate risk of loss on the individual loan. Cash payments are treated as interest income when management believes the remaining principal balance is fully collectable.
Allowance for Loan Losses: The allowance for loan losses is maintained at the level considered to be adequate for probable loan losses inherent based on management’s assessment of various factors affecting the loan portfolio, which include: growth trends in the portfolio, historical experience, concentrations of credit risk, delinquency trends, general economic conditions, and internal and external credit reviews. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance for loan losses based on their judgment of information available to them at the time of their examination. Additions to the allowance for loan losses, in the form of provision for loan losses, are reflected in current operating results, while charge-offs to the allowance for loan losses are made when a loss is determined to have occurred. Management uses the best information available on which to base estimates, however, ultimate losses may vary from current estimates.
Gain or Loss on Sale of Loans: Transfers of real estate mortgage loans held for sale in which the Company surrenders control over those loans are accounted for as a sale to the extent that consideration other than beneficial interests in the transferred loans is received in exchange. There were no loans held for sale as of December 31, 2004 and 2003. Gains or losses are recognized at the time of sale and are calculated based on the amounts received and the book value of the loans sold.
Premises and Equipment: Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are computed on the straight line basis over the estimated useful life of each type of asset. Estimated useful lives range up to 39 years for buildings, up to the lease term for leasehold improvements, and 3 to 15 years for furniture and equipment.
Other Real Estate: Other real estate is comprised of property acquired through foreclosure proceedings or acceptance of deeds-in-lieu of foreclosure. Losses recognized at the time of acquiring property in full or partial satisfaction of debt are charged against the allowance for loan losses. Other real estate is recorded at the lower of the related loan balance or fair value, less estimated disposition costs. Fair value of other real estate is generally based on an independent appraisal of the property. Any subsequent costs or losses are recognized as noninterest expense when incurred.
Goodwill and Other Intangible Assets: Goodwill represents the excess of costs over the fair value of net assets of businesses acquired. Goodwill was generated with the purchase of the Town and County Finance and Thrift
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(the “Thrift”) in June 1996. The Thrift’s assets, including intangible assets, were subsequently merged into County Bank in November 1999, and the Thrift’s charter eliminated. Goodwill associated with the purchase of the Thrift is no longer being amortized beginning on January 1, 2002 and had a balance of $1,405,000 as of December 31, 2004 and 2003. The goodwill associated with the purchase of Regency Investment Advisors Inc. in June 2002 was $520,000. RIA was subsequently sold and goodwill was included in the sale. Core deposit intangibles, representing the excess of purchase price paid over the fair value of net savings deposits acquired, were generated by the purchase of the Thrift in June 1996 and the purchase of three branches from the Bank of America in December, 1997. Core deposit intangibles resulting from these acquisitions are being amortized over 10 and 7 years, respectively. Core deposit intangibles had a balance of $69,000 and $724,000 as of December 31, 2004 and 2003. Amortization of core deposit premiums was $655,000, $676,000, and $680,000 for the years ended December 31, 2004, 2003 and 2002. Core deposit premiums are scheduled to amortize by $46,000 in the year 2005 and are scheduled to be fully amortized by June 2006. Goodwill and intangible assets are reviewed on an annual basis for impairment. If such impairment is indicated, recoverability of the asset is assessed based upon expected undiscounted net cash flows.
An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. This determination is made at the reporting unit level and consists of two steps. First, the Company determines the fair value of a reporting unit and compares it to its carrying amount. Second, if the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation, in accordance with FASB Statement No. 141, Business Combinations. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. There has been no recorded amortization and no impairment losses recognized on the Town and Country Finance and Thrift recorded goodwill as of December 31, 2004.
Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of: Long-lived assets, such as property, plant, and equipment and certain purchased intangibles subject to amortization are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future net cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, such an asset is considered to be impaired, and an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposed group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet.
Director Elective Income Deferral Agreements: The Company has purchased single premium universal life insurance policies in conjunction with implementation of salary continuation plans for certain members of management, a deferred compensation plan for certain members of the Board of Directors, and for general funding of various benefit programs of the company. This plan was changed in 2004 and is currently being used by five directors. The expenses related to the deferral agreements are accrued in other expenses. The Company is the owner and beneficiary of these policies. The Bank has also formed a Rabbi trust and has irrevocably assigned some of these universal life insurance policies to the Rabbi trust in support of these salary continuation and deferred compensation benefits. The cash surrender value of the insurance policies totaled $28,362,000 and $24,138,000 as of December 31, 2004 and 2003. Income from these policies is recorded in other income and the load, mortality and surrender charges have been recorded in other expenses. An accrued liability of $3,610,000 and $3,125,000 as of December 31, 2004 and 2003 was recorded to reflect the present value of the expected retirement benefits for the salary continuation plans and the deferred compensation benefits and was included in other liabilities. Salary continuation expense of $484,000 and $669,000 and deferred compensation expense of $97,000 and $64,000 was recorded for the years ending December 31, 2004 and 2003.
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Income Taxes: The Company files a consolidated federal income tax return and a combined state franchise tax return. The provision for income taxes includes federal income and state franchise taxes. Income tax expense is allocated to each entity of the Company based upon the analysis of the tax consequences of each company on a stand alone basis.
The Company accounts for income taxes under the asset and liability method. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
Income Tax Credits: The Company has investments in limited partnerships which own low income affordable housing projects that generate tax benefits in the form of federal and state housing tax credits. As an investor in these partnerships, the Company receives tax benefits in the form of tax deductions from partnership operating losses and income tax credits. These income tax credits are earned over a 10-year period as a result of the investment meeting certain criteria and are subject to recapture over a 15-year period. The expected benefit resulting from the affordable housing income tax credits is recognized in the period in which the tax benefit is recognized in the Company’s consolidated tax returns. These investments are accounted for using the effective yield method and are evaluated at each reporting period for impairment. The Bank had gross investments in these partnerships of $10,901,000 and $10,407,000 as of December 31, 2004 and 2003.
Derivative Instruments and Hedging Activities: All derivative instruments are recognized in the consolidated balance sheet at fair value. The accounting treatment for gains or losses from changes in the derivative instrument’s fair value is contingent on whether the derivative instrument qualifies as a hedge under the accounting standard. On the date the Company enters into a derivative contract, the Company designates the derivative instruments as (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge), (2) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge) or (3) hedge for trading, customer accommodation or not qualifying for hedge accounting (free-standing derivative instruments). For a fair value hedge, changes in the far value of the derivative instrument and changes in the fair value of the hedged asset or liability or of an unrecognized firm commitment attributable to the hedged risk are recorded in current period net income. For a cash flow hedge, changes in the fair value of the derivative instrument to the extent that it is effective are recorded in other comprehensive income, net of tax, within shareholders’ equity and subsequently reclassified to net income in the same period(s) that the hedged transaction impacts net income. For free-standing derivative instruments, changes in the fair values are reported in current period net income. The Company formally documents the relationship between hedging instruments and hedged items, as well as the risk management objective and strategy for undertaking any hedge transaction. This process includes linking all derivative instruments that are designated as fair value or cash flow hedges to specific assets and liabilities on the balance sheet or to specific forecasted transactions. The Company also formally assesses both at the inception of the hedge and on an ongoing basis, whether the derivative instruments used are highly effective in offsetting changes in fair values or cash flows of hedged items. If it is determined that the derivative instrument is not highly effective as a hedge, hedge accounting is discontinued.
During the third quarter of 2001, the Company entered into an interest rate exchange agreement with the Federal Home Loan Bank of San Francisco that was recorded as a cash flow hedge transaction. The notional amount of the swap was $20 million with a term of 3 years that expired on August 23, 2004. The Company has no hedging relationships as of December 31, 2004.
Earnings Per Share: Basic earnings per share (EPS) includes no dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution of securities that could share in the earnings of an entity.
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
On January 27, 2004, April 27, 2004, July 27, 2004, October 26, 2004 and January 25, 2005, the Board of Directors authorized a $0.05 cash dividend payable on February 26, 2004, May 26, 2004, August 25, 2004, November 29, 2004, and February 25, 2005 respectively.
The following table provides a reconciliation of the numerator and denominator of the basic and diluted earnings per share computation for the years ended December 31:
In 2004, 2003, and 2002 there were options covering 0, 7,675, and 0 shares that were not considered in the earnings per share computations because the option exercise price was in excess of the stock closing price on December 31, 2004, 2003 and 2002 making these shares antidilutive.
Stock Option Plan: Statement of Financial Accounting Standards No 148, “Accounting for Stock Based Compensation-Transition and Disclosure” an amendment of FASB Statement No. 123 and Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” establishes financial accounting and reporting standards for stock-based compensation plans, including employee stock purchase plans, stock options and restricted stock. Statement No. 148 and 123 encourages all entities to adopt a fair value method of accounting for stock-based compensation plans, whereby compensation cost is measured at the grant date upon the fair value of the award and is realized as an expense over the service or vesting period. However, Statement No. 148 and 123 also allow an entity to continue to measure compensation cost for these plans using the intrinsic value method of accounting prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” as long as proforma fair market method disclosures of net income and basic and diluted earnings per share and stock-based compensation costs, net of related tax effects, are prominently disclosed. The Company accounts for stock-based awards to employees and directors using the intrinsic value method of accounting in accordance with Accounting Principles Board Opinion No. 25. Under the intrinsic value method, compensation cost is generally the excess, if any, of the quoted market price of the stock at the grant or other measurement date over the exercise price. See Note 12 for additional disclosure information relative to options granted and outstanding.
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
The Company applies APB Opinion No. 25 in accounting for its stock options and, accordingly, no compensation cost has been recognized for its stock options in the accompanying consolidated financial statements. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS No. 123, Accounting for Stock-Based Compensation, the Company’s net income would have been reduced to the proforma amounts indicated as follows:
Total compensation expense related to the issuance of options that would have been reported was $972,000, $601,000, and $449,000 during 2004, 2003 and 2002, respectively.
The per share weighted average fair value of stock options granted during 2004, 2003, and 2002 was $13.96, $11.02, and $7.57 on the date of grant using the Black Scholes option pricing model with the following weighted average assumptions: 2004, 2003, and 2002 expected dividend yield of 0.4%, 0% and 0%; 2004, 2003, and 2002 expected volatility of 26%, 29%, and 29%; and a risk free interest rate of 4.00%, 4.75%, and 4.75% for 2004, 2003, and 2002, and an expected life of 7 years in 2004, 2003, and 2002, respectively.
Comprehensive Income: Comprehensive income consists of net income and unrealized gains (losses) on securities and certain derivative instruments and is presented in the consolidated statements of income and comprehensive income.
Reclassifications: Certain amounts in the 2003 and 2002 consolidated financial statements have been reclassified to conform with the 2004 presentation.
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 2. Investment Securities
The amortized cost and estimated market value of investment securities at December 31 are summarized below:
At December 31, 2004 and 2003, investment securities with carrying values of approximately $321,688,000 and $295,204,000, respectively, were pledged as collateral for deposits of public funds, government deposits, the Bank’s use of the Federal Reserve Bank’s discount window and Federal Home Loan Bank line of credit. The Bank is a member of the Federal Reserve Bank and the Federal Home Loan Bank. The Bank carried balances, stated at cost, of $7,304,000 and $4,914,000 of Federal Home Loan Bank stock and $1,187,000 and $1,127,000 of Federal Reserve Bank stock as of December 31, 2004 and 2003. Gross realized losses on sale of available for sale securities of $6,000, $0, and $99,000, were recognized in 2004, 2003, and 2002. Gross realized gains on sale of available
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
for sale securities of $50,000, $0, and $279,000 were recognized in 2004, 2003, and 2002. Gross losses on sale of available for sale securities were $3,715,000, $0, and $0 in 2004, 2003, and 2002. The gross losses on sale of available for sale securities in 2004 is composed of an unrealized other-than-temporary impairment loss of $3,709,000 and a realized loss of $6,000 on the sale of available for sale securities.
In June, 2003, state and municipal debt securities with a carrying value of $24,558,000 and a market value of $26,204,000 were transferred from the available for sale portfolio to the held to maturity portfolio at market value. The Company made the decision based on management’s intent to hold these securities to maturity. The unrealized holding gain at the date of transfer is reported as a separate component of shareholders’ equity and amortized over the remaining life of the securities as an adjustment of yield in a manner consistent with the amortization of a premium or accretion of a discount.
The carrying and estimated fair values of debt securities at December 31, 2004 by contractual maturity, are shown on the following table. Actual maturities may differ from contractual maturities because issuers generally have the right to call or prepay obligations with or without call or prepayment penalties.
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Gross unrealized losses on investment securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2004, were as follows:
U.S. government agencies: The unrealized losses on investments in U.S. government agency securities were caused by market interest rate increases that occurred after these securities were purchased. There were two securities that had a fair market value of $9,876,000 and a total unrealized loss of $129,000 that had been in an unrealized loss position for more than twelve months as of December 31, 2004. The first of these securities had a fair market value of $4,898,000 and an unrealized loss of $102,000 as of December 31, 2004. This government agency security has been in an unrealized loss position for 19 consecutive months as of December 31, 2004. The second had a fair market value of $4,978,000 and an unrealized loss of $27,000 as of December 31, 2004. This government agency security has been in an unrealized loss position for 18 consecutive months as of December 31, 2004. Due to the fact the Company has the ability and intent to hold these investments until a market price recovery or maturity, these investments are not considered other-than-temporarily impaired.
State and political subdivisions: The unrealized losses on state and political subdivision investments were caused by market interest rate increases that occurred after these securities were purchased. There were no state and political subdivision securities that had been in an unrealized loss position for twelve months or more. Because the Company has the ability and intent to hold these investments until a market price recovery or maturity, these investments are not considered other-than-temporarily impaired.
Mortgage-backed securities: The unrealized losses on available for sale and held to maturity investments in mortgage-backed securities were caused by market interest rate increases that occurred after these securities were purchased and higher actual prepayment rates than were originally estimated on mortgage-backed securities that were purchased at a premium. When the marketplace believes that prepayment rates will remain high, higher coupon mortgage-backed securities are priced to reflect lower premiums and higher expected principal prepayments. There were four available for sale and three held to maturity mortgage-backed securities that had a fair market value of $19,770,000 and an unrealized loss of $449,000 that had been in an unrealized loss position for more than twelve months as of December 31, 2004. The four available for sale mortgage-backed securities had a fair market value of $7,283,000 and an unrealized loss of $96,000 as of December 31, 2004. These four securities had been in an unrealized loss position for 20, 19, 17, and 16 consecutive months as of December 31, 2004. The three held to maturity securities had a fair market value of $12,487,000 and an unrealized loss of $353,000 as of December 31,
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
2004. These three held to maturity mortgage-backed securities had been in an unrealized loss position for 18, 18, and 17 consecutive months as of December 31, 2004. Due to the fact the Company has the ability and intent to hold these investments until a market price recovery or maturity, these investments are not considered other-than-temporarily impaired.
Collateralized mortgage obligations: The unrealized losses on collateralized mortgage obligation securities were caused by market rate increases that occurred after these securities were purchased. There was one collateralized mortgage obligation that had a fair value of $5,058,000 and an unrealized loss of $26,000 as of December 31, 2004. This collateralized mortgage obligation has been in an unrealized loss position for 19 consecutive months as of December 31, 2004. Due to the fact the Company has the ability and intent to hold these investments until a market price recovery or maturity, these investments are not considered other-than-temporarily impaired.
Equity securities: The Company invests in mutual funds that hold adjustable rate mortgage loan investments that fluctuate in value with prevailing market interest rates. The unrealized losses on equity securities were caused by generally low prevailing market rates. The market price of adjustable rate loans declines during periods of falling or flat interest rates. There was one investment in an adjustable rate mortgage mutual fund that had a fair market value of $12,738,000 and an unrealized loss of $261,000 as of December 31, 2004. This mutual fund has been in an unrealized loss position for 12 consecutive months as of December 31, 2004. Due to the fact the Company has the ability and intent to hold these investments until a market price recovery, and the Company believes that the market price of these securities will improve as interest rates move higher, these investments are not considered other-than-temporarily impaired.
NOTE 3. Loans
Loans at December 31 consisted of the following:
Loans are net of deferred loan fees of $2,446,000 and $2,683,000, excluding consumer loans, as of December 31, 2004 and 2003. Consumer loans are net of deferred loan costs of $401,000 and $417,000 as of December 31, 2004 and 2003.
Nonaccrual loans totaled $4,394,000 and $3,987,000 at December 31, 2004 and 2003. Foregone interest on nonaccrual loans was approximately $4,000, $39,000, and $131,000 for the years ended December 31, 2004, 2003 and 2002.
Impaired loans are loans for which it is probable that the Company will not be able to collect all amounts due. At December 31, 2004 and 2003, the recorded investment in impaired loans was $4,394,000, and $3,987,000 which had a related allowance for loan losses of $704,000, and $598,000 in 2004 and 2003. As of December 31, 2004 and 2003, there were no impaired loans without a related allowance for loan loss assigned to them. The average outstanding balance of impaired loans for the years ended December 31, 2004, 2003 and 2002 was $4,206,000, $2,328,000, and $5,134,000 on which $216,000, $231,000, and $210,000 was recognized as interest income on a cash basis.
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
At December 31, 2004 and 2003, the collateral value method was used to measure impairment for all loans classified as impaired. The following table shows the recorded investment in impaired loans by loan category at December 31:
The following is a summary of changes in the allowance for loan losses during the years ended December 31:
In the ordinary course of business, the Company, through its subsidiaries, has made loans to certain directors and officers and their related businesses. In management’s opinion, these loans are granted on substantially the same terms, including interest rates and collateral, as those prevailing on comparable transactions with unrelated parties, and do not involve more than the normal risk of collectibility.
Activity in loans to, or guaranteed by, directors and executive officers and their related businesses at December 31, are summarized as follows:
The Bank’s business activity is with customers located primarily in the counties of Fresno, Madera, Mariposa, Merced, San Francisco, San Joaquin, Stanislaus, and Tuolumne in the state of California. Consumer lending and small working capital total loan portfolio consists of consumer lending, loans to small businesses, credit cards and the purchase of financing contracts principally from automobile dealers. Individual loans and lines are made in a variety of ways. In many cases collateral such as real estate, automobiles and equipment are used to support the extension of credit. Repayment, however, is largely dependent upon the borrower’s personal cash flow.
Commercial lending activities are spread across a wide spectrum including loans to businesses, construction and permanent real estate financing, short and long term agricultural loans for production and real estate purposes and SBA financing. Where appropriate, collateral is taken to secure and reduce the Bank’s credit risk. Each loan is submitted to an individual risk grading process but the borrowers’ ability to repay is dependent, in part, upon factors affecting the local and national economies.
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 4. Premises and Equipment
Premises and equipment consisted of the following at December 31:
Included in the totals above are construction in progress of $2,268,000 and $541,000 at December 31, 2004 and 2003 respectively. Depreciation expense totaled $1,717,000, $1,661,000 and $1,903,000 in 2004, 2003 and 2002.
NOTE 5. Other Borrowings
The following is a summary of selected information for short term borrowings. These borrowings generally mature in less than one year.
As of December 31,
(1)
The Treasury tax loan is a variable rate product that reprices weekly based on the Federal Funds rate. The account is payable on a daily basis.
The Company maintains a secured line of credit with the Federal Home Loan Bank of San Francisco (FHLB). Based on the FHLB stock requirements at December 31, 2004, this line provided for maximum borrowings of $163,956,000 of which $155,326,000 was outstanding. At December 31, 2004 this borrowing line is collateralized by securities with a market value of $172,585,000. At December 31, 2003, the line of credit collateralized by securities totaled $119,372,000 of which $83,346,000 was outstanding. At December 31, 2003 this borrowing line is collateralized by securities with a market value of $125,655,000. The Company had additional secured, unused lines of credit of $9,876,000 and unsecured unused lines of credit of $44,000,000 at December 31, 2004. This compares with secured, unused lines of credit of $14,941,000 and unsecured unused lines of credit of $40,000,000 as of December 31, 2003.
The following is a summary of selected information for long-term borrowings. These borrowings generally mature in greater than one year.
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Interest expense related to FHLB borrowings totaled $4,368,000, $4,069,000, and $4,265,000 in 2004, 2003, and 2002. Interest expense related to the mortgage note totaled $236,000, $240,000, and $245,000 in 2004, 2003, and 2002. This long term note is secured by Company land and buildings. Interest expense on federal funds purchased was $21,000, $11,000 and $22,000 in 2004, 2003, and 2002. Compensating balance arrangements are not significant to the operations of the Company.
Principal payments required to service the Company’s borrowings during the next five years are:
NOTE 6. Junior Subordinated Debentures
At December 31, 2004 the Company had 2 wholly-owned trusts (“Trusts”) that were formed to issue trust preferred securities and related common securities of the Trusts. As a result of adoption of FIN 46R, the Company deconsolidated the Trusts as of and for the years ended December 31, 2004 and 2003. There was $16,496,000 of junior subordinated debentures issued and outstanding as of December 31, 2004 and 2003. The junior subordinated debentures were reflected as long-term debt in the consolidated balance sheets at December 31, 2004 and 2003.
County Statutory Trust I and County Statutory Trust II are Connecticut statutory trusts, which were formed for the purpose of issuing County Statutory Trust I Capital Securities and County Statutory Trust II Capital Securities (“Trust Preferred Securities”). The Trust Preferred Securities are described below. Interest on the Trust Preferred Securities is payable semi-annually on the 10.20% issue and quarterly on the Statutory Trust II issue and is deferrable, at the option of the Company for up to five years for both issues. Following the issuance of the Trust Preferred Securities, the Trust used the proceeds from the Trust Preferred Securities offering to purchase a like amount of Junior Subordinated Debt Securities (the Debt Securities) of the Company. The debt securities bear the same terms and interest rates as the related Trust Preferred Securities. The Debt Securities are the sole assets of the Trust. The Company has fully and unconditionally guaranteed all of the obligations of the Trust.
County Statutory Trust I issued $6,000,000 in Trust Preferred Securities on February 22, 2001. These securities pay interest at the rate of 10.20% and have a stated maturity date of February 22, 2031. They also have an optional redemption date of February 22, 2021. County Statutory Trust II issued $10,000,000 in Trust Preferred Securities on December 17, 2003. These securities pay interest at a variable rate of interest that was 4.07% at December 31, 2004, and have a stated maturity date of December 17, 2033. They have an optional redemption date of December 17, 2008. The interest rate on this issue is fixed for five years, then after the optional redemption date of December 17, 2008, the rate will be indexed to the then-current 3 month LIBOR rate plus 2.85%.
The debentures issued, less the common securities of the Trusts, qualify as Tier 1 capital under the interim guidance issued by the Board of Governors of the Federal Reserve System (Federal Reserve Board).
The Trust Preferred Securities are mandatorily redeemable, in whole or in part, upon repayment of their underlying Debt Securities at their respective stated maturities or their earlier redemption. The Debt Securities are redeemable prior to maturity at the option of the Company on or after their respective optional redemption dates.
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 7. Income Taxes
The provision for income taxes for the years ended December 31 is comprised of the following:
In April 2004, the Company amended 2001 and 2002 state income tax returns and paid $2,411,000 in state income taxes as part of the State of California’s Voluntary Compliance Initiative. The payment was related to the tax treatment of consent dividends received by the Bank from the Bank’s REIT subsidiaries. The Company has maintained the right to file income tax refunds related to these payments, but has recorded the payments as a state income tax expense.
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31 consists of the following:
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
In assessing the Company’s ability to realize the tax benefits of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods which the deferred tax assets are deductible, management believes it is more likely than not the Company will realize the benefits of these deductible differences, net of the existing valuation allowances at December 31, 2004 and 2003.
During 2004, the Company increased the tax valuation allowance by $404,000 to a total valuation allowance of $424,000 at December 31, 2004. The increase was related to management’s assessment of the ultimate collectibility of tax benefits related to the book deduction for other than temporary impairment of equity securities. In order to realize the tax benefits related to any realized capital losses, the Company would need to be able to generate offsetting capital gains within six years beginning with the year of any realized loss. After an evaluation by management of the potential sources of future capital gains from the recorded assets at December 31, 2004, it was management’s conclusion that the deferred tax asset related to the other than temporary impairment of equity securities was impaired, and a partial tax valuation allowance was established to the extent that management believed it was more likely than not that the asset would not be realized.
A reconciliation of income tax at the federal statutory rate to the provision for income taxes follows:
As of December 31, 2004, the anticipated 2004 tax refund related to federal and state income taxes was $1,683,000.
NOTE 8. Regulatory Matters
The Company is subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate mandatory and possibly, additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the Company’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weighting and other factors.
First, a bank must meet a minimum Tier I (as defined in the regulations) capital ratio ranging from 3% to 5% based upon the bank’s CAMEL (“capital adequacy, asset quality, management, earnings and liquidity”) rating.
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Second, a bank must meet minimum total risk based capital to risk weighted assets ratio of 8%. Risk based capital and asset guidelines vary from Tier I capital guidelines by redefining the components of capital, categorizing assets into different risk classes, and including certain off-balance sheet items in the calculation of the capital ratio. The effect of the risk based capital guidelines is that banks with high exposure will be required to raise additional capital while institutions with low risk exposure could, with the concurrence of regulatory authorities, be permitted to operate with lower capital ratios. In addition, a bank must meet minimum Tier I capital to average assets ratio of 4%.
Management believes, as of December 31, 2004 that the Company and the Bank met all capital adequacy requirements to which they are subject, including the ratio test for a well capitalized bank under the regulatory framework for prompt corrective action. The most recent notification from the FRB categorized the Company and the Bank as well capitalized under the FDICIA regulatory framework for prompt corrective action. Subsequent to this notification, there are no conditions or events that management believes have changed the risk based capital category of the Company and the Bank. To be categorized as well capitalized, the Bank must meet minimum ratios.
On October 26, 2004 County Bank entered into a written agreement (the “Agreement”) with the Federal Reserve Bank of San Francisco (“FRBSF”). Under the Agreement, the Bank will, among other actions to be taken, (i) develop a written program designed to improve the Bank’s system of internal controls to ensure compliance with applicable provisions of the Bank Secrecy Act; (ii) develop an enhanced written customer due diligence program designed to reasonably ensure the identification and reporting of all known or suspected violations of law and suspicious transactions against or involving the Bank; (iii) establish enhanced written policies and procedures designed to strengthen the Bank’s internal controls and audit program, and (iv) submit quarterly progress reports to the FRBSF detailing actions taken to secure compliance with the Agreement.
The Bank has already made significant progress in addressing the deficiencies identified by the FRBSF. The compliance effort will entail certain additional expenditures. In addition, while the Agreement is in place, its effect may be to limit the Bank’s ability to engage in certain expansionary activity. Neither of these effects is expected to have a material adverse impact on the financial condition nor results of operations of the Bank or the Company. The next review date is scheduled for May 2005.
The Company has no formal dividend policy, and dividends are issued solely at the discretion of the Company’s Board of Directors subject to compliance with regulatory requirements. In order to pay any cash dividends, the Company must receive payments of dividends from the Bank. There are certain regulatory limitations on the payment of cash dividends by banks.
Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain minimum amounts and ratios (set forth in the following table).
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
The Company’s and Bank’s actual capital amounts and ratios as of December 31, 2004 are as follows:
(1)
The leverage ratio consists of Tier 1 capital divided by quarterly average assets. The minimum leverage ratio is 3 percent for banking organizations that do not anticipate significant growth and that have well diversified risk, excellent asset quality and in general, are considered top-rated banks.
The Company’s and Bank’s actual capital amounts and ratios as of December 31, 2003 are as follows:
(1)
The leverage ratio consists of Tier 1 capital divided by quarterly average assets. The minimum leverage ratio is 3 percent for banking organizations that do not anticipate significant growth and that have well diversified risk, excellent asset quality and in general, are considered top-rated banks.
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 9. Commitments and Financial Instruments With Off-Balance Sheet Credit Risk
At December 31, 2004, the Company has operating lease rental commitments for remaining terms of one to twenty years. The Company has options to renew four of its leases for periods of 10 through 20 years. The minimum future commitments under non-cancelable lease agreements having terms in excess of one year at December 31, 2004 are as follows:
Rent expense was approximately $1,226,000, $986,000, and $873,000, for the years ended December 31, 2004, 2003, and 2002.
In the ordinary course of business, the Company enters into various types of transactions which involve financial instruments with off-balance sheet risk. These instruments include commitments to extend credit and standby letters of credit and are not reflected in the accompanying balance sheets. These transactions may involve, to varying degrees, credit and interest risk in excess of the amount, if any, recognized in the balance sheets.
The Company’s off-balance sheet credit risk exposure is the contractual amount of commitments to extend credit and standby letters of credit. The Company applies the same credit standards to these contracts as it uses in its lending process. Additionally, commitments to extend credit and standby letters of credit bear similar credit risk characteristics as outstanding loans.
Financial instruments whose contractual amount represents risk:
Commitments to extend credit are agreements to lend to customers. These commitments have specified interest rates and generally have fixed expiration dates, but may be terminated by the Company if certain conditions of the contract are violated. Although currently subject to draw down, many of these commitments are expected to expire or terminate without funding. Therefore, the total commitment amounts do not necessarily represent future cash requirements. Collateral held relating to these commitments varies, but may include securities, equipment, inventory and real estate.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of the customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held for standby letters of credit is based on an individual evaluation of each customer’s credit worthiness, but may include cash, equipment, inventory and securities.
The Company, because of the nature of its business, is subject to various threatened or filed legal cases. The Company, based on the advice of legal counsel, does not expect such cases will have a material, adverse effect on its financial position or results of operations.
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 10. Time Deposits
At December 31, 2004 the aggregate maturities for time deposits are as follows:
NOTE 11. Employee and Director Benefit Plans
The Company has a noncontributory employee stock ownership plan (“ESOP”) and an employee savings plan covering substantially all employees. During 2004, 2003, and 2002, the Company contributed approximately $580,000, $541,000, and $468,000, to the ESOP and $226,000, $193,000, and $173,000 to the employee savings plan.
Under provisions of the ESOP, the Company can make discretionary contributions to be allocated based on eligible individual annual compensation, as approved by the Board of Directors. Contributions to the ESOP are recognized as compensation expense. For the years ended December 31, 2004, 2003, and 2002, the ESOP owned 213,607, 206,980, and 206,100 shares of the Company’s stock. ESOP shares are included in the weighted average number of shares outstanding for earnings per share computations.
The employee savings plan allowed participating employees to contribute up to $13,000 each in 2004. The Company matched 25% of the employees’ elective contribution, as defined, not to exceed 10% of eligible annual compensation.
The Company maintains a non-qualified salary continuation plan for certain senior executive officers of the Company and the Bank. Under the plan, the Company has agreed to pay these executives retirement benefits for a ten to fifteen year period after their retirement so long as they meet certain length of service vesting requirements. The plan is informally linked to several single premium universal life insurance policies that provide life insurance on certain senior executive officers with the Company named as the owner and beneficiary of these policies. The Bank has a Rabbi trust and specific life insurance contracts have been irrevocably assigned to the trust in support of the salary continuation plans. Salary continuation expense totaled $484,000, $669,000, and $656,000, in 2004, 2003, and 2002. Total liabilities carried by the Company for salary continuation totaled $3,067,000, $2,499,000, and $1,925,000 in 2004, 2003, and 2002, respectively.
The Company also maintains a non-qualified Director Elective Income Deferral Agreement plan for members of the board of directors of the Company and the Bank. This plan was recently changed and is now call the “Director Elective Income Deferral Agreements”. Under the deferred compensation plan, members of the board of directors have the ability to defer compensation they receive as directors until a future date elected by the director. The director then also elects either to be paid in a lump sum or annuity starting at the date elected by the director. The plan is informally linked to several single premium universal life insurance policies that provide life insurance on certain directors with the Company named as the owner and beneficiary of these policies. The Bank has a Rabbi trust and life insurance contracts have been irrevocably assigned to the trust in support of the deferred compensation plans. Deferred compensation expense totaled $97,000, $64,000, and $59,000 in 2004, 2003, and 2002. Total liabilities carried by the Company for Director Elective Income Deferral totaled $543,000, $446,000, and $387,000 in 2004, 2003, and 2002, respectively.
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 12. Stock Option Plan
In 1992, shareholders approved the adoption of an incentive stock option plan for bank management and a non-statutory stock option plan for directors. In 2002, shareholders approved the adoption of a new incentive stock option plan for bank management and a new non-statutory stock option plan for directors. The maximum number of shares issuable under the plans was 126,000 and was amended by the shareholders in 1995 and 2001 to 450,000 and 675,000 options available for grant. Options are available for grant under the plans at prices that approximate fair market value of the stock at the date of grant. Options granted under both plans become exercisable 25% at the time of grant and 25% each year thereafter and expire 10 years from the date of grant.
A summary of the status of the Company’s stock options as of and for the years ended December 31, 2004, 2003, and 2002 and changes during the years ended on those dates, follows:
The following table summarizes information about options outstanding at December 31, 2004:
The number of shares and exercise price per share has been adjusted for stock dividends and stock splits. See footnote 1 for additional information related to total compensation and effects on net income.
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 13. Fair Value of Financial Instruments
The Company in estimating its fair value disclosures for financial instruments used the following methods and assumptions:
Financial Assets:
Cash and cash equivalents: For these assets, the carrying amount is a reasonable estimate for fair value.
Investments: Fair values for available for sale and held to maturity investment securities are based on quoted market prices where available. If quoted market prices were not available, fair values were based upon quoted market prices of comparable instruments.
Net loans: The fair value of loans is estimated by utilizing discounted future cash flow calculations using the interest rates currently being offered for similar loans to borrowers with similar credit risks and for the remaining or estimated maturities considering prepayments. The carrying value of loans is net of the allowance for loan losses and unearned loan fees.
Bank Owned Life Insurance: The carrying amount of this asset is a reasonable estimate of fair value.
Interest Receivable: The carrying amount of this asset is a reasonable estimate of fair value.
Financial Liabilities:
Deposits: The fair values disclosed for deposits generally paid upon demand (i.e. noninterest-bearing and interest-bearing demand) savings and money market accounts are considered equal to their respective carrying amounts as reported on the consolidated balance sheets. The fair value of fixed rate certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities.
Borrowings: For these instruments, the fair value is estimated using rates currently available for similar loans with similar credit risk and for the remaining maturities.
Commitments to extend credit and standby letters of credit: The fair value of commitments to extend credit and standby letters of credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present credit worthiness of the counter parties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rate. The fair value of letters of credit is based on fees currently charged for similar arrangements or on the estimated cost to terminate them or otherwise settle the obligation with the counter parties at the recording date.
Fair values for financial instruments are management’s estimates of the values at which the instruments could be exchanged in a transaction between willing parties. These estimates are subjective and may vary considerably from amounts that would be realized in actual transactions. In addition, other significant assets are not considered financial assets including, any deferred tax assets and premises and equipment. Further, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on the fair value estimates and have not been considered in any of these estimates.
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 14. Parent Company Only Financial Information
This information should be read in conjunction with the other notes to the consolidated financial statements. The following are the condensed balance sheets of the Company as of December 31, 2004 and 2003 and the condensed statements of income and cash flows for the years ended December 31, 2004, 2003, and 2002:
Condensed balance sheets
Condensed statements of income
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Condensed statements of cashflows
CAPITAL CORP OF THE WEST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 15. Quarterly Results of Operations (Unaudited)
(1)
Basic and diluted earnings per share calculations are based upon the weighted average number of shares outstanding during each period. Full year weighted average shares differ from quarterly weighted average shares and, therefore, annual earnings per share may not equal the sum of the quarters.
During the fourth quarter of 2004, the Company recorded two separate adjustments to earnings. The first was an other-than-temporary impairment charge $3,709,000 related to unrealized losses on three agency preferred stocks. The second was a charge to income tax expense of $1,229,000 related to the write-off of tax benefits derived from the utilization of consent dividends declared by the Bank’s REIT. See Note 2 and Note 8 for additional disclosure information related to these two charges.