Item 1. Business
Forward Looking Statements
Certain statements contained in this Annual Report on Form 10-K that are not statements of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Act”), notwithstanding that such statements are not specifically identified. These statements are based on management’s beliefs and assumptions, and on information available to management as of the date of this document. Forward-looking statements include the information concerning possible or assumed future results of operations of the Company set forth under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Forward-looking statements also include statements in which words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “estimate,” “consider” or similar expressions are used. Forward-looking statements are not guarantees of future performance. They involve risks, uncertainties and assumptions, including the risks discussed under the heading “Risk Factors” and elsewhere in this report. The Company’s actual future results and shareholder values may differ materially from those anticipated and expressed in these forward-looking statements. Many of the factors that will determine these results and values, including those discussed under the heading “Risk Factors That May Affect Results,” are beyond the Company’s ability to control or predict. Investors are cautioned not to put undue reliance on any forward-looking statements. In addition, the Company does not have any intention or and assumes no obligation to update forward-looking statements after the date of the filing of this report, even if new information, future events or other circumstances have made such statements incorrect or misleading. Except as specifically noted herein all referenced to the “Company” refer to Community Valley Bancorp, a California corporation, and its consolidated subsidiaries.
General
The Company
Community Valley Bancorp (the “Company”) is a California corporation registered as a financial holding company under the Financial Holding Company Act of 1956, as amended (the “BHC Act”), and is headquartered in Chico, California. The Company was incorporated in July, 2001 and acquired all of the outstanding shares of Butte Community Bank (the “Bank”) in May, 2002. The Company’s principal subsidiary is the Bank. The Company also has a subsidiary in the name of Community Valley Bancorp Trust I, which was formed in December, 2002 solely to facilitate the issuance of capital trust pass-through securities. The Company also has an insurance subsidiary in the name of Community Valley Bancorp Insurance Agency, LLC (subsequently changed to Butte Community Insurance Agency, LLC) which was formed in December 2004 to provide a full service insurance agency offering all lines of coverage. The Company exists primarily for the purpose of holding the stock of the Bank and of such other subsidiaries as it may acquire or establish.
The Company’s principal source of income is currently dividends from the Bank, but the Company intends to explore additional supplemental sources of income in the future. The expenditures of the Company, including (but not limited to) the payment of dividends to shareholders, if and when declared by the Board of Directors, and the cost of servicing debt will generally be paid from such payments made to the Company by the Bank.
At December 31, 2006, the Company had consolidated assets of $550.0 million, deposits of $484.9 million and shareholders’ equity of $45.7 million.
The Company’s Administrative Offices have moved to the new headquarters located at 1360 East Lassen Avenue, Chico, California and its telephone number is (530) 899-2344. References herein to the “Company” include the Company and the Bank, unless the context indicates otherwise.
The Company files annual, quarterly and other reports under the Securities Exchange Act of 1934 with the Securities and Exchange Commission. These reports are posted and are available at no cost on the Company’s website, www.communityvalleybancorp.com through the reports link, as soon as reasonably practicable after the Company files such documents with the SEC. The Company’s filings are also available through the SEC’s website at www.sec.gov.
The Bank
Butte Community Bank was incorporated under the laws of the State of California on May 11, 1990 and commenced operations as a California state-chartered commercial bank on December 14, 1990. The Bank’s Administrative Office is located at 1360 East Lassen Avenue, Chico, California. The Bank is an insured bank under the Federal Deposit Insurance Act up to the maximum limits thereof. The Bank is not a member of the Federal Reserve System. At December 31, 2006, the Bank had approximately $549.6 million in assets, $442.3 million in loans and $488.4 million in deposits.
We operate seven full-service branch offices in four Butte County communities, one full-service branch office in Sutter County, two full-service branches in Tehama County, one full-service branch in Yuba County, one full-service branch in Colusa County, one full-service branch in Shasta County, one Loan Production office in Sacramento County, and one Loan Production office in Butte County. We offer a full range of banking services to individuals and various-sized businesses in the communities we serve. The locations of those offices are:
Chico:
Main Office
Paradise
South Paradise Branch
2041 Forest Avenue
672 Pearson Road
Administrative Headquarters
1360 East Lassen Avenue
North Paradise Branch
6653 Clark Road
North Chico Branch
Oroville
Oroville Branch
237 West East Avenue
2227 Myers Street
Central Chico Branch
Magalia
Magalia Branch
900 Mangrove Avenue
14001 Lakeridge Circle
Citrus
Heights
Citrus Heights Loan Office
5959 Greenback Lane #450
Yuba
City
Yuba City Branch
1600 Butte House Road
Redding
Redding Branch
2951 Churn Creek
Red
Bluff
Red Bluff Branch
10 Gilmore Rd
Marysville
Marysville Branch
Colusa
Colusa Branch
904 B Street
1017 Bridge Street
Gridley
Gridley Loan Office
Corning
Corning Branch
1010 Spruce Street
950 Hwy 99W
In addition, our, Data Processing, Call Center and Bank Card Center are located at 1390 Ridgewood Drive, Chico. Our Real Estate Loan Center and Central Note Department are located at 1360 East Lassen Avenue, Chico. We also have specialized credit centers for agricultural lending and construction and real estate lending within a number of these branch offices. These facilities are located in the cities of Chico, Paradise, and Oroville in Butte County, the city of Yuba City in Sutter County, The cities of Red Bluff and Corning in Tehama County, the city of Marysville in Yuba County, the city of Colusa in Colusa County, the city of Citrus Heights in Sacramento County, and the city of Redding in Shasta County.
Throughout the history of Butte Community Bank, our growth has been exclusively by establishing de novo full-service branch offices and credit centers in various locations in California’s Northern Sacramento Valley and foothill region. With a predominant focus on personal service, Butte Community Bank has positioned itself as a multi-community independent bank serving the financial needs of individuals and businesses, including agricultural and real estate customers in Butte and other surrounding counties. Our principal retail lending services include home equity and consumer loans. In addition, we have two other significant dimensions which surround this core of retail community banking: Agricultural lending, and real estate financing (both construction and long term).
The Agricultural Credit Centers located in Yuba City, Chico, and Red Bluff provide a complete line of credit services in support of the agricultural activities which are key to the continued economic development of the communities we serve. “Ag lending” clients include a full range of individual farming customers and small business farming organizations.
The Bank Card Center, headquartered in Chico, provides a range of credit, debit and ATM card services, which are made available to each of the customers served by the branch banking offices. In addition, we staff our Chico, Paradise, Oroville, Red Bluff and Yuba City offices with real estate lending specialists. These officers are responsible for a complete line of land acquisition and development loans, construction loans for residential and commercial development, and the origination of multifamily credit facilities. Secondary market services are provided through the Bank’s affiliations with Fannie Mae and various non-governmental programs. The Bank services these real estate loans sold on the secondary market, and as of year end the portfolio serviced was in excess of $152 million. We also have an orientation toward Small Business Administration lending and have been designated as a Preferred Lender since 1998. The Bank’s SBA program generated approximately $5.3 million in loans during the past year. It is anticipated that loans under this program will be an increasing segment of our loan portfolio over the next few years. In September, 2006 a lender with SBA expertise was hired to work out of the Loan Office in Citrus Heights. The Bank was also recognized as the number one USDA Business and Industry (B&I) Lender in the nation during 2006 having originated fifteen loans totaling more than $46 million. The primary purpose of the B&I program is to stimulate the local economy, create additional employment, attract additional commercial investment capital and support potential growth in tax revenue, which will improve the quality of life for rural residents.
As of December 31, 2006, the principal areas in which we directed our lending activities, and the percentage of our total loan portfolio for which each of these areas was responsible, were as follows: (i) agricultural loans (6%); (ii) commercial and industrial (including SBAand B&I) loans (15%); (iii) real estate loans (commercial and construction) (69%); (iv) consumer loans (10%).
In addition to the lending activities noted above, we offer a wide range of deposit products for the retail banking market including checking, interest bearing transaction, savings, time certificates of deposit and retirement accounts, as well as telephone banking and internet banking with bill pay options. As of December 31, 2006, we had 34,021 deposit accounts with balances totaling approximately $488 million, compared to 30,097 deposit accounts with balances totaling approximately $434 million at December 31, 2005. Butte Community Bank attracts deposits through its customer-oriented product mix, competitive pricing, convenient locations, extended hours drive-up and on-line banking, all provided with the highest level of customer service.
We also offer other products and services to our customers, which complement the lending and deposit services previously reviewed. These include cashier’s checks, traveler’s checks, bank-by-mail, ATM, night depository, safe deposit boxes, direct deposit, automated payroll services, cash management, lockbox and other customary banking services. Shared ATM and Point of Sale (POS) networks allow customers access to the national and international funds transfer networks. During the past few years we have substantially enhanced our ATM locations to include off-site areas not previously served by cash or deposit facilities. We now have a total of five such remote ATM’s at five different locations, including two hospitals, two convenience stores, and an entertainment center. These locations facilitate cash advances which would not otherwise be available to consumers at non-branch locations, thereby increasing consumer convenience. In addition to such specifically oriented customer applications, we provide safe deposit, wire transfer capabilities and a convenient customer service group in our Call Center to answer questions and assure a high level of customer satisfaction with the level of services and products we provide.
Most of the Bank’s deposits are attracted from individuals, business-related sources and smaller municipal entities. This results in a relatively modest average deposit balance of approximately $10,000 at December 31, 2006, but makes the Bank less subject to adverse effects from the loss of a substantial depositor who may be seeking higher yields in other markets or who may have need of money otherwise on deposit with the Bank, especially during periods of inflation or conservative monetary policies. The Bank has had a relationship with a local title company for many years. They have kept substantial deposit balances over the years but during 2006, with the downturn in the real estate market, these balances decreased. Management believes this relationship to be very secure and does not anticipate this business leaving the Bank.
For non-deposit services, we have a strategic alliance with Linsco Private Ledger Financial Services. Through this arrangement, our registered and licensed representatives provide Bank customers with convenient access to annuities, insurance products, mutual funds, and a full range of investment products which are not FDIC insured. They conduct business from all of our full service offices.
We do not believe there is a significant demand for additional trust services in our service areas, and we do not operate or have any present intention to seek authority to operate a Trust Department. We believe that the cost of establishing and operating such a department would not be justified by the potential income to be gained there from.
The officers and employees of the Bank are continually engaged in marketing activities, including the evaluation and development of new products and services, which enable the Bank to retain and improve its competitive position in its service area. All of these developments are meant to increase public convenience and enhance public access to the electronic payments system. The cost to the Bank for these development, implementation, and marketing activities cannot expressly be calculated with any degree of certainty.
The Bank holds no patents or licenses (other than licenses required by appropriate bank regulatory agencies), franchises, or concessions. The Bank is not dependent on a single customer or group of related customers for a material portion of its deposits, nor is a material portion of the Bank’s loans concentrated within a single industry or group of related industries. There has been no material effect upon the Bank’s capital expenditures, earnings, or competitive position as a result of Federal, state, or local environmental regulation.
Recent Developments
On May 19, 2006 the Company filed applications with the California Department of Financial Institutions and the Federal Deposit Insurance Corporation for permission to relocate its branch office in the city of Red Bluff. This branch subsequently opened on June 26, 2006.
On June 22, 2006 the Company filed applications with the California Department of Financial Institutions and the Federal Deposit Insurance Corporation for permission to relocate its branch office in the city of Redding. This branch subsequently opened on July 31, 2006.
On September 12, 2006 the Company filed applications with the California Department of Financial Institutions and the Federal Deposit Insurance Corporation for permission to relocate its branch office in the city of Marysville. This branch subsequently opened for business on October 30, 2006.
On August 30, 2006 the Company filed applications with the California Department of Financial Institutions and the Federal Deposit Insurance Corporation to relocate its branch office in the city of Corning. This branch was subsequently opened on November 20, 2006.
Competition
The banking business in California generally, and specifically in our market areas, is highly competitive with respect to virtually all products and services and has become increasingly more so in recent years. The
industry continues to consolidate and strong, unregulated competitors have entered banking markets with focused products targeted at highly profitable customer segments. Many largely unregulated competitors are able to compete across geographic boundaries and provide customers increasing access to meaningful alternatives to banking services in nearly all significant products. These competitive trends are likely to continue.
With respect to commercial bank competitors, the business is largely dominated by a relatively small number of major banks with many offices operating over a wide geographical area. These banks have, among other advantages, the ability to finance wide-ranging and effective advertising campaigns and to allocate their investment resources to regions of highest yield and demand. Many of the major banks operating in the area offer certain services which we do not offer directly but may offer indirectly through correspondent institutions. By virtue of their greater total capitalization, such banks also have substantially higher lending limits than we do.
In addition to other banks, competitors include savings institutions, credit unions, and numerous non-banking institutions such as finance companies, leasing companies, insurance companies, brokerage firms, and investment banking firms. In recent years, increased competition has also developed from specialized finance and non-finance companies that offer wholesale finance, credit card, and other consumer finance services, including on-line banking services and personal finance software. Strong competition for deposit and loan products affects the rates of those products as well as the terms on which they are offered to customers. Mergers between financial institutions have placed additional pressure on banks within the industry to streamline their operations, reduce expenses, and increase revenues to remain competitive. Competition has also intensified due to recently enacted federal and state interstate banking laws, which permit banking organizations to expand geographically, and the California market has been particularly attractive to out-of-state institutions. The Financial Modernization Act, which, effective March 11, 2000, has made it possible for full affiliations to occur between banks and securities firms, insurance companies, and other financial companies, is also expected to intensify competitive conditions.
Technological innovation has also resulted in increased competition in financial services markets. Such innovation has, for example, made it possible for non-depository institutions to offer customers automated transfer payment services that previously have been considered traditional banking products. In addition, many customers now expect a choice of several delivery systems and channels, including telephone, mail, home computer, ATMs, self service branches, and/or in-store branches. In addition to other banks, the sources of competition for such products include savings associations, credit unions, brokerage firms, money market and other mutual funds, asset management groups, finance and insurance companies, internet-only financial intermediaries, and mortgage banking firms.
For many years, we have countered this increasing competition by providing our own style of community-oriented, personalized service. We rely upon local promotional activity, personal contacts by our officers, directors, employees, and shareholders, automated 24-hour banking, and the individualized service which we can provide through our flexible policies. In addition, to meet the needs of customers with electronic access requirements, the Company has embraced the electronic age and installed telephone banking and personal computer and internet banking with bill payment capabilities. This high tech and high touch approach allows the individual to customize the Bank’s contact methodologies to their particular preference. Moreover, for customers whose loan demands exceed our legal lending limit, we attempt to arrange for such loans on a participation basis with correspondent banks. We also assist our customers in obtaining from our correspondent banks other services that the Bank may not offer.
Our credit card business is subject to an even higher level of competitive pressure than our general banking business. There are a number of major banks and credit card issuers that are able to finance often highly successful advertising campaigns with which community banks generally do not have the resources to compete. As a result, our credit card balances outstanding are much more likely to increase at a slower rate than that which might be seen in nationwide issuers’ year-end statistics. Additional competition comes from many non-financial institutions, such as providers of various retail products, which offer many types of credit cards.
Employees
As of December 31, 2006 the Company had 191 full-time and 115 part-time employees. On a full time equivalent basis, the Company’s staff level was 263 at December 31, 2006, as compared to 241 at December 31, 2005. None of our employees is concurrently represented by a union or covered by a collective bargaining agreement. Management of the Company believes its employee relations are satisfactory.
Regulation and Supervision
The Company and the Bank are subject to significant regulation by federal and state regulatory agencies. The following discussion of statutes and regulations is only a brief summary and does not purport to be complete. This discussion is qualified in its entirety by reference to such statutes and regulations. No assurance can be given that such statutes or regulations will not change in the future.
The Company
The Company is a financial holding company within the meaning of the Financial Holding Company Act of 1956 and is registered as such with the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). A financial holding company is required to file with the Federal Reserve Board annual reports and other information regarding its business operations and those of its subsidiaries. It is also subject to examination by the Federal Reserve Board and is required to obtain Federal Reserve Board approval before acquiring, directly or indirectly, ownership or control of any voting shares of any bank if, after such acquisition, it would directly or indirectly own or control more than 5% of the voting stock of that bank, unless it already owns a majority of the voting stock of that bank.
The Federal Reserve Board has by regulation determined certain activities in which a financial holding company may or may not conduct business. A financial holding company must engage, with certain exceptions, in the business of banking or managing or controlling banks or furnishing services to or performing services for its subsidiary banks. The permissible activities and affiliations of certain bank holding companies have recently been expanded. (See “Financial Modernization Act” below.)
The Bank
As a California state-chartered bank whose accounts are insured by the FDIC up to a maximum of $100,000 per depositor, the Bank is subject to regulation, supervision and regular examination by the Department of Financial Institutions (the “DFI”) and the FDIC. In addition, while the Bank is not a member of the Federal Reserve System, it is subject to certain regulations of the Federal Reserve Board. The regulations of these agencies govern most aspects of the Bank’s business, including the making of periodic reports by the Bank, and the Bank’s activities relating to dividends, investments, loans, borrowings, capital requirements, certain check-clearing activities, branching, mergers and acquisitions, reserves against deposits and numerous other areas. Supervision, legal action and examination of the Bank by the FDIC are generally intended to protect depositors and are not intended for the protection of shareholders.
The earnings and growth of the Bank are largely dependent on its ability to maintain a favorable differential or “spread” between the yield on its interest-earning assets and the rate paid on its deposits and other interest-bearing liabilities. As a result, the Bank’s performance is influenced by general economic conditions, both domestic and foreign, the monetary and fiscal policies of the federal government, and the policies of the regulatory agencies, particularly the Federal Reserve Board. The Federal Reserve Board implements national monetary policies (such as seeking to curb inflation and combat recession) by its open-market operations in United States Government securities, by adjusting the required level of reserves for financial institutions subject to its reserve requirements and by varying the discount rate applicable to borrowings by banks which are members of the Federal Reserve System. The actions of the Federal Reserve Board in these areas influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and deposits. The nature and impact of any future changes in monetary policies cannot be predicted.
Capital Adequacy Requirements
The Company and the Bank are subject to the regulations of the Federal Reserve Board and the FDIC, respectively, governing capital adequacy. Those regulations incorporate both risk-based and leverage capital requirements. Each of the federal regulators has established risk-based and leverage capital guidelines for the banks or bank holding companies it regulates, which set total capital requirements and define capital in terms of “core capital elements,” or Tier 1 capital; and “supplemental capital elements,” or Tier 2 capital. Tier 1 capital is generally defined as the sum of the core capital elements less goodwill and certain other deductions, notably the unrealized net gains or losses (after tax adjustments) on available for sale investment securities carried at fair market value. The following items are defined as core capital elements: (i) common shareholders’ equity; (ii) trust preferred securities are a form of long-term borrowing that currently qualifies as Tier 1 capital not to exceed 25% of pro-forma Tier 1 capital; (iii) qualifying non-cumulative perpetual preferred stock and related surplus (not to exceed 25% of pro-forma Tier 1 capital); and (iv) minority interests in the equity accounts of consolidated subsidiaries. Supplementary capital elements include: (i) allowance for loan and lease losses (but not more than 1.25% of an institution’s risk-weighted assets); (ii) perpetual preferred stock and related surplus not qualifying as core capital; (iii) hybrid capital instruments, perpetual debt and mandatory convertible debt instruments; and (iv) term subordinated debt and intermediate-term preferred stock and related surplus. The maximum amount of supplemental capital elements which qualifies as Tier 2 capital is limited to 100% of Tier 1 capital, net of goodwill.
The minimum required ratio of qualifying total capital to total risk-weighted assets is 8.0% (“Total Risk-Based Capital Ratio”), at least one half of which must be in the form of Tier 1 capital, and the minimum required ratio of Tier 1 capital to total risk-weighted assets is 4.0% (“Tier 1 Risk-Based Capital Ratio”). Risk-based capital ratios are calculated to provide a measure of capital that reflects the degree of risk associated with a banking organization’s operations for both transactions reported on the balance sheet as assets, and transactions, such as letters of credit and recourse arrangements, which are recorded as off-balance sheet items. Under the risk-based capital guidelines, the nominal dollar amounts of assets and credit-equivalent amounts of off-balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain U. S. Treasury securities, to 100% for assets with relatively high credit risk, such as business loans. As of December 31, 2006 and 2005, the Bank’s Total Risk-Based Capital Ratios were 11.1% and 11.3%, respectively and its Tier 1 Risk-Based Capital Ratios were 10.0% and 10.1%, respectively. As of December 31, 2006 and 2005, the Company’s Total Risk-Based Capital was 11.9% and 12.5% respectively, and its Tier 1 Risk-Based Capital Ratio was 10.7% and 11.4% respectively. The risk-based capital requirements also take into account concentrations of credit (i.e., relatively large proportions of loans involving one borrower, industry, location, collateral or loan type) and the risks of “non-traditional” activities (those that have not customarily been part of the banking business). The regulations require institutions with high or inordinate levels of risk to operate with higher minimum capital standards, and authorize the regulators to review an institution’s management of such risks in assessing an institution’s capital adequacy.
The risk-based capital regulations also include exposure to interest rate risk as a factor that the regulators will consider in evaluating a bank’s capital adequacy. Interest rate risk is the exposure of a bank’s current and future earnings and equity capital arising from adverse movements in interest rates. While interest risk is inherent in a bank’s role as financial intermediary, it introduces volatility to bank earnings and to the economic value of the bank.
The FDIC and the Federal Reserve Board also require the maintenance of a leverage capital ratio designed to supplement the risk-based capital guidelines. Banks and bank holding companies that have received the highest rating of the five categories used by regulators to rate banks and are not anticipating or experiencing any significant growth must maintain a ratio of Tier 1 capital (net of all intangibles) to adjusted total assets (“Leverage Capital Ratio”) of at least 3%. All other institutions are required to maintain a leverage ratio of at least 100 to 200 basis points above the 3% minimum, for a minimum of 4% to 5%. Pursuant to federal regulations, banks must maintain capital levels commensurate with the level of risk to which they are exposed, including the volume and severity of problem loans, and federal regulators may, however, set higher capital requirements when a bank’s particular circumstances warrant. As of December 31, 2006 and 2005, the Bank’s Leverage Capital Ratios were 9.0% and 8.8%, respectively. As of December 31, 2006 and 2005, the Company’s leverage capital ratios were 10.1% and 9.8%, respectively,
exceeding regulatory minimums. At December 31, 2006 and 2005 the Company met all of its capital adequacy guidelines and the Bank was considered “well capitalized” under the prompt corrective action provisions. See Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operation - Liquidity and Market Risk Management.
Prompt Corrective Action Provisions
Federal law requires each federal banking agency to take prompt corrective action to resolve the problems of insured financial institutions, including but not limited to those that fall below one or more prescribed minimum capital ratios. The federal banking agencies have by regulation defined the following five capital categories: “well capitalized” (Total Risk-Based Capital Ratio of 10%; Tier 1 Risk-Based Capital Ratio of 6%; and Leverage Ratio of 5%); “adequately capitalized” (Total Risk-Based Capital Ratio of 8%; Tier 1 Risk-Based Capital Ratio of 4%; and Leverage Ratio of 4%) (or 3% if the institution receives the highest rating from its primary regulator); “undercapitalized” (Total Risk-Based Capital Ratio of less than 8%; Tier 1 Risk-Based Capital Ratio of less than 4%; or Leverage Ratio of less than 4%) (or 3% if the institution receives the highest rating from its primary regulator); “significantly undercapitalized” (Total Risk-Based Capital Ratio of less than 6%; Tier 1 Risk-Based Capital Ratio of less than 3%; or Leverage Ratio less than 3%); and “critically undercapitalized” (tangible equity to total assets less than 2%). A bank may be treated as though it were in the next lower capital category if after notice and the opportunity for a hearing, the appropriate federal agency finds an unsafe or unsound condition or practice so warrants, but no bank may be treated as “critically undercapitalized” unless its actual capital ratio warrants such treatment.
At each successively lower capital category, an insured bank is subject to increased restrictions on its operations. For example, a bank is generally prohibited from paying management fees to any controlling persons or from making capital distributions if to do so would make the bank “undercapitalized.” Asset growth and branching restrictions apply to undercapitalized banks, which are required to submit written capital restoration plans meeting specified requirements (including a guarantee by the parent holding company, if any). “Significantly undercapitalized” banks are subject to broad regulatory authority, including among other things, capital directives, forced mergers, restrictions on the rates of interest they may pay on deposits, restrictions on asset growth and activities, and prohibitions on paying certain bonuses without FDIC approval. Even more severe restrictions apply to critically undercapitalized banks. Most importantly, except under limited circumstances, not later than 90 days after an insured bank becomes critically undercapitalized, the appropriate federal banking agency is required to appoint a conservator or receiver for the bank.
In addition to measures taken under the prompt corrective action provisions, insured banks may be subject to potential actions by the federal regulators for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the issuance of cease and desist orders, termination of insurance of deposits (in the case of a bank), the imposition of civil money penalties, the issuance of directives to increase capital, formal and informal agreements, or removal and prohibition orders against “institution-affiliated” parties.
Safety and Soundness Standards
The federal banking agencies have also adopted guidelines establishing safety and soundness standards for all insured depository institutions. Those guidelines relate to internal controls, information systems, internal audit systems, loan underwriting and documentation, compensation and interest rate exposure. In general, the standards are designed to assist the federal banking agencies in identifying and addressing problems at insured depository institutions before capital becomes impaired. If an institution fails to meet these standards, the appropriate federal banking agency may require the institution to submit a compliance plan and institute enforcement proceedings if an acceptable compliance plan is not submitted.
Premiums for Deposit Insurance
The FDIC regulations also implement a risk-based premium system, whereby insured depository institutions are required to pay insurance premiums depending on their risk classification. Under this system, institutions such as the Bank which are insured by the Bank Insurance Fund (“BIF”) are
categorized into one of three capital categories (well capitalized, adequately capitalized, and undercapitalized) and one of three supervisory categories based on federal regulatory evaluations. The three supervisory categories are: financially sound with only a few minor weaknesses (Group A), demonstrates weaknesses that could result in significant deterioration (Group B), and poses a substantial probability of loss (Group C). The capital ratios used by the FDIC to define well capitalized, adequately capitalized and undercapitalized are the same in the FDIC’s prompt corrective action regulations. The current BIF base assessment rates (expressed as cents per $100 of deposits) are summarized as follows:
In addition, BIF member banks (such as the Bank) must pay an amount which fluctuates but is currently 1.22 basis points, or cents per $100 of insured deposits, toward the retirement of the Financing Corporation bonds issued in the 1980’s to assist in the recovery of the savings and loan industry.
Dividends
The Company is entitled to receive dividends, when and as declared by its subsidiary banks’ Boards of Directors. Those dividends may come from funds legally available for those dividends, as specified and limited by the California Financial Code and the U.S. Code. Under the California Financial Code, funds available for cash dividends by a California-chartered bank are restricted to the lesser of:(i) the bank’s retained earnings; or (ii) the bank’s net income for its last three fiscal years (less any distributions to shareholders made during such period). With the prior approval of the California Department of Financial Institutions (“DFI”) , cash dividends may also be paid out of the greater of: (i) the bank’s retained earnings; (ii) net income for the bank’s last preceding fiscal year; or (iii) net income for the bank’s current fiscal year. If the DFI determines that the shareholders’ equity of the bank paying the dividend is not adequate or that the payment of the dividend would be unsafe or unsound for the bank, the DFI may order the bank not to pay the dividend.
It is also possible, depending upon its financial condition and other factors, that a regulatory agency could assert that the payment of dividends or other payments might, under some circumstances, constitute an unsafe or unsound practice and thereby prohibit such payments.
California Corporations Code Section 500 allows the Company to pay a dividend to its shareholders only to the extent that it has retained earnings and, after the dividend, its:
· assets (exclusive of goodwill and other intangible assets) would be 1.25 times its liabilities (exclusive of deferred taxes, deferred income and other deferred credits); and
· current assets would be at least equal to current liabilities.
Additionally, the FRB’s policy regarding dividends provides that a bank holding company should not pay cash dividends exceeding its net income or which can only be funded in ways that weaken the bank holding company’s financial health, such as by borrowing. The FRB also possesses enforcement powers over bank holding companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations.
Transactions With Affiliates
The Company and any of its subsidiaries and certain related interests are deemed to be affiliates of its subsidiary banks within the meaning of Sections 23A and 23B of the Federal Reserve Act. Under those terms, loans by a subsidiary bank to affiliates, investments by them in affiliates’ stock, and taking affiliates’ stock as collateral for loans to any borrower is limited to 10% of the particular banking subsidiary’s capital, in the case of any one affiliate, and is limited to 20% of the banking subsidiary’s capital, in the case of all affiliates. In addition, such transactions must be on terms and conditions that are consistent with safe and sound banking practices; in particular, a bank and its subsidiaries generally may not purchase from an
affiliate a low-quality asset, as defined in the Federal Reserve Act. These restrictions also prevent a bank holding company and its other affiliates from borrowing from a banking subsidiary of the bank holding company unless the loans are secured by marketable collateral of designated amounts. The Company and its subsidiary banks are also subject to certain restrictions with respect to engaging in the underwriting, public sale and distribution of securities.
Recent Legislation
From time to time legislation is enacted which has the effect of increasing the cost of doing business and changing the competitive balance between banks and other financial and non-financial institutions. Various federal laws enacted over the past several years have provided, among other things, for:
· the maintenance of mandatory reserves with the Federal Reserve Bank on deposits by depository institutions;
· the phasing-out of the restrictions on the amount of interest which financial institutions may pay on certain types of accounts; and
· the authorization of various types of new deposit accounts, such as “NOW” accounts, “Money Market Deposit” accounts and “Super NOW” accounts, designed to be competitive with money market mutual funds and other types of accounts and services offered by various financial and non-financial institutions.
The lending authority and permissible activities of certain non-bank financial institutions such as savings and loan associations and credit unions have been expanded, and federal regulators have been given increased enforcement authority. These laws have generally had the effect of altering competitive relationships existing among financial institutions, reducing the historical distinctions between the services offered by banks, savings and loan associations and other financial institutions, and increasing the cost of funds to banks and other depository institutions.
Amendments to Regulation H and Y for Trust Preferred Securities. The Federal Reserve Board issued a final rule on March 1, 2005 that amends Regulation H and Regulation Y to limit restricted core capital elements (including trust preferred securities) which count as Tier 1 capital to 25 percent of all core capital elements, net of goodwill less any associated deferred tax liability. Internationally active bank holding companies, will be subject to a 15 percent limit, but they may include qualifying mandatory convertible preferred securities up to the generally applicable 25 percent limit. Amounts of restricted core capital elements in excess of these limits generally may be included in Tier 2 capital. The final rule provides a five-year transition period, ending March 31, 2009, for application of the quantitative limits.
Community Reinvestment Act
The Bank is subject to certain requirements and reporting obligations involving Community Reinvestment Act (“CRA”) activities. The CRA generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of its local communities, including low and moderate income neighborhoods. The CRA further requires the agencies to take a financial institution’s record of meeting its community credit needs into account when evaluating applications for, among other things, domestic branches, consummating mergers or acquisitions, or holding company formations. In measuring a bank’s compliance with its CRA obligations, the regulators utilize a performance-based evaluation system which bases CRA ratings on the bank’s actual lending service and investment performance, rather than on the extent to which the institution conducts needs assessments, documents community outreach activities or complies with other procedural requirements. In connection with its assessment of CRA performance, the FDIC assigns a rating of “outstanding,” “satisfactory,” “needs to improve” or “substantial noncompliance.” The Bank was last examined for CRA compliance in January 2004 and received a “satisfactory” CRA Assessment Rating.
Other Consumer Protection Laws and Regulations The bank regulatory agencies are increasingly focusing attention on compliance with consumer protection laws and regulations. Examination and enforcement has become intense, and banks have been advised to
carefully monitor compliance with various consumer protection laws and their implementing regulations. The federal Interagency Task Force on Fair Lending issued a policy statement on discrimination in home mortgage lending describing three methods that federal agencies will use to prove discrimination: overt evidence of discrimination, evidence of disparate treatment, and evidence of disparate impact. In addition to CRA and fair lending requirements, the Bank is subject to numerous other federal consumer protection statutes and regulations. Due to heightened regulatory concern related to compliance with consumer protection laws and regulations generally, the Bank may incur additional compliance costs or be required to expend additional funds for investments in the local communities it serves.
Interstate Banking and Branching
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Interstate Banking Act”) regulates the interstate activities of banks and bank holding companies and establishes a framework for nationwide interstate banking and branching. Since June 1, 1997, a bank in one state has generally been permitted to merge with a bank in another state without the need for explicit state law authorization. However, states were given the ability to prohibit interstate mergers with banks in their own state by “opting-out” (enacting state legislation applying equality to all out-of-state banks prohibiting such mergers) prior to June 1, 1997.
Since 1995, adequately capitalized and managed bank holding companies have been permitted to acquire banks located in any state, subject to two exceptions: first, any state may still prohibit bank holding companies from acquiring a bank which is less than five years old; and second, no interstate acquisition can be consummated by a bank holding company if the acquirer would control more than 10% of the deposits held by insured depository institutions nationwide or 30% percent or more of the deposits held by insured depository institutions in any state in which the target bank has branches.
A bank may establish and operate de novo branches in any state in which the bank does not maintain a branch if that state has enacted legislation to expressly permit all out-of-state banks to establish branches in that state.
In 1995 California enacted legislation to implement important provisions of the Interstate Banking Act discussed above and to repeal California’s previous interstate banking laws, which were largely preempted by the Interstate Banking Act.
The changes effected by Interstate Banking Act and California laws have increased competition in the environment in which the Bank operates to the extent that out-of-state financial institutions directly or indirectly enter the Bank’s market areas. It appears that the Interstate Banking Act has contributed to the accelerated consolidation of the banking industry. While many large out-of-state banks have already entered the California market as a result of this legislation, it is not possible to predict the precise impact of this legislation on the Bank and the Company and the competitive environment in which they operate.
Financial Modernization Act
Effective March 11, 2000 the Gramm-Leach-Bliley Act eliminated most barriers to affiliations among banks and securities firms, insurance companies, and other financial service providers, and enabled full affiliations to occur between such entities. This legislation permits bank holding companies to become “financial holding companies” and thereby acquire securities firms and insurance companies and engage in other activities that are financial in nature. A bank holding company may become a financial holding company if each of its subsidiary banks is well capitalized under the FDICIA prompt corrective action provisions, is well managed, and has at least a satisfactory rating under the CRA by filing a declaration that the bank holding company wishes to become a financial holding company. No regulatory approval will be required for a financial holding company to acquire a company, other than a bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board. The Company became a financial holding company in 2004 for the purpose of establishing the subsidiary CVB Insurance Agency.
The Gramm-Leach-Bliley Act defines “financial in nature” to include securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agency; merchant banking activities; and activities that the Board has determined to be closely related to banking. A
national bank (and therefore, a state bank as well) may also engage, subject to limitations on investment, in activities that are financial in nature, other than insurance underwriting, insurance company portfolio investment, real estate development and real estate investment, through a financial subsidiary of the bank, if the bank is well capitalized, well managed and has at least a satisfactory CRA rating. Subsidiary banks of a financial holding company or national banks with financial subsidiaries must continue to be well capitalized and well managed in order to continue to engage in activities that are financial in nature without regulatory actions or restrictions, which could include divestiture of the financial in nature subsidiary or subsidiaries. In addition, a financial holding company or a bank may not acquire a company that is engaged in activities that are financial in nature unless each of the subsidiary banks of the financial holding company or the bank has a CRA rating of satisfactory or better.
The Gramm-Leach-Bliley Act also imposes significant new requirements on the sharing of customer information between financial institutions. The Company has responded to these new restrictions.
The Company and the Bank must file periodic reports with the various regulators to keep them informed of their financial condition and operations as well as their compliance with all the various regulations. Three regulatory agencies - the Federal Reserve Bank of San Francisco for the Company, and the FDIC and the California Department of Financial Institutions - conduct periodic examinations of the Company and the Bank to verify their reporting is accurate and to ascertain that they are in compliance with regulations.
A banking agency may take action against a financial holding company or a bank should it find the financial institution has failed to maintain adequate capital. This action has usually taken the form of restrictions on the payment of dividends to shareholders, requirements to obtain more capital from investors, and restrictions on operations. The FDIC may also take action against a bank that is not acting in a safe and sound manner. Given the strong capital position and performance of the Company and the Bank, Management does not expect to be impacted by these types of restrictions in the foreseeable future.
Sarbanes-Oxley Act
In 2002, the Sarbanes-Oxley Act was enacted as Federal legislation. This legislation imposes a number of new requirements on financial reporting and corporate governance on all corporations. Passed in response to corporate accounting and reporting failures, the act requires all public companies to document their internal controls over financial reporting, evaluate the design and effectiveness of those controls, periodically test all significant controls to ensure they are functioning, and provide a certification by the Chief Executive Officer and Chief Financial Officer of the documentation, evaluation, and testing. The act further requires companies’ independent registered public accounting firm to evaluate this assertion.
Regulatory Capital Treatment of Equity Investments.
In December of 2001 and January of 2002, the OCC, the FRB and the FDIC adopted final rules governing the regulatory capital treatment of equity investments in non-financial companies held by banks, bank holding companies and financial holding companies. The new capital requirements apply symmetrically to equity investments made by banks and their holding companies in non-financial companies under the legal authorities specified in the final rules. Among others, these include the merchant banking authority granted by the Gramm-Leach-Bliley Act and the authority to invest in small business investment companies (“SBICs”) granted by the Small Business Investment Act. Covered equity investments will be subject to a series of marginal Tier 1 capital charges, with the size of the charge increasing as the organization’s level of concentration in equity investments increases. The highest marginal charge specified in the final rules requires a 25 percent deduction from Tier 1 capital for covered investments that aggregate more than 25 percent of an organization’s Tier 1 capital. Equity investments through SBICs will be exempt from the new charges to the extent such investments, in the aggregate, do not exceed 15 percent of the banking organization’s Tier 1 capital. Grandfathered investments made by state banks under section 24(f) of the Federal Deposit Insurance Act also are exempted from coverage.
Other Pending and Proposed Legislation
Other legislative and regulatory initiatives which could affect the Company, the Bank and the banking industry in general are pending, and additional initiatives may be proposed or introduced before the United States Congress, the California legislature and other governmental bodies in the future. Such proposals, if enacted, may further alter the structure, regulation and competitive relationship among financial institutions, and may subject the Bank to increased regulation, disclosure and reporting requirements. In addition, the various banking regulatory agencies often adopt new rules and regulations to implement and enforce existing legislation. It cannot be predicted whether, or in what form, any such legislation or regulations may be enacted or the extent to which the business of the Company or the Bank would be affected thereby.
Recent Accounting Pronouncements
Accounting for Servicing of Financial Assets
In March 2006, the Financial Accounting Standards Board (FASB) issued Statement No. 156 (SFAS 156), Accounting for Servicing of Financial Assets - An Amendment of FASB Statement No. 140. SFAS 156 requires that all separately recognized servicing assets and servicing liabilities be initially measured at fair value, if practicable, and permits, but does not require, the subsequent measurement of servicing assets and servicing liabilities at fair value. Under SFAS 156, an entity can elect subsequent fair value measurement of its servicing assets and servicing liabilities by class. An entity should apply the requirements for recognition and initial measurement of servicing assets and servicing liabilities prospectively to all transactions after the effective date. SFAS 156 permits an entity to reclassify certain available-for-sale securities to trading securities provided that they are identified in some manner as offsetting the entity's exposure to changes in fair value of servicing assets or servicing liabilities subsequently measured at fair value. The provisions of SFAS 156 are effective for an entity as of the beginning of its first fiscal year that begins after September 15, 2006 and the Bank adopted these provisions on January 1, 2007. Management does not expect the adoption of SFAS 156 to have a material impact on the Bank's financial position or results of operations.
Accounting for Uncertainty in Income Taxes
In July 2006,, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement 109 (FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company's financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. The Company presently recognizes income tax positions based on management’s estimate of whether it is reasonably possible that a liability has been incurred for unrecognized income tax benefits by applying FASB Statement No. 5, Accounting for Contingencies. FIN 48 prescribes a comprehensive model for recognizing, measuring, presenting and disclosing in the financial statements tax positions taken or expected to be taken in a tax return.
The provisions of FIN 48 will be effective for the Company on January 1, 2007 and are to be applied to all tax positions upon initial application of this standard. Only tax positions that meet the more-likely-than-not recognition threshold at the effective date may be recognized or continue to be recognized upon adoption.
The cumulative effect of applying the provisions of FIN 48, if any, will be reported as an adjustment to the opening balance of retained earnings for he fiscal year of adoption. Management does not expect the adoption to have a material impact on the Company’s financial position or results of operations.
Considering the Effects of Prior Year Misstatements
In September 2006, the Securities and Exchange Commission published Staff Accounting Bulleting No. 108 Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. The interpretations in this Staff Accounting Bulleting are being issued to address diversity in practice in quantifying financial statement misstatements and the potential under current practice to build up improper amounts on the balance sheet. This guidance will apply to the first fiscal year ending after November 15, 2006, or December 31, 2006 for the Company. The adoption of SAB 108 did not have a material impact on the Company’s financial position, results of operations or cash flows and no cumulative adjustment was required.
Fair Value Measurements
In September 2006, the FASB issued Statement No. 157 (SFAS 157), Fair Value Measurements. SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. In this standard, the FASB clarifies the principle that fair value should be based on the assumptions market
participants would use when pricing the asset or liability. In support of this principle, SFAS 157 establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The provisions of SFAS 157 are effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The provisions should be applied prospectively, except for certain specifically identified financial instruments. Management does not expect the adoption of SFAS 157 to have a material impact to the Bank's financial position or result of operations.
Accounting for Purchases of Life Insurance
In September 2006, the FASB ratified the consensuses reached by the Emerging Issues Task Force (the Task Force) on Issue No. 06-5 (EITF 06-5) Accounting for the Purchases of Life Insurance - Determining the Amount that Could be Realized in Accordance with FASB Technical Bulletin No. 85-4 (FTB 85-4). FTB 85-4 indicates that the amount of the asset included in the balance sheet for life insurance contracts within its scope should be "the amount that could be realized under the insurance contract as of the date of the statement of financial position." Questions arose in applying the guidance in FTB 85-4 to whether "the amount that could be realized" should consider 1) any additional amounts included in the contractual terms of the insurance policy other than the cash surrender value and 2) the contractual ability to surrender all of the individual-life policies (or certificates in a group policy) at the same time. EITF 06-5 determined that "the amount that could be realized" should 1) consider any additional amounts included in the contractual terms of the policy and 2) assume the surrender of an individual-life by individual-life policy (or certificate by certificate in a group policy). Any amount that is ultimately realized by the policy holder upon the assumed surrender of the final policy (or final certificate in a group policy) shall be included in the "amount that could be realized." An entity should apply the provisions of EITF 06-5 through either a change in accounting principle through a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption or a change in accounting principle through retrospective application to all prior periods. The provisions of EITF 06-5 are effective for fiscal years beginning after December 15, 2006. Management has not yet completed its evaluation of the impact that EITF 06-5 will have.
Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements
In September 2006, the FASB ratified the consensuses reached by the Task Force on Issue No. 06-4 (EITF 06-4) Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements. A question arose when an employer enters into an endorsement split-dollar life insurance arrangement related to whether the employer should recognize a liability for the future benefits or premiums to be provided to the employee. EITF 06-4 indicates that an employer should recognize a liability for future benefits and that a liability for the benefit obligation has not been settled through the purchase of an endorsement type policy. An entity should apply the provisions of EITF 06-4 either through a change in accounting principle through a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption or a change in accounting principle through retrospective application to all prior periods. The provisions of EITF 06-4 are effective for fiscal years beginning after December 15, 2007. Management has not yet completed its evaluation of the impact that EITF 06-4 will have.
Item 1a.
Item 1a. Risk Factors
This discussion and analysis provides insight into Management’s assessment of the operating trends over the last several years and its expectations for 2007. Such expressions of expectations are not historical in nature and are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are subject to risks and uncertainties that may cause actual future results to differ materially from those expressed in any forward-looking statement. Such risks and uncertainties with respect to the Company include:
· increased competitive pressure among financial services companies;
· changes in the interest rate environment reducing interest margins or increasing interest rate risk;
· deterioration in general economic conditions, internationally, nationally or in the State of California;
· the occurrence of future events such as the terrorist acts of September 11, 2001;
· the availability of sources of liquidity at a reasonable cost; and
· legislative or regulatory changes adversely affecting the business in which the Company engages.
Competition
The Company faces competition from other financial institutions and from businesses in other industries that have developed financial products. Banks once had an almost exclusive franchise for deposit products and provided the majority of business financing. With deregulation in the 1980’s, other kinds of financial institutions began to offer competing products. Also, increased competition in consumer financial products has come from companies not typically associated with the banking and financial services industry, such as AT &T, General Motors and various software developers. Similar competition is faced for commercial financial products from insurance companies and investment bankers. Community banks, including the Company, attempt to offset this trend by developing new products that capitalize on the service quality that a local institution can offer. Among these are new loan, deposit, and investment products. The Company’s primary competitors are different for each specific product and market area. While this offers special challenges for the marketing of our products, it offers protection from one competitor dominating the Company in its market areas. Many of these competitors are much larger in total assets and capitalization, have greater access to capital markets and offer a broader array of financial services than we do, which creates certain competitive disadvantages for the Company.
Economic Conditions
Beginning in the summer of 2004 the Fed began raising its target rate and by year end it had increased by 1.25% to 5.25%. Throughout 2005 the Fed continued to increase its target rate and by year end it reached 7.25%. During 2006 the target rate was increased 25 basis points four times ending on June 29, 2006 at 8.25% where it remained through the end of the year. These changes impacted the Company as market rates for loans, investments and deposits respond to the Fed’s actions. The most significant economic factors impacting the Company in the last three years have been the healthy economic expansion during 2004 and 2005 and the gradual real estate slow down in 2006. A significant portion of our total loan portfolio is related to real estate obligations, particularly residential real estate loans. Our local economies continue to grow and prosper but we are experiencing stabilization in the rapid pace of people moving into our service areas. The smaller towns in close proximity to Chico such as Orland and Oroville are continuing to grow due to the lower cost of land acquisition for new housing. The areas around Redding such as Cottonwood and Anderson are also experiencing modest growth.
Risk Management
The Company sees the process of addressing the potential impacts of the external factors listed above as part of its management of risk. In addition to common business risks such as disasters, theft, and loss of market share, the Company is subject to special types of risk due to the nature of its business. New and sophisticated financial products are continually appearing with different types of risk which need to be defined and managed if the Company chooses to offer them to its customers. Also, the risks associated with existing products must be reassessed periodically. The Company cannot operate risk-free and make a profit. Instead, the process of risk definition and assessment allows the Company to select the appropriate level of risk for the anticipated level of reward and then decide on the steps necessary to manage this risk. The Company’s Risk Officer and the other members of its Senior Management Team under the direction and oversight of the Board of Directors lead the risk management process.
Some of the risks faced by the Company are those faced by most enterprises - reputational risk, operational risk, and legal risk. The special risks related to financial products are credit risk and interest rate risk. Credit risk relates to the possibility that a debtor will not repay according to the terms of the debt contract. Credit risk is discussed in the sections related to loans. Interest rate risk is discussed in the sections related to Liquidity and Market Risk Management and relates to the adverse impacts of changes in interest rates. The effective management of these and other risks mentioned above is the backbone of the Company’s business strategy.
Managing Our Growth
Our Company’s total assets increased from $495 million at December 31, 2005 to $550 million at December 31, 2006. Management’s intention is to leverage the Company’s current infrastructure to sustain the momentum achieved in 2006, although no assurance can be provided that this strategy will result in significant growth. Our ability to manage growth will depend primarily on our ability to:
· monitor operations;
· control funding costs and operating expenses;
· maintain positive customer relations; and
· attract, assimilate and retain qualified personnel.
The Impact of Changes in Assets and Liabilities to Net Interest Income and Net Interest Margin
The Company earns income from two sources. The primary source is from the management of its financial assets and liabilities and the second is from charging fees for services provided. The first source involves functioning as a financial intermediary, that is, the Company accepts funds from depositors or obtains funds from other creditors and then either lends the funds to borrowers or invests those funds in securities or other financial instruments. Income is earned as a spread between the interest earned from the loans or investments and the interest paid on the deposits and other borrowings. The second source, fee income, is discussed in other sections of this analysis, specifically in “Noninterest Revenue.”
Changes in Net Interest Income and Net Interest Margin
Net interest income is the difference or spread between the interest and fees earned on loans and investments (the Company’s earning assets) and the interest expense paid on deposits and other liabilities. The amount by which interest income will exceed interest expense depends on two factors: (1) the volume or balance of earning assets compared to the volume or balance of interest-bearing deposits and liabilities, and (2) the interest rate earned on those interest earning assets compared with the interest rate paid on those interest-bearing deposits and liabilities.
Net interest margin is net interest income expressed as a percentage of average earning assets. It is used to measure the difference between the average rate of interest earned on assets and the average rate of interest that must be paid on liabilities used to fund those assets. To maintain its net interest margin, the Company must manage the relationship between interest earned and paid. A shift in the relative size of the major balance sheet categories has an impact on net interest income and net interest margin. To the extent that funds invested in securities can be repositioned into loans, earnings increase because of the higher rates paid on loans. However, additional credit risk is incurred with loans compared to the very low risk of loss on securities, and the Company must carefully monitor the underwriting process to ensure that the benefit of the additional interest earned is not offset by additional credit losses. In general, depositors are willing to accept a lower rate on their funds than are other providers of funds because of the Federal Deposit Insurance Corporation (“FDIC”) insurance coverage. To the extent that the Company can fund asset growth by deposits, especially the lower cost transaction accounts, rather than borrowing funds from other financial institutions, the average rates paid on funds will be less, and net interest income more.
The Allowance for Loan Losses May Not Cover Actual Loan Losses. We attempt to limit the risk that borrowers will fail to repay loans by carefully underwriting the loans, nevertheless losses can and do occur. We create an allowance for loan losses in our accounting records, based on estimates of the following:
· industry standards;
· historical experience with our loans;
· evaluation of qualitative factors such as loan concentrations and local economic conditions;
· regular reviews of the quality, mix and size of the overall loan portfolio;
· regular reviews of delinquencies; and
· the quality of the collateral underlying our loans;
· loan impairment.
We maintain an allowance for loan losses at a level which we believe is adequate to absorb any specifically identified losses as well as any other losses inherent in our loan portfolio. However, changes in economic, operating and other conditions, including changes in interest rates, which are beyond our control, may cause our actual loan losses to exceed our current allowance estimates. If the actual loan losses exceed the amount reserved, it will hurt our business. In addition, the FDIC and the Department of Financial Institutions, as part of their supervisory functions, periodically review our allowance for loan losses. Such agencies may require us to increase our provision for loan losses or to recognize further loan losses, based on their judgments, which may be different from those of our management. Any increase in the allowance required by the FDIC or the California Department of Financial Institutions could also impact our business.
Item 1b.
Item 1b. Unresolved Staff Comments
No comments have been submitted to the registrant by the staff of the Securities Exchange Commission.
Item 2.
Item 2. Properties
The following properties (real properties and/or improvements thereon) are owned by the Company and are unencumbered. In the opinion of Management, all properties are adequately covered by insurance.
On June 1, 2005, Community Valley Bancorp entered into a short term, unsecured note payable in a principal amount of $800,000 in conjunction with the purchase of real property. The interest rate on the note at December 31, 2005 was 4.5%. The note was paid in full on January 4, 2006. This real property is a 19,000 square foot building in Chico that serves as the corporate administrative headquarters and also houses other service departments. The remodeling of this building was completed at the end of January 2007 and is now fully occupied.
The following facilities are leased by the Company:
Additionally, the Bank has five remote ATM locations. The amount of monthly rent at these locations is minimal.
(1) This is the termination date of the current 5-year lease. The Company also has two renewal options for five years each.
(2) This is the termination date of the current 25-year lease. The Company also has three renewal options for five years each
(3) This is the termination date of the current 10-year lease. The Company also has three renewal options for five years each.
(4) This is the termination date of the current 10-year lease. The Company also has two renewal options for five years each.
(5) This is the termination date of the current 10-year lease. The Company has two renewal options for five years each.
(6) This is the termination date of the current 3-year lease. The Company does not have renewal options on this property.
(7) This is the termination date of the current 10-year lease. The Company also has one renewal option for ten years.
(8) This is the termination date of the current 3-year lease. The Company has one renewal option for three years.
(9) This is the termination date of the current 10-year lease. The Company has two renewal options for five years each.
(10) This is the termination date of the current 10-year lease. The Company does not have renewal options on this property.
(11) This is the termination date of the current 20 year lease. The Company does not have renewal options on this property.
(12) This is the termination date of the current 15 year land lease. The Company has three renewal options for five years each.
Item 3.
Item 3. Legal Proceedings
From time to time, the Company is a party to claims and legal proceedings arising in the ordinary course of business. After taking into consideration information furnished by counsel to the Company as to the current status of these claims or proceedings to which the Company is a party, management is of the opinion that the ultimate aggregate liability represented thereby, if any, will not have a material adverse affect on the financial condition of the Company.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of our shareholders’ during the fourth quarter of the fiscal year ended December 31, 2006.
PART II
Item 5.
Item 5. Market for Registrants Common Equity and Related Shareholder Matters and Issuer Purchases of Equity Securities
(a) Market Information
Community Valley Bancorp was previously listed on the Nasdaq OTC Bulletin Board starting June 17, 2002 (the effective date of the holding company reorganization), and Butte Community Bank was previously also listed on the Nasdaq OTC Bulletin Board. Our Common Stock trades under the symbol CVLL and the CUSIP number for such common stock is #20415P101. Previously the Butte Community Bank CUSIP number for the common stock was #12406Q107. On May 1, 2006 the Company began trading on the Nasdaq Capital Market. Trading in the Company has not been extensive and such trades cannot be characterized as amounting to an active trading market. Management is aware of the following securities dealers who make a market in the Company’s stock: Howe Barnes Hoefer & Arnett Inc., San Francisco, California, Wachovia First Union Securities, Grass Valley, California, Wedbush Morgan Securities, Lake Oswego, Oregon and Sandler O’Neill & Partners, LP, New York, NY, (the “Securities Dealers”).
The graph that follows shows the total return performance of the Company as compared to the Russell 3000 and the SNL $100 million to $500 million peer group of banks over the past five years.
CommunityValleyBancorp
The following table summarizes trades of the Company setting forth the approximate high and low sales prices and volume of trading for the periods indicated, based upon information provided by public sources. The information in the following table does not include trading activity between dealers. The stock prices and approximate trading volumes and cash dividends have been adjusted to give effect to the four-for-three stock split issued in March 2004 and the two-for-one stock split issued in May 2005.
(b) Holders On March 6, 2007 there were approximately 557 shareholders of record of the Company.
(c) Dividends
As a financial holding company which currently has no significant assets other than its equity interest in the Bank and the proceeds from the issuance of the Trust Preferred Securities previously mentioned, the Company’s ability to declare dividends depends primarily upon dividends it receives from the Bank. The Bank’s dividend practices in turn depend upon the Bank’s earnings, financial position, current and anticipated cash requirements and other factors deemed relevant by the Bank’s Board of Directors at that time.
The Company paid cash dividends quarterly totaling $1.9 million or $0.26 per share in 2006 and $1.1 million or $0.16 per share in 2005, representing 27% and 16%, respectively of the prior year’s earnings. The Company anticipates paying dividends in the future consistent with the general dividend policy which declares that dividends must meet applicable legal requirements while maintaining the minimum capital ratios established by the Company.
The policy is to declare and pay dividends of no more than 40% of its previous years net income to shareholders. However, no assurance can be given that the Bank’s and the Company’s future earnings and/or growth expectations in any given year will justify the payment of such a dividend.
The ability of the Bank’s Board of Directors to declare cash dividends is also limited by statutory and regulatory restrictions which restrict the amount available for cash dividends depending upon the earnings, financial condition and cash needs of the Bank, as well as general business conditions. A detailed discussion is located in Item 1 above.
(d) Stock Repurchase Plan
The Board of Directors approved a plan to repurchase up to $3,000,000 of the outstanding common stock of the Company in 2003. Stock repurchases were made from time to time on the open market or through privately negotiated transactions. The timing of purchases and the exact number of shares purchased was dependent on market conditions. The share repurchase program did not include specific price targets or timetables and could have been suspended at any time. During 2005 and 2003, no shares of the Company’s common stock were repurchased. During 2004, 38,470 shares of the Company’s common stock were repurchased for $502,000. During 2006, 143,950 shares were repurchased for $2,498,000.
(e) Equity Compensation Plan Information
The following chart sets forth information for the fiscal year ended December 31, 2006, regarding equity based compensation plans of the Company.
(f) Sales of Unregistered Securities
On December 19, 2002, the Company issued an aggregate of $8,248,000 in principal amount of its Floating Rate Junior Subordinated Deferrable Interest Debentures due 2032 (the “Subordinated Debt Securities”). All of the Subordinated Debt Securities were issued to Community Valley Trust I, a Delaware statutory business trust and a wholly-owned but unconsolidated subsidiary of the Company (the “Trust”). The Subordinated Debt Securities were not registered under the Securities Act in reliance on the exemption set forth in Section 4(2) thereof. The Subordinated Debt Securities were issued to the Trust in consideration for the receipt of the net proceeds (approximately $7.75 million) raised by the Trust from the sale of $8,000,000 in principal amount of the Trust’s Floating Rate Capital Trust Pass-through Securities (the “Trust Preferred Securities”). Bear Stearns & Co. Inc. acted as the placement agent in connection with the offering of the Trust Preferred Securities for aggregate commissions of $240,000 payable by the Trust. The sale of the Trust Preferred Securities was part of a larger transaction arranged by Bear Stearns & Co. pursuant to which the Trust Preferred Securities were deposited into a special purpose vehicle along with similar securities issued by a number of other banks and the special purpose vehicle then issued its securities to the public (the “Pooled Trust Preferred Securities”). The Pooled Trust Preferred Securities were sold by Bear Stearns & Co. Inc. only (i) to those entities Bear Stearns & Co. Inc. reasonably believed were qualified institutional buyers (as defined in Rule 144A under the Securities Act), (ii) to “accredited investors” (as defined in Rule 501(a)(1), (2), (3) or (7) or Regulation D promulgated under the Securities
Act) or (iii) in offshore transactions in compliance with Rule 903 of Regulation S under the Securities Act. The Trust Preferred Securities were not registered under the Securities Act in reliance on exemptions set forth in Rule 144A, Regulation D and Regulation S, as applicable.
Item 6.
Item 6. Selected Financial Data
The “selected financial data” for 2006 which follows is derived from the audited Consolidated Financial Statements of the Company and other data from our internal accounting system. The selected financial data should be read in conjunction with the audited Consolidated Financial Statements and Notes thereto, and Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7
Item 7 below. Statistical information below is generally based on average daily amounts.
Selected Financial Data
(1) All per share data and the average number of shares outstanding have been retroactively restated on a split-adjusted basis.
(2) Net income divided by average shareholders’ equity.
(3) Net income divided by average total assets.
(4) Net interest income divided by average earning assets.
(5) Dividends declared per share divided by net income per share.
(6) Average equity divided by average total assets.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This discussion presents Management’s analysis of the financial condition as of December 31, 2006 and 2005 and results of operations of the Company for each of the years in the three-year period ended December 31, 2006. The discussion should be read in conjunction with the Consolidated Financial Statements of the Company and the Notes related thereto presented elsewhere in this Form 10-K Annual Report (see Item 8).
Statements contained in this report that are not purely historical are forward looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 as amended, including the Company’s expectations, intentions, beliefs, or strategies regarding the future. All forward-looking statements concerning economic conditions, rates of growth, rates of income or values as may be included in this document are based on information available to the Company on the date noted, and the Company assumes no obligation to update any such forward-looking statements. It is important to note that the Company’s actual results could materially differ from those in such forward-looking statements. Factors that could cause actual results to differ materially from those in such forward-looking statements are fluctuations in interest rates, inflation, government regulations, economic conditions, customer disintermediation and competitive product and pricing pressures in the geographic and business areas in which the Company conducts its operations.
Critical Accounting Policies
General
The Company’s significant accounting principles are described in Note 1 of the consolidated financial statements and are essential to understanding Management’s Discussion and Analysis of Results of Operations and Financial Condition. Community Valley Bancorp’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. Some of the Company’s accounting principles require significant judgment to estimate values of assets or liabilities. In addition, certain accounting principles require significant judgment in applying the complex accounting principles to transactions to determine the most appropriate treatment. The following is a summary of the more judgmental and complex accounting estimates and principles.
Allowance for Loan Losses (ALL)
The allowance for loan losses is management’s best estimate of the probable losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (1) SFAS No.5 which requires that losses be accrued when they are probable of occurring and estimable and (2) SFAS No. 114, which requires that losses be accrued on impaired loans based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.
The Company performs periodic and systematic detailed evaluations of its lending portfolio to identify and estimate the inherent risks and assess the overall collectibility. These evaluations include general conditions such as the portfolio composition, size and maturities of various segmented portions of the portfolio such as secured, unsecured, construction, and Small Business Administration (“SBA”).
Additional factors include concentrations of borrowers, industries, geographical sectors, loan product, loan classes and collateral types, volume and trends of loan delinquencies and non-accrual, criticized and classified assets and trends in the aggregate in significant credits identified as watch list items. There are several components to the determination of the adequacy of the ALL. Each of these components is determined based upon estimates that can and do change when the actual events occur. The Company estimates the SFAS No. 5 portion of the ALL based on the segmentation of its portfolio. For those segments that require an ALL, the Company estimates loan losses on a monthly basis based upon its ongoing loan review process and analysis of loan performance. The Company follows a systematic and consistently applied approach to select the most appropriate loss measurement methods and support its conclusions and rationale with written documentation. One method of estimating loan losses for groups of loans is through the application of loss rates to the groups’ aggregate loan balances. Such rates typically reflect historical loss experience for each group of loans, adjusted for relevant economic factors over a defined period of time. The Company evaluates and modifies its loss estimation model as needed to ensure that the resulting loss estimate is consistent with GAAP.
For individually impaired loans, SFAS No. 114 provides guidance on the acceptable methods to measure impairment. Specifically, SFAS No. 114 states that when a loan is impaired, the Company should measure impairment based on the present value of expected future principal and interest cash flows discounted at the loan’s effective interest rate, except that as a practical expedient, a creditor may measure impairment based on a loan’s observable market price or the fair value of collateral, if the loan is collateral dependent. When developing the estimate of future cash flows for a loan, the Company considers all available information reflecting past events and current conditions, including the effect of existing environmental factors.
Loan Sales and Servicing
The Company originates government guaranteed loans and mortgage loans that may be sold in the secondary market. The amounts of gains recorded on sales of loans and the initial recording of servicing assets and interest only (I/O) strips is based on the estimated fair values of the respective components. In recording the initial value of the servicing assets and the fair value of the I/O strips receivable, the Company uses estimates which are made based on management’s expectations of future prepayment and discount rates. Servicing assets are amortized over the estimated life of the related loan. I/O strips are not significant at December 31, 2006. These prepayment and discount rates were based on current market conditions and historical performance of the various pools of serviced loans. If actual prepayments with respect to sold loans occur more quickly than projected the carrying value of the servicing assets may have to be adjusted through a charge to earnings.
Stock-Based Compensation
On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123(R), Share Based Payment (“SFAS 123(R)”). Under SFAS No.123(R), compensation expense is recognized for options granted prior to the adoption date in an amount equal to the fair value of the unvested amounts over their remaining vesting period, based on the grant date fair value estimated in accordance with SFAS No. 123, Accounting for Stock Based Compensation and compensation expense for all share based payments granted after adoption based on the grant date fair values estimated in accordance with SFAS No. 123(R) . The estimates of the grant date fair values are based on an option pricing model that uses assumptions based on the expected option life, the level of estimated forfeitures, expected stock volatility and the risk-free interest rate. The calculation of the fair value of share based payments is by nature inexact, and represents management’s best estimate of the grant date fair value of the share based payments. See Note 1 to the audited Consolidated Financial Statements in Item 8 of this Annual Report.
Revenue Recognition
The Company’s primary source of revenue is interest income, which is the difference between the interest income it receives on interest-earning assets and the interest expense it pays on interest-bearing liabilities, and (ii) fee income, which includes fees earned on deposit services, income from SBA lending, electronic-based cash management services, mortgage brokerage fee income and merchant credit card processing services. Interest income is recorded on an accrual basis. Note 1 to the Consolidated Financial Statements offers an explanation of the process for determining when the accrual of interest income is discontinued on an impaired loan.
Income Taxes
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 currently enacted tax rates applied to such 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. If future income should prove non-existent or less than the amount of deferred tax assets within the tax years to which they may be applied, the asset may not be realized and our net income will be reduced.
Summary of Performance For 2006, net income was $7.15 million, compared to the $7.20 million earned in 2005 and net income of $5.61 million in 2004. Net income per diluted share was $.93 for 2006, as compared to $.95 during 2005 and $.74 in 2004. The Company’s Return on Average Assets (“ROAA”) was 1.38% and Return on Average Equity (“ROAE”) was 15.99% in 2006, as compared to 1.51% and 18.82%, respectively, in 2005 and 1.34% and 17.20%, respectively, for 2004.
The upward movement in rates of 100 basis points by the FOMC (Federal Open Market Committee), during the first half of 2006 helped the Company achieve a better net interest margin on a year over year basis. Net interest income, generated by a higher level of average earning assets, increased by $4.2 million from 2005 to 2006. Moreover, the relatively stable long-term market rates allowed the Company to maintain a steady volume of mortgage loans, which we were able to sell at substantial gains. The Company was also able to sell several USDA Business and Industry guaranteed loans and SBA loans for substantial gains. Offsetting these increases in income was increased non interest expenses, primarily related to salaries and employee benefits and increased occupancy costs from the full year impact in 2006 of the branches and loan production offices opened in 2005.
Results of Operations The Impact of Changes in Assets and Liabilities to Net Interest Income and Net Interest Margin
We monitor asset and deposit levels, developments and trends in interest rates, liquidity, capital adequacy and marketplace opportunities. We respond to all of these to protect and increase income while managing risks within acceptable levels as set by the Company’s policies. In additional alternative business plans and contemplated transactions are analyzed for their impact on the level of risk assumed by the Company. This process, known as asset/liability management, is carried out by changing the maturities and relative proportions of the various types of loans, investments, deposits and other borrowings in ways described below. The management staff responsible for asset/liability management operates under the oversight of the Asset/Liability Committee and provides regular reports to the Board of Directors. Board approval is obtained for major actions or the occasional exception to policy.
Net Interest Income and Net Interest Margin The Company earns income from two primary sources. The first is net interest income brought about by income from the successful deployment of earning assets less the costs of interest-bearing liabilities. The second is non-interest income, which generally comes from customer service charges and fees, but can also result from non-customer sources such as gains on loan sales. The majority of the Company’s non-interest expenses are operating costs which relate to providing a full range of banking services to our customers.
Net interest income, which is simply total interest income (including fees) less total interest expense, was $31.3 million in 2006 compared to $27.1 million and $20.9 million in 2005 and 2004, respectively. This
represents an increase of 15.5% in 2006 over 2005 and an increase of 29.7% in 2005 over 2004. The amount by which interest income exceeds interest expense depends on several factors. Among those factors are yields on earning assets, the cost of interest-bearing liabilities, the relative volume of total earning assets and total interest-bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other interest-bearing liabilities. Change in the amount and mix of interest-earning assets and interest-bearing liabilities is referred to as “volume change.” Change in interest rates earned on assets and rates paid on deposits and other borrowed funds is referred to as “rate change.”
The Volume and Rate Variances table which follows sets forth the dollar amount of changes in interest earned and paid for each major category of interest-earning assets and interest-bearing liabilities and the amount of change attributable to changes in average balances (volume) or changes in average interest rate. The calculation is as follows: the change due to increase or decrease in volume is equal to the increase or decrease in the average balance times the prior period’s rate. The change due to an increase or decrease in the rate is equal to the increase or decrease in the average rate times the current period’s balance. The variances attributable to both the volume and rate changes have been allocated to the change in rate.
(1) Yields on tax exempt income have not been computed on a tax equivalent basis.
The Company’s net interest margin is its net interest income expressed as a percentage of average earning assets. The Company’s net interest margin for 2006 was 6.62% an increase of 30 basis points from the 6.32% reported in 2005. For the year 2004, this margin was 5.70%. The following Distribution, Rate and
Yield table shows, for each of the past three years, the rates earned on each component of the Company’s investment and loan portfolio and the rates paid on each segment of the Company’s interest bearing liabilities. That same table also shows the Company’s average daily balances for each principal category of assets, liabilities and shareholders’ equity, the amount of interest income or interest expense, and the average yield or rate for each category of interest-earning asset and interest-bearing liability along with the net interest margin for each of the reported periods.
Distribution, Rate & Yield
(a) Average balances are obtained from the best available daily or monthly data.
(1) Yields on tax exempt income have not been computed on a tax equivalent basis.
(2) Non-accrual loans have been included in total loans for purposes of total earning assets.
(3) Represents net interest income as a percentage of average interest-earning assets.
(4) Yields and amounts earned on loans include loan fees of $2,450,000, $2,453,000 and $2,303,000 for the years ended December 31, 2006, 2005 and 2004 respectively.
During 2006, the Company’s net interest margin improved primarily as a result of the growth and change in the mix in earning assets. Average investments decreased as maturities and growth in deposits were used to fund the increase in average loans. This combination contributed to an overall increase in net interest margin. On an average basis, the rates on loans increased by 79 basis points resulting in an increase in interest income of $3.7 million. This increase in rates was augmented by the increase in the average volume of loans of $62 million that generated an additional $4.9 million in loan related interest income. On an average basis, the rates on investments increased by 141 basis points resulting in an increase in interest income of $382 thousand, however this was more than offset by the decrease in the average volume of investment securities of $18.7 million which resulted in a decrease in interest income of $604 thousand. Overall interest income on earning assets increased by $8.4 million.
A large portion of the Bank’s loans carry variable rates and re-price immediately, versus a large base of core deposits which are generally slower to re-price. Interest expense increased in 2006 as rates increased and the Company’s mix of deposits changed from transaction based lower rate demand deposits to higher rate certificates of deposit. The average rates paid on interest bearing deposits for 2006 was 2.33% compared to 1.42% in 2005 and 1.22% in 2004. The changes in rates in 2006 compared to 2005 were primarily due to the changes in interest rates brought on by Fed actions as discussed previously. The average rates that are paid on deposits generally trail behind these money market rate changes for two reasons: (1) financial institutions do not try to change deposit rates with each small increase or decrease in short-term rates; and (2) with time deposit accounts, even when new offering rates are established, the average rates paid during the year are a blend of the rate paid on individual accounts. Only new accounts and those that mature and are renewed will bear the new rate. On an average basis, NOW account deposits were down $5.9 million, savings account deposits were up $1.1 million, money market account deposits were down $1.7 million and certificate of deposit balances were up $49.8 million. Average non interest bearing demand deposits balances decreased by $6.9 million or 8.4%, from 2005 to 2006.
From 2005 to 2006, the Company’s average loan portfolio grew by approximately $62 million, or 16.3%, building on the growth of $69 million, or 21.9% from 2004 to 2005. The earnings on that growth, net of associated funding costs, are a significant contributor to net interest income. Additionally, loan balances, which are the highest yielding component of the Company’s earning assets, increased during 2006 as a portion of the Company’s average asset base. During 2006, the loan portfolio averaged 86% of total assets, while for 2005 and 2004 such balances represented 80.2% and 75.3%, respectively, of average assets.
Based on these indications and current economic conditions, the Company expects moderate increases in the rates paid on interest-bearing liabilities and rates earned on both the investment and loan portfolio during 2007. In order to fund the loan portfolio growth anticipated in 2007, it is anticipated that the Company’s net interest margin will experience some compression as we will have to pay higher rates on deposits to attract the funds necessary for that growth. Net interest income should increase if loans grow as planned even if the loan growth is funded by higher priced deposits. However, no assurance can be given that this will, in fact, occur.
Non-interest Income and Non-interest Expense For the year 2006, non-interest income increased slightly by $58,000 or (.86%) to $6,769,000 as compared to $6,711,000 for 2005. Non interest income in 2004 was $6,018,000. The primary traditional sources of non-interest income for the Company are service charges on deposit accounts, gains on the sale of loans, loan servicing income, alternative investment fees earned on the sales of non-deposit investment products and merchant credit card fees. Service charges on deposit accounts and loan sales income in 2006 accounted for 39.7% and 23.3%, respectively, of total non-interest income, as compared to 35% and 27.8%,
respectively, for 2005 and 34.7% and 30.3%, respectively, for 2004. Loan servicing income, alternative investment fees and merchant credit card fees for 2006 were 6.8%, 5.2% and 5.6% respectively, of total non-interest income, as compared to 6.3%, 7.7% and 5.8%, respectively, for 2005 and 6.4%, 7.1% and 5.1%, respectively, for 2004.
The primary source of non-interest income during 2006 was from service charges on deposit accounts followed by the gain recognized on the sale of loans. The increase in service charges on deposit accounts was primarily a result of the fees charged on additional deposit accounts opened during the year, and the overdraft privilege deposit product which on a year over year basis increased $320,000. Loan sales income decreased $228,000 from $1,806,000 in 2005 to $1,578,000 in 2006. This was a result of the lower volume of mortgage loans sold during 2006. Mortgage loan activity was still vigorous in 2005 and fees derived from the sale of these loans increased from 2004. The real estate market has softened in most of the areas we serve which has resulted in more homes for sale thereby creating an environment more advantageous to the buyer than the seller.
The loan portfolio also includes loans which are 75% to 90% guaranteed by the Small Business Administration (SBA), U.S. Department of Agriculture, Rural Business-Cooperative Service (RBS) and Farm Services Agency (FSA). The guaranteed portion of these loans may be sold to a third party, with the Company retaining the unguaranteed portion. The Company generally receives a premium in excess of the adjusted carrying value of the loan at the time of sale.
The portfolio of real estate loans being serviced by the Company declined by 3% from 2005 to 2006. The portfolio of SBA, RBS and FSA government guaranteed loans being serviced by the Company declined by 1.8% from 2005 to 2006. These reductions resulted in a decrease in loan servicing income of $24,000 from $481,000 in 2005 to $457,000 in 2006.
Alternative investment fees earned on the sales of non-deposit investment products decreased by $170,000 in 2006 compared to 2005 primarily as a result of fewer sales throughout the year.
Merchant credit card fees declined by $9,000 from $390 thousand in 2005, to $381 thousand in 2006. Through more aggressive marketing efforts of this product, management expects income from this area to increase somewhat in 2007.
A ratio that is used to compare the Company’s expenses to those of other financial institutions is the operating efficiency ratio. This ratio takes into account the fact that for many financial institutions some of their income is not asset-based, it is based on fees for services provided rather than income earned from a spread between the interest earned on assets and interest paid on liabilities. The operating efficiency ratio measures what portion of each dollar of net revenue is spent earning that revenue. With a portion of the Company’s revenues coming from such areas as the Insurance Agency, Payroll Services and Merchant Services, i.e., from programs that require operating expenses to run but are not related to assets on the Company’s balance sheet, management focuses more on this ratio than the operating expense to assets ratio. The Company is increasingly focused on enhancing its fee income. Based on the Company’s efficiency ratio of 65.8% for 2006, 61.6% for 2005, and 62.1% for 2004 as compared to the 55% and lower ratios of certain major financial institutions, it is expected that this focus will continue for the foreseeable future.
The Company’s total non-interest expense increased to $25.2 million in 2006, as compared to $20.9 million in 2005, and $16.8 million in 2004.
The largest dollar increase in non-interest expense was in salaries and employee benefits, which increased by $3,155,000, or 25.7% from 2005 to 2006. Included within salaries and benefits are actual salaries, bonuses, commissions, retirement benefits, payroll taxes, and stock option expense. This increase resulted from normal cost of living raises, and salaries paid to employees for a full year during 2006 at the Corning branch which opened in March, 2005 and the Redding branch which opened in September, 2005. We also opened a Loan Production Office in the city of Gridley in July, 2005. Staffing additions made during the year as the Company continued to grow also contributed to the increase. The increase in salaries and benefits in 2005 compared to 2004 was $2,290,000 or 22.9%. Full time equivalent employees increased to 263 at December 31, 2006 from 240 at December 31, 2005 and 204 at December 31, 2004. Benefit costs
and employer taxes increased commensurate with the salaries. It is management’s opinion that the Company can achieve significant growth in loans and deposits with the current staff, however increases in staffing are expected during 2007 as the Company moves forward with the planned addition of a second full service branch in Redding and Yuba City and a full service branch in Anderson. The Redding and Anderson branches are scheduled to open at the end of the second quarter with the Yuba City branch due to open during the third quarter.
Occupancy and equipment expenses were $3,480,000, an increase of $511,000 or 17.2% when compared to the 2005 total of $2,969,000. Much of the increase in occupancy expense was related to furniture, fixtures and equipment for the relocation to the new Red Bluff, Redding, Marysville and Corning branches opened during 2006. The lease agreements and remodeling costs associated with these offices, also added to the year over year increase. The increase in occupancy expenses in 2005 compared to 2004 was $444,000 or 18%.
The majority of the increase in professional services costs of $152,000 from 2005 to 2006 relates to outsourcing audit work and the process of implementing Sarbanes-Oxley 404 compliance. The increase in 2005 compared to 2004 was due to outsourcing of audit work and the application process for the Company to join the NASDAQ exchange. Advertising and marketing expenses increased by 60% in 2006 from 2005 after increasing by 36% in 2005 from 2004 as we promoted the new branches and the four branch relocations to new facilities.
Expenses representing telephone and data communications, postage and mail, stationery and supplies, director fees and retirement accruals, advertising and promotion, and other expenses totaled $4,931,000 for 2006 compared to $4,651,000 in 2005 and $3,657,000 in 2004, an increase of 6.0% and 27.2% on a year over year basis. Management considers this increase in expenses commensurate with the growth of the Company.
The Company has two share based compensation plans. In 2006, the Company adopted Statement of Financial Accounting Standards No. 123(R), Share-Based Payment (SFAS 123(R)), using the modified prospective application transition method. Prior to January 1, 2006, the Company accounted for these plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations (APB 25). No stock-based compensation cost is reflected in net income prior to January 1, 2006, as all options granted under these plans had an exercise price equal to the market value of the underlying common stock on the date of the grant. As a result of adopting SFAS 123(R), the Company’s income before provision for income taxes and net income for the year ended December 31, 2006 are $175,000 and $163,000, respectively, lower than if it had continued to account for share-based compensation under APB 25. Basic and diluted earnings per share for the year ended December 31, 2006 would have been $.02 higher without the adoption of SFAS 123(R). Results for prior periods have not been restated.
The Company bases the fair value of the options previously granted on the date of grant using a Black-Scholes option pricing model that uses assumptions based on expected option life, the level of estimated forfeitures, expected stock volatility and the risk-free interest rate. Stock volatility is based on the historical volatility of the Company’s stock. The risk-free rate is based on the U.S. Treasury yield curve and the expected term of the options. The “simplified” method described in SEC Staff Accounting Bulletin No. 107 was used to determine the expected term of the Bank’s options in 2006 and 2005.
There were no significant changes in the valuation methods or types of awards or terms made by the Company subsequent to the adoption of SFAS No. 123(R) and no cumulative effect adjustments were made to the financial statements.
As of December 31, 2006, there was $391,000 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the Plans. The cost is expected to be recognized over a weighted average period of 2.33 years. See Notes 1 and 11 to the audited Consolidated Financial Statements in Item 8.
Non Interest Income/Expense
(dollars in thousands, unaudited)
Provision for Loan Losses Credit risk is inherent in the business of making loans. The Company sets aside an allowance for loan losses through charges to earnings. The charges are shown in the income statements as provisions for loan losses, and specifically identifiable and quantifiable losses are immediately charged off against the allowance.
The Company’s provisions for loan losses and undisbursed commitments in 2006, 2005, and 2004 were $775,000, $825,000, and $790,000 respectively. The amounts allocated to the provision and the undisbursed commitments were $638,000 and $137,000 respectively for 2006, $724,000 and $101,000 for 2005 and $734,000 and $56,000 for 2004. The loan loss provision is determined by conducting a monthly evaluation of the adequacy of the Company’s allowance for loan losses, and charging the shortfall, if any, to the current month’s expense. This has the effect of creating variability in the amount and frequency of charges to the Company’s earnings. The procedures for monitoring the adequacy of the allowance, as well as detailed information concerning the allowance itself, are included below under “Allowance for Loan Losses.”
Income Taxes As indicated in Note 13 in the Notes to the Consolidated Financial Statements, the provision for income taxes is the sum of two components, the provision for current taxes and deferred taxes. The provision for current taxes results from applying the current tax rate to taxable income, and is in essence the actual current income tax liability. Some items of income and expense are recognized in different years for tax
purposes than when applying accounting principles generally accepted in the United States of America, however, leading to differences between the Company’s actual tax liability and the amount accrued for this liability based on book income. These temporary timing differences comprise the deferred portion of the Company’s tax provision.
Most of the Company’s temporary differences involve recognizing more expenses in its financial statements than it has been allowed to deduct for tax purposes, and therefore the Company normally carries a net deferred tax asset on its books. At December 31, 2006, the Company’s $5.2 million net deferred tax asset was primarily due to temporary differences in the reported allowance for loan losses, deferred compensation, and future benefit of state tax deduction offset by the temporary differences related to certain deferred tax liabilities.
Financial Condition The following discussion of the financial condition of the Company is grouped into earning assets, comprised of loans and investments; non-earning assets, comprised of cash and due from banks, premises and equipment and other assets; liabilities, consisting of deposits and other borrowings; capital resources; and liquidity and market risk. Each section provides details where applicable on volume, rates of change, and significance relative to the overall activities of the Company.
A comparison between the summary year-end balance sheets for 2002 through 2006 was presented previously in the table of Selected Financial Data (see Item 6 above). As indicated in that table, the Company’s total assets, loans, deposits, and shareholders’ equity have grown each year for the past four years, with asset growth, in terms of total dollars, most pronounced in 2004 when the Company grew by $63 million, or 16.3%. This was followed by growth in the Company’s total assets during 2005 of $45 million or 10% and growth in the Company’s total assets during 2006 of approximately $55 million, or 11.2%.
The mix of deposits in NOW, money market and savings average balances changed very little from 2005 to 2006 declining by $5.5 million or 3%. As interest rates gradually increased through 2006 the growth in deposits was primarily in certificates of deposit. These balances increased by $49.9 million while the average rates paid on all interest bearing deposits increased by 91 basis points. In the third quarter our loan volume peaked which resulted in the Company obtaining brokered deposits from the wholesale market. These brokered deposits also contributed to the increase in average rates paid for the year. Throughout 2006 deposit growth was achieved in our newer markets in Red Bluff, Marysville, Corning and Redding. We believe this will be the case again in 2007 as we have relocated all of these branches from their less desirable storefront environment to free standing buildings with drive-up lanes. As mentioned previously construction is underway for a second full service branch in Redding and for a new branch in Anderson. When opened in the second quarter of 2007, these two branches will complement the existing branch in Redding in gathering more deposits. The opening in the third quarter of 2007of a second branch in Yuba City will cover more of the southern section and will be located in a shopping center on Highway 99.
Loan Portfolio The Company offers a wide variety of loan types and terms to customers along with very competitive pricing and quick delivery of the credit decision. The Company’s loan portfolio represents the single largest portion of invested assets, substantially greater than the investment portfolio or any other asset category. At December 31, 2006, gross loans represented 81.5% of total assets, as compared to 82.3% and 76.4% at December 31, 2005 and 2004, respectively. The quality and diversification of the Company’s loan portfolio are important considerations when reviewing the Company’s results of operations.
The Selected Financial Data table in Item 6 reflects the net amount of loans outstanding at December 31st for each year between 2002 and 2006. The Loan Distribution table which follows sets forth the amount and composition of the Company’s total loans outstanding in each category at the dates indicated.
Loan Distribution
As reflected in the Loan Distribution table, aggregate loan balances have increased $212 million, or 92%, over the last four years. The largest percentage of growth and largest dollar volume increase during that that four year period and during 2006 was in commercial real estate which grew by $126 million or 153% and $34.6 million or 20% respectively.
Loan growth in the Company’s immediate market has been oriented toward loans secured by real estate, commercial loans, including Small Business Administration loans, as well as consumer loans. As a result, these areas have comprised the major portion of the Company’s loan growth over the past few years. During 2006 loans secured by real estate grew by $29 million, or 10.2%, and commercial loans grew by $4.1 million, or 6.7%. Consumer loans increased by $7.3 million, or 20%. Loans secured by real estate and commercial loans comprised 69.9% and 14.6%, respectively, of the Bank’s total loan portfolio at December 31, 2006.
The Company’s commercial loans are centered in locally oriented commercial activities in the markets where the Company has a presence. Additionally, the Company has a Government Lending Division dedicated to its SBA product and its Business and Industry (B&I) Guaranteed Loan Program. For the fiscal year ended September 30, 2006, the Company was named the number one USDA Business and Industry lender in the entire United States by originating over $46 million in loans. The Company is also designated as an SBA Preferred Lender, which means it has the authority to underwrite and approve SBA loans locally. This recognition lends credence to the Company’s success in meeting the needs of smaller business owners in the communities in which the Company conducts its banking activities.
Consistent with the overall growth in loans, the most significant shift in the loan portfolio mix over the past four years has been in loans secured by commercial real estate, which increased from 35.1% of total loans at the end of 2002 to 46.4% of total loans at the end of 2006. Real estate lending is an important part of the Company’s focus, and is likely to remain so for the immediate future. Commercial loans declined to just 14.6% of total loan balances by the end of 2006 from 20.8% at the end of 2002, and agricultural loans decreased during the same period to 5.7% of the total loan balances from 8.1%. The decline in the percentage of agricultural loans to total loans over the last few years has been due to the growth in the other
lending areas outpacing the growth in the agricultural lending. Agricultural borrowing relationships have remained consistent year after year and we have not substantially expanded this part of our business.
Another important aspect of the Company’s loan business has been that of residential real estate loans which were generated internally by the real estate mortgage loan department and then sold in the secondary market to government sponsored enterprises or other long-term lenders. The Company has consistently been among the largest real estate mortgage lenders in Butte County for the past several years. During 2006, the Company originated and sold aggregate balances of approximately $52 million of such loans, a $26 million decrease from the $78 million originated and sold in 2005. The Company services the mortgage loans sold to the Federal National Mortgage Association (FNMA). As of December 31, 2006, aggregate balances of $153 million were being serviced down slightly from the $157 million at the end of 2005.
In the normal course of business, the Company makes commitments to extend credit as long as there are no violations of any condition established in the contractual arrangement. Total outstanding commitments to extend credit were $186 million at December 31, 2006 as compared to $201 million at December 31, 2005. These commitments represented 41% of outstanding gross loans at December 31, 2006 and 49% at December 31, 2005, respectively. The Company’s stand-by letters of credit at December 31, 2006 and 2005 were $5.1 million and $4.9 million, respectively, which represented approximately 2.7% and 2.4% of total commitments outstanding at the end of 2006 and 2005. It is not anticipated that all of these commitments or stand-by letters of credit will fund.
Approximately one half of the loans held by the Company have floating rates of interest tied to the Company’s base lending rate or to another market rate indicator so that they may be re-priced as interest rates change. The same interest rate and liquidity risks that apply to securities are also applicable to lending activity. Fixed-rate loans are subject to market risk: they decline in value as interest rates rise. The Company’s loans that have fixed rates generally have relatively short maturities or amortize monthly, which effectively lessens the market risk. The table in Note 16 to the consolidated financial statements shows that at December 31, 2006, the difference in the carrying amount of loans, i.e., their face value, is about $ 3.5 million or .80 % less than their fair value. At the end of 2005, the fair value of loans was about $1.7 million or .42% less than the carrying amount.
Because the Company is not involved with chemicals or toxins that might have an adverse effect on the environment, its primary exposure to environmental legislation is through its lending activities. The Company’s lending procedures include steps to identify and monitor this exposure to avoid any significant loss or liability related to environmental regulations.
Loan Maturities
The following Loan Maturity table shows the amounts of total loans outstanding as of December 31, 2006, which, based on remaining scheduled repayments of principal, are due within one year, after one year but less than five years, and in more than five years. (Non-accrual loans are intermixed within each category.)
Loan Maturity
(dollars in thousands)
This schedule, which aggregates contractual principal repayments by time period, can be used in combination with the Investment Maturities table in the Investment Securities section and the Deposit Maturities table in the Deposits section to identify time periods with potential liquidity exposure. The referenced maturity schedules do not convey a complete picture of the Company’s re-pricing exposure or interest rate risk, however. For details on the re-pricing characteristics of the Company’s balance sheet and a more comprehensive discussion of the Company’s sensitivity to changes in interest rates, see the “Liquidity and Market Risk” section.
Non-performing Assets Banks have generally suffered their most severe earnings declines as a result of customers’ inability to generate sufficient cash flow to service their debts, or as a result of the downturns in national and regional economies which have brought about declines in overall property values. In addition, certain investments which the Company may purchase have the potential of becoming less valuable as the conditions change in the obligor’s financial capacity to repay, based on regional economies or industry downturns. As a result of these types of failures, an institution may suffer asset quality risk, and may lose the ability to obtain full repayment of an obligation to the Company. Since loans are the most significant assets of the Company and generate the largest portion of revenues, the Company’s management of asset quality risk is focused primarily on loan quality.
The Company achieves a certain level of loan quality by establishing a sound credit plan, which includes defining goals and objectives and devising and documenting credit policies and procedures. These policies and procedures identify certain markets, set goals for portfolio growth or contraction, and establish limits on industry and geographic concentrations. In addition, these policies establish the Company’s underwriting standards and the methods of monitoring ongoing credit quality. Unfortunately, however, the Company’s asset-quality risk may be affected by external factors such as the level of interest rates, employment, general economic conditions, real estate values and trends in particular industries or certain geographic markets. The Company’s internal factors for controlling risk are centered in underwriting practices, credit granting procedures, training, risk management techniques, and familiarity with our loan customers as well as the relative diversity and geographic concentration of our loan portfolio.
As a multi-community, independent bank headquartered in and serving Butte County (with a smaller presence in each of Colusa, Sutter, Sacramento, Shasta, Tehama, and Yuba counties); the Company has mitigated its risk to any one segment of these Northern Sacramento Valley markets. The Company’s asset quality continues to be excellent with delinquency ratios at low levels. The Company is optimistic that the local and regional economy will continue to perform, but no assurance can be given that this performance will in fact continue.
From time to time, Management has reason to believe that certain borrowers may not be able to repay their loans within the parameters of the present repayment term, even though, in some cases, the loans are current at the time. These loans are regarded as potential problem loans, and a portion of the allowance is assigned and/or allocated, as discussed below, to cover the Company’s exposure to loss would the borrowers indeed fail to perform according to the terms of the notes. This class of loans does not include loans in a nonaccrual status or 90 days or more delinquent but still accruing, which are shown in the table below.
Non-performing assets are comprised of loans on non-accrual status, loans 90 days or more past due and still accruing interest, loans restructured where the terms of repayment have been renegotiated resulting in a deferral of interest or principal and other real estate (“ORE”). Loans are generally placed on non-accrual status when they become 90 days past due as to principal or interest. Loans may be restructured by management when a borrower has experienced some change in financial status causing an inability to meet the original repayment terms and where the Company believes the borrower will eventually overcome those circumstances and repay the loan in full. ORE consists of properties acquired by foreclosure or similar means that management intends to offer for sale.
Management’s classification of a loan as non-accrual is an indication that there is reasonable doubt as to the full collectibility of principal or interest on the loan; at that point, the Company stops recognizing income from the interest on the loan and reverses any uncollected interest that had been accrued but unpaid. These loans may or may not be collateralized, but collection efforts are continuously pursued.
The following table provides information with respect to components of the Company’s non-performing assets at the date indicated. The Company has not had any loans 90 days past due and still accruing interest in any periods presented.
Non-performing Assets
(dollars in thousands)
Total non-performing balances were $2,282,000 at the end of 2006, which consisted of a commercial loan for $1.6 million for an industrial building on which the Company has an 80% guarantee from the USDA, and two residential properties. As of March 9, 2007 the Company has completed foreclosure on all three of these properties and has reclassified them as ORE. We have a buyer for the $1.6 million industrial building and have entered into escrow with an anticipated close by March 31, 2007. There was no ORE outstanding at December 31, 2006, 2005 or 2004. Other than the loans included as non-performing assets at December 31, 2006, the company has not identified any potential problem loans that would result in any loan being included as a non-performing asset at a future date.
Allowance for Loan Losses The allowance for loan losses is established through a provision for loan losses based on management’s evaluation of known and inherit risk in our loan portfolio. The allowance is increased by provisions charged against current earnings and reduced by net charge-offs. Loans are charged off when they are deemed to be uncollectible; recoveries are generally recorded only when cash payments are received subsequent to the charge off. The following table summarizes the activity in the allowance for loan losses for the past five years.
Allowance For Loan Losses
(dollars in thousands)
We employ a systematic methodology for determining the allowance for loan losses that includes a monthly review process and monthly adjustment of the allowance. Our process includes a periodic review of individual loans that have been specifically identified as problem loans or have characteristics which could lead to impairment, as well as detailed reviews of other loans (either individually or in pools). While this methodology utilizes historical and other objective information, the establishment of the allowance for loan losses and the classification of loans are, to some extent, based on management’s judgment and experience.
Our methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan losses that management believes is appropriate at each reporting date. Quantitative factors include our historical loss experience, delinquency and charge-off trends, collateral values, changes in non-performing loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers’ sensitivity to interest rate movements and borrowers’ sensitivity to quantifiable external factors including commodity prices as well as acts of nature (freezes, earthquakes, fires, etc.) that occur in a particular period.
Qualitative factors include the general economic environment in Northern California and, in particular, in our markets wherein we monitor the state of the agriculture industry and other key industries in the Northern Sacramento Valley. The way a particular loan might be structured, the extent and nature of waivers of existing loan policies, loan concentrations and the rate of portfolio growth are other qualitative factors that are considered.
Our methodology is, and has been, consistently followed. However, as we add new products, increase in complexity, and expand our geographic coverage, we expect to enhance our methodology to keep pace with the size and complexity of the loan portfolio. On an ongoing basis we engage outside firms to independently assess our methodology, and to perform independent credit reviews of our loan portfolio. The FDIC and the California Department of Financial Institutions review the allowance for loan losses as an integral part of the examination processes. Management believes that our current methodology is appropriate given our size and level of complexity. Further, management believes that the allowance for loan losses is adequate as of December 31, 2006 to cover known and inherent risks in the loan portfolio. However, fluctuations in credit quality, or changes in economic conditions or other factors could cause management to increase or decrease the allowance for loan losses as necessary.
The following table provides a summary of the allocation of the allowance for loan losses for specific loan categories at the dates indicated. The allocation presented should not be interpreted as an indication that charges to the allowance for loan losses will be incurred in these amounts or proportions, or that the portion of the allowance allocated to each loan category represents the total amounts available for charge-offs that may occur within these categories. The unallocated portion of the allowance for loan losses and the total allowance is applicable to the entire loan portfolio.
Allocation of Loan Loss Allowance
(dollars in thousands)
(1) Represents percentage of loans in category to total loans.
At December 31, 2006, the Company’s allowance for loan losses was $5.3 million. The loan loss and undisbursed commitment provisions in 2006, 2005, and 2004 totaled $775,000, $825,000, and $790,000, respectively. Over the past five years, net charge-offs have averaged $30,000. The Company ended 2006 with net loan losses of $80,000, compared to net losses of $8,000 during 2005.
Other Loan Portfolio Information
Loan Concentrations: The concentration profile of the Company’s loans is discussed in Note 10 to the accompanying Consolidated Financial Statements.
Loan Sales and Mortgage Servicing Rights: The Company sells or brokers some of the fixed-rate single family mortgage loans it originates as well as other selected portfolio loans. Some are sold “servicing released” and the purchaser takes over the collection of the payments. However, most are sold with “servicing retained” and the Company continues to receive the payments from the borrower and forwards the funds to the purchaser. The Company earns a fee for this service. The sales are made without recourse, that is, the purchaser cannot look to the Company in the event the borrower does not perform according to the terms of the note. When loans are sold, a portion of the sale is attributed to the right to receive the fee for servicing and this value is recorded as a separate servicing asset. Mortgage servicing rights are amortized over the expected term of the related servicing income. At December 31, 2006 and 2005, the amortized cost of these assets was $872,000 and $1,073,000 respectively.
Investment Portfolio The investment securities portfolio had a carrying value of $5.1 million at December 31, 2006. The Company classified its investments into two portfolios: “held-to-maturity”, and “available-for-sale”. The Company does not have any investments classified as trading. The held-to-maturity portfolio should consist only of investments that the Company has both the intention and ability to hold until maturity, to be sold only in the event of concerns with an issuer’s creditworthiness, a change in tax law that eliminates their tax exempt status or other infrequent situations as permitted under GAAP. Given the small and non complex nature of the portfolio, management does not rely heavily on these investments as a source of funds for growth in the loan portfolio.
Securities pledged as collateral on repurchase agreements, public deposits and for other purposes as required or permitted by law were $3,357,000 for both periods ending December 31, 2006 and 2005.
The total investment portfolio decreased in 2006 to $5.1 million at the end of the year from $6.7 million at December 31, 2005. The Company’s investment portfolio is composed primarily of: (1) U.S. Treasury and Agency issues for liquidity and pledging; and (2) state, county and municipal obligations which provide tax free income and pledging potential. The distribution of these groups within the overall portfolio remained relatively consistent as there were no purchases or sales in 2006. The U.S. Treasury and Agency issues continue to be the largest portion of the total portfolio at 73%, down from 80% at the end of 2005. Municipal issues comprised 27% of total investments at the end of 2006, up from 20% at the end of 2005.
The following Investment Portfolio table reflects the amortized cost and fair market values for the total portfolio for each of the categories of investments for the past three years.
Federal funds sold comprise the remainder of the assets that are not invested in the securities portfolio or in the loan portfolio. These are overnight transactions that are highly liquid and are returned to the Company the next day. The Company sold $42 million and $29 million as of December 31, 2006 and December 31, 2005.
Investment Portfolio
(dollars in thousands)
The investment maturities table below summarizes the maturity of the Company’s investment securities and their weighted average yields at December 31, 2006. Expected remaining maturities may differ from remaining contractual maturities because obligors may have the right to repay certain obligations with or without penalties.
Investment Maturities
(dollars in thousands)
Cash and Due From Banks Cash on hand and balances due from correspondent banks represent the major portion of the Company’s non-earning assets. At December 31, 2006 these areas comprised 3.7% of total assets, as compared to 3.8% of total assets at December 31, 2005. The Company strives to maintain vault cash at a level consistent with the withdrawal needs of the customers. The vault cash amount for December 31, 2006 was $4.2 million.
The Company’s operating branches lie within the Federal Reserve Bank (FRB) of San Francisco’s responsibility area of check clearing activities, while the Company’s item processing activities are performed in Chico. As a result of the Federal Reserve Banks’ new Check 21 services the Company is taking advantage of quicker clearing times to offset time zone and geography challenges and improve availability. With traditional paper check clearing, all non-local and country items in the 12th District receive availability that is at least one day deferred. Under the new programs currently available from the Federal Reserve Banks, many of these items receive immediate availability if received by the 1:00 a.m. Pacific time deadline. With file deposit deadlines starting as early as 5:00 p.m. Pacific through 9:00 a.m. Pacific time, image cash letters enable institutions on the West Coast to reduce the clearing time of many high value East Coast items by at least one business day, thereby increasing funds available for investment and reducing risk.
Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is charged to income over the estimated useful lives of the assets and leasehold improvements are amortized over the terms of the related lease, or the estimated useful lives of the improvements, whichever is shorter. Depreciation expense was $1,662,000 for the year ended December 31, 2006 as compared to $1,574,000 during 2005 and $1,313,000 during 2004. The following premises and equipment table reflects the balances by major category of fixed assets:
Premises & Equipment
(dollars in thousands)
The net book value of the Company’s premises and equipment increased by $4,068,000 in 2006, primarily due to the opening of the new branches in Red Bluff, Redding, Marysville and Corning . In 2005 the Company purchased a 14,000 square foot building in Chico that will serve as the corporate administrative headquarters and also house other service departments. This building was remodeled and an additional 5,000 square feet was added. As of the end of January 2007 the building is fully occupied. As a percentage of total assets, the Company’s premises and equipment was 2.8%, at the end of 2006, 2.3% at the end of 2005 and 2.0% at the end of 2004.
Deposits The composition and cost of the Company’s deposit base are important components in analyzing the Company’s net interest margin and balance sheet liquidity characteristics, both of which are discussed in greater detail in other sections herein. Net interest margin is improved to the extent that growth in deposits can be concentrated in historically lower-cost core deposits, namely non-interest-bearing demand, NOW accounts, savings accounts and money market deposit accounts. Liquidity is impacted by the volatility of deposits or other funding instruments, or in other words their propensity to leave the institution for rate-related or other reasons. Potentially, the most volatile deposits in a financial institution are large certificates of deposit, which generally mean time deposits with balances exceeding $100,000. Because these deposits (particularly when considered together with a customer’s other specific deposits) may exceed FDIC insurance limits, depositors may select shorter maturities to offset perceived risk elements associated with deposits over $100,000. Certificates of deposits exceeding $100,000 represented 15.9% of average total deposits in 2006, 11.3% in 2005 and 9.9% in 2004. While the trend of these deposits has been steadily increasing over the past three years, the Company’s community-oriented deposit gathering activities in Butte, Colusa, Shasta, Sutter, Tehama, and Yuba counties have engendered a less volatile than usual base of depositor certificates over $100,000.
The Company’s total deposit volume increased to $485 million at the end of 2006, as compared to $434 million at the end of 2005. Deposit growth of $51 million was achieved during 2006, primarily as a result of the full year of operations for the branches opened in 2005 and the new branches opened in 2006. The mix of the deposits changed from 2005 to 2006 as the growth was realized in certificates of deposit rather than the lower cost core deposit accounts (demand deposits, NOW, money market, and savings). We expect deposit rates to be relatively unchanged in 2007, and our focus will be to attract lower cost deposits to fund our loan growth and maintain a reasonable net interest margin in 2007.
The scheduled maturity distribution of the Company’s time deposits, including IRA accounts as of December 31, 2005 was as follows:
Deposit Maturity Distribution
(dollars in thousands)
Notes Payable and Other Borrowings
The Company has $15 million in unsecured borrowing arrangements with two of its correspondent banks to meet short-term liquidity needs. There were no borrowings outstanding under these arrangements at December 31, 2006 and 2005.
The following summarizes the note payable to the Company’s subsidiary grantor trust at December 31, 2006:
The Company has guaranteed, on a subordinated basis, distributions and other payments due on the trust preferred securities issued by the subsidiary grantor trust. Interest expense recognized by the Company for the years ended December 31, 2006, 2005 and 2004 related to the junior subordinated debentures was $733,000, $592,000 and $438,000, respectively. These junior subordinated debentures currently qualify as Tier 1 capital when determining regulatory risk-based capital ratios.
On April 28, 2006 the ESOP obtained financing through a $1.3 million unsecured line of credit from another financial institution with the Company acting as the guarantor. The note has a variable interest rate, based on an independent index, and a maturity date of April 10, 2014. At December 31, 2006, the interest rate was 8.25%. Advances on the line of credit totaled $1,217,000, $981,000 at December 31, 2006 and 2005, respectively. A summary of the activity in this line of credit follows.
On June 1, 2005, Community Valley Bancorp entered into a short term, unsecured note payable in a principal amount of $800,000 in conjunction with the purchase of real property. The interest rate on the note at December 31, 2005 was 4.5%. The note was paid in full on January 4, 2006.
Capital Resources At December 31, 2006, the Company had total shareholders equity of $45.7 million, comprised of $8.2 million in common stock, and $37.5 million in retained earnings. Total shareholders equity at the end of 2005 was $41.6 million. Net income has provided $20 million in capital over the last three years, of which $4.1 million or approximately 20% was distributed in dividends. The retention of earnings has been the Company’s main source of capital since 1990, however the Company issued $8.2 million in Subordinated Debentures in 2002, the proceeds of which are considered Tier 1 capital for regulatory purposes but long-term debt in accordance with GAAP.
The Company paid quarterly cash dividends totaling $1,933,000 or $.26 per share in 2006 and $1,092,000 or $.16 per share in 2005, representing 27% and 15.8%, respectively of the prior year’s earnings. Since the second quarter of 2001, the Company has adhered to a policy of paying quarterly cash dividends totaling about 18% of the prior year’s net earnings to the extent consistent with general considerations of safety and soundness, provided that such payments do not adversely affect the Bank’s or the Company’s financial condition and are not overly restrictive to its growth capacity. The Company anticipates paying dividends in the future consistent with the general dividend policy as described above. However, no assurance can be given that the Bank’s and the Company’s future earnings and/or growth expectations in any given year will justify the payment of such a dividend.
The Company uses a variety of measures to evaluate capital adequacy. Management reviews various capital measurements on a monthly basis and takes appropriate action to ensure that such measurements are within established internal and external guidelines. The external guidelines, which are issued by the FDIC, establish a risk-adjusted ratio relating capital to different categories of assets and off balance sheet exposures. There are two categories of capital under the FDIC guidelines: Tier 1 and Tier 2 Capital. Tier 1 Capital includes common shareholders’ equity and the proceeds from the issuance of trust-preferred securities (subject to the limitations previously discussed), less goodwill and certain other deductions, notably the unrealized net gains or losses (after tax adjustments) on securities available for sale, which are carried at fair market value. Tier 2 Capital includes preferred stock and certain types of debt equity, which the Company does not hold, as well as the allowance for loan losses, subject to certain limitations. (For a more detailed definition, see “Item 1, Business-Supervision and Regulation - Capital Adequacy Requirements” herein.)
At December 31, 2006, the Company had a Tier 1 risk based capital ratio of 10.9%, a total capital to risk-weighted assets ratio of 11.9%, and a leverage ratio of 10.1%. The Company had a Tier 1 risk-based capital ratio of 11.4%, a total risk-based capital ratio of 12.5%, and a leverage ratio of 9.8% at December 31, 2005. Note 11 of the Notes to Consolidated Financial Statements provides more detailed information concerning the Company’s capital amounts and ratios as of December 31, 2006 and 2005.
At the current time, the Bank is considered “well capitalized” under the Prompt Corrective Action standards. It is anticipated that the current level of capital will allow the Company to grow and remain well capitalized, although no assurance can be given that this will be the case.
Off-Balance Sheet Items and Contractual Obligations
The Company has certain ongoing commitments under operating leases. See Note 10 to the consolidated financial statements at Item 8 of this report for the terms. These commitments do not significantly impact operating results. As of December 31, 2006 commitments to extend credit and stand-by-letters of credit were the Company’s only financial instruments with off-balance sheet risk. Loan commitments decreased to $186 million at December 31, 2006 from $201 million at December 31, 2005. Stand-by-letters of credit increased slightly to $5.1 million from $4.9 million over the same period. The commitments and stand-by letters of credit represent 42% of the total loans outstanding at year-end 2006 versus 49% at December 31, 2005.
The following chart summarizes certain contractual obligations of the Company as of December 31, 2006:
(1) These amounts represent the accrued liabilities as of December 31, 2006 under the Company’s deferred compensation and supplemental retirement plans. See Note 15 to the consolidated financial statements at Item 8 of this report for additional information related to the Company’s deferred compensation and supplemental retirement plan liabilities.
Liquidity and Market Risk Management The Company must address on a daily basis the various and sundry factors which impact its continuing operations. Three of these factors, the economic climate which encompasses our business environment, the regulatory framework which governs our practices and procedures, and credit risk have been previously discussed. There are other risks specific to the operation of a financial institution which also need to be managed, and this section will address liquidity risk and market risk.
Liquidity refers to the Company’s ability to maintain a cash flow adequate to fund operations, and to meet obligations and other commitments in a timely and cost-effective fashion. At various times the Company requires funds to meet short-term cash requirements brought about by loan growth or deposit outflows, the purchase of assets, or liability repayments. To manage liquidity needs properly, cash inflows must be timed to coincide with anticipated outflows, or sufficient liquidity resources must be available to meet varying demands. The Company manages its own liquidity in such a fashion as to be able to meet unexpected sudden changes in levels of its assets or deposit liabilities, without maintaining excessive amounts of on-balance sheet liquidity. Excess balance sheet liquidity can negatively impact the interest margin.
An integral part of the Company’s ability to manage its liquidity position appropriately is provided by the Company’s large base of core deposits, which were generated by offering traditional banking services in the communities in its service area and which have, historically, been a very stable source of funds.
Additionally, the Company maintains $15 million in unsecured borrowing arrangements with two of its correspondent banks. The Company also has the ability to raise deposits through various deposit brokers, sell investment securities, or sell loans if required for liquidity purposes.
Market risk arises from changes in interest rates, exchange rates, commodity prices and equity prices. The Company’s market risk exposure is primarily that of interest rate risk, and it has risk management policies to monitor and limit earnings and balance sheet exposure to changes in interest rates. The Company does not engage in the trading of financial instruments.
The principal objective of interest rate risk management (often referred to as “asset/liability management”) is to manage the financial components of the Company in a manner that will optimize the risk/reward equation for earnings and capital in relation to changing interest rates. In order to identify areas of potential exposure to rate changes, the Company calculates its re-pricing gap on a monthly basis. It also performs an earnings simulation analysis and a market value of portfolio equity calculation on a monthly basis to
identify more dynamic interest rate risk exposures than those apparent in the standard re-pricing gap analysis.
Modeling software is used by the Company for asset/liability management in order to simulate the effects of potential interest rate changes on the Company’s net interest margin. These simulations can also provide both static and dynamic information on the projected fair market values of the Company’s financial instruments under differing interest rate assumptions. The simulation program utilizes specific individual loan and deposit maturities, embedded options, rates and re-pricing characteristics to determine the effects of a given interest rate change on the Company’s interest income and interest expense. Rate scenarios consisting of key rate and yield curve projections are run against the Company’s investment, loan, deposit and borrowed funds portfolios. These rate projections can be shocked (an immediate and sustained change in rates, up or down), ramped (an incremental increase or decrease in rates over a specified time period), economic (based on current trends and econometric models) or stable (unchanged from current actual levels). The Company typically uses seven standard interest rate scenarios in conducting the simulation, namely stable, an upward shock of 100, 200, and 300 basis points, and a downward shock of 100, 200, and 300 basis points. The Company’s policy is to limit the change in the Company’s net interest margin and economic value to plus or minus 5%, 15%, and 25% and 12.5%, 25%, and 37.5% respectively upon application of interest rate shocks of 100 bp, 200 bp, and 300 bp as compared to a base rate scenario. As of December 31, 2006, the Company had the following estimated net interest margin sensitivity profile:
The above profile illustrates that if there were an immediate increase of 200 basis points in interest rates, the Company’s annual net interest income would likely increase by about $3,752,000, or approximately 12.3%. Likewise, if there were an immediate downward adjustment of 200 basis points in interest rates, the Company’s net interest income would likely decrease by approximately $4,211,000, or 13.8%, over the next year.
The results for the Company’s December 31, 2006, balances indicate that the Company’s net interest income at risk over a one-year period and net economic value at risk from 2% shocks are within normal expectations for such sudden changes.
The amount of change is based on the profiles of each loan and deposit class, which include the rate, the likelihood of prepayment or repayment, whether its rate is fixed or floating, the maturity of the instrument and the particular circumstances of the customer. The quantification of the change in economic value is somewhat apparent in Note 16, Fair Value of Financial Instruments, in the consolidated financial statements; however such values change over time based on certain assumptions about interest rates and likely changes in the yield curve.
Selected Quarterly Financial Data
(Dollars in thousands, except per share data)
Item 7a.
Item 7a. Quantitative and Qualitative Disclosures About Market Risk
The information require by Item 7a of Form 10-K is contained in the Liquidity and Market Risk Management section of Item 7 - Managements Discussion and Analysis of Financial Condition and Results of Operations.
Item 8.
Item 8. Financial Statements and Supplementary Data
The financial statements begin on page 57 of this report.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
There were no changes or disagreements with Accountants for the year 2006.
Item 9a.
Item 9a. Controls and Procedures As of the end of the period covered by this report, we conducted an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. There was no change in our internal control over financial reporting during our most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Item 9b.
Item 9b. Other Information
PART III
Item 10.
Item 10. Directors and Executive Officers and Corporate Governance
The information required by Item 10 of Form 10-K is incorporated by reference to the information contained in the Company’s Proxy Statement for the 2007 Annual Meeting of Shareholders which will be filed pursuant to Regulation 14A.
Item 11.
Item 11. Executive Compensation
The information required by Item 11 of Form 10-K is incorporated by reference to the information contained in the Company’s Proxy Statement for the 2007 Annual Meeting of Shareholders which will be filed pursuant to Regulation 14A.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information required by Item 12 of Form 10-K is incorporated by reference to the information contained in the Company’s Proxy Statement for the 2007 Annual Meeting of Shareholders which will be filed pursuant to Regulation 14A.
Item 13.
Item 13. Certain Relationships and Related Transactions and Director Independence
The information required by Item 13 of Form 10-K is incorporated by reference to the information contained in the Company’s Proxy Statement for the 2007 Annual Meeting of Shareholders which will be filed pursuant to Regulation 14A.
Item 14.
Item 14. Principal Accountant Fees and Services
The information required by Item 14 of Form 10-K is incorporated by reference to the information contained in the Company’s Proxy Statement for the 2007 Annual Meeting of Shareholders which will be filed pursuant to Regulation 14A.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.
(a) List of documents filed as part of this report
(1) Financial Statements
The following financial statements and independent auditor’s reports are included in this Annual Report on Form 10-K immediately following.
I.
Report of Independent Registered Public Accounting Firm
II.
Consolidated Balance Sheet - December 31, 2006 and
III.
Consolidated Statement of Income - Years Ended December 31, 2006, 2005 and 2004
IV.
Consolidated Statement of Changes in Shareholders’ Equity - Years Ended December 31, 2006, 2005 and 2004
V.
Consolidated Statement of Cash Flows - Years Ended December 31, 2006, 2005 and 2004
VI.
Notes to the Consolidated Financial Statements
(2) Financial Statement Schedules
Schedules to the financial statements are omitted because the required information is not applicable or because the required information is presented in the Company’s Consolidated Financial Statements or related notes.
(3) Exhibits
(4.0)
Specimen of Company’s Common Stock Certificate incorporated by reference from the Company’s Registration Statement Form S-4EF, file #333-85950.
(10.1)
Employment Agreement with Keith C Robbins dated April 27, 1995. Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.1)1
Amendment to Employment Agreement with Keith C. Robbins dated September 12, 2006 attached hereto.
(10.2)
Salary Continuation Agreement dated April 14, 1998, and Amendment to Salary Continuation Agreement dated January 10, 2002, for Keith C Robbins. Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.2)1.
Amendment to Salary Continuation Agreement of April 14, 1998 for Keith C Robbins dated January 1, 2004 Incorporated by reference to the Company’s Annual Report on Form 10-K for the period ended December 31, 2003, filed with the Commission on March 20, 2004.
(10.2)2
Additional Salary Continuation Agreement with Keith C. Robbins dated September 12, 2006, attached hereto.
(10.3)
Executive Supplemental Retirement Plan dated August 1, 2000, and Amendment to Executive Supplement Retirement Plan dated January 10, 2002, for Keith C Robbins. Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.4)
1997 Stock Option Agreement for Keith C Robbins dated May 1, 1997. Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.5)
2000 Stock Option Agreement for Keith C Robbins dated March 14, 2000. Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.6)
Employment Agreement with John F Coger dated April 27, 1995. Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.7)
Salary Continuation Agreement dated April 14, 1998, and Amendment to Salary Continuation Agreement dated January 10, 2002, for John F Coger. Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.7)1.
Amendment to Salary Continuation Agreement of April 14, 1998 for John F Coger dated January 1, 2004. Incorporated by reference to the Company’s Annual Report on Form 10-K for the period ended December 31, 2003, filed with the Commission on March 20, 2004.
(10.8)
Executive Supplemental Retirement Plan dated August 1, 2000, and Amendment to Executive Supplement Retirement Plan dated January 10, 2002, for John F Coger. Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.9)
000 Stock Option Agreement for John F. Coger dated March 14, 2000 Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002 2
(10.10)
1997 Stock Option Agreement for M. Robert Ching dated May 1, 1997 Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002
(10.11)
2000 Stock Option Agreement for M Robert Ching dated May 1, 2000. Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.12)
1997 Stock Option Agreement for Eugene B. Even dated May 1, 1997 Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002
(10.13)
2000 Stock Option Agreement for Eugene B Even dated May 1, 2000. Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.14)
1997 Stock Option Agreement for John D Lanam dated May 1, 1997. Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.15)
2000 Stock Option Agreement for John D Lanam dated May 1, 2000. Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.16)
1997 Stock Option Agreement for Donald W Leforce dated May 1, 1997. Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.17)
2000 Stock Option Agreement for Donald W. Leforce dated May 1, 2000 Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002
(10.18)
1997 Stock Option Agreement for Ellis L. Matthews dated May 1, 1997 Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002
(10.19)
2000 Stock Option Agreement for Ellis L. Matthews dated May 1, 2000 Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002
(10.20)
1997 Stock Option Agreement for Robert L Morgan dated May 1, 1997 Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.21)
2000 Stock Option Agreement for Robert L. Morgan dated May 1, 2000 Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002
(10.22)
1997 Stock Option Agreement for James S Rickards dated May 1, 1997. Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.23)
2000 Stock Option Agreement for James S. Rickards dated May 1, 2000 Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002
(10.24)
1997 Stock Option Agreement for Gary B. Strauss dated May 1, 1997 Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002
(10.25)
2000 Stock Option Agreement for Gary B Strauss dated May 1, 2000. Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.26)
1997 Stock Option Agreement for Hubert I. Townshend dated May 1, 1997 Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002
(10.27)
2000 Stock Option Agreement for Hubert I. Townshend dated May 1, 2000 Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002
(10.28)
Director Deferred Fee Agreement for M. Robert Ching dated April 8, 1998 Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002
(10.29)
Director Retirement Agreement for M. Robert Ching dated April 14, 1998 Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002
(10.30)
Director Retirement Agreement for Eugene B. Even dated April 14, 1998 Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002
(10.31)
Director Retirement Agreement for John D Lanam dated April 14, 1998. Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.32)
Director Deferred Fee Agreement for Donald W. Leforce dated April 14, 1998 Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002
(10.33)
Director Retirement Agreement for Donald W. Leforce dated April 14, 1998 Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002
(10.34)
Director Retirement Agreement for Ellis L Matthews dated April 14, 1998. Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.35)
Director Retirement Agreement for Robert L. Morgan dated April 14, 1998 Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002
(10.36)
Director Retirement Agreement James S. Rickards dated April 14, 1998 Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002
(10.37)
Director Retirement Agreement for Gary B Strauss dated April 14, 1998. Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.38)
Director Retirement Agreement for Hubert I Townshend dated April 14, 1998. Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.39)
Lease agreement between Butte Community Bank and Anna Laura Schilling Trust dated March 20, 2001, related to 900 Mangrove Ave, Chico, California. Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(10.40)
2000 Stock Option Agreement for Charles J Mathews dated October 21, 2003 Incorporated by reference to the Company’s Annual Report on Form 10-K for the period ended December 31, 2005, filed with the Commission on March 14, 2006.
(10.41)
2000 Stock Option Agreement for Luther W McLaughlin dated March 10, 2003. Incorporated by reference to the Company’s Annual Report on Form 10-K for the period ended December 31, 2005, filed with the Commission on March 14, 2006
(11)
See Item 6. Selected Financial Data Note 1 for Statement re computation of earnings per share
(12)
See Item 6. Selected Financial Data Notes 2 through 6 for Statements re computation of ratios
(21)
List of Subsidiaries: Butte Community Bank, BCB Insurance Agency, Community Valley Trust I (unconsolidated)
(23.1)
Consent of Independent Registered Public Accounting Firm
(31.1)
Rule 13a-14(a)/15d-14(a) certification of Chief Executive Officer
(31.2)
Rule 13a-14(a)/15d-14(a) certification of Chief Financial Officer
(32.1)
Section 1350 certification of Chief Executive Officer
(32.2)
Section 1350 certification of Chief Financial Officer
(99.1)
1991 Stock Option Plan is incorporated by reference from the Company’s Registration Statement Form S-8, filed August 14, 2002 .
(99.2)
1997 Stock Option Plan is incorporated by reference from the Company’s Registration Statement Form S-8, filed August 14, 2002 .
(99.3)
2000 Stock Option Plan is incorporated by reference from the Company’s Registration Statement Form S-8, filed August 14, 2002 .
(99.4)
Director Emeritus Plan dated March 20, 2001 Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002, filed with the Commission on August 14, 2002.
(b) Reports on Form 8-K
On January 20, 2006 the Company issued a press release announcing earnings for the fourth quarter and year ending December 31, 2005.
On March 15, 2006 the company issued a press release announcing the payment of a five cent dividend to shareholders of record as of March 31, 2006. The payment date for the dividend was April 28, 2006.
On April 13, 2006 the Company issued a press release announcing earnings for the first quarter of 2006.
On April 14, 2006 the Company issued a press release announcing the acceptance of Community Valley Bancorp toThe Nasdaq Capital Markets.
On June 27, 2006 the Company issued a press release announcing the payment of a six cent dividend to shareholders of record as of June 30, 2006. The payment date for the dividend was July 28, 2006.
On July 14, 2006 the Company issued a press release announcing second quarter 2006 earnings.
On September 15, 2005 the Company issued a press release announcing the payment of a seven cent dividend to shareholders of record as of September 29, 2005. The payment date for the dividend was October 27, 2006.
On October 18, 2006 the Company issued a press release announcing third quarter 2006 earnings.
On December 23, 2005 the Company issued a press release announcing the payment of a eight cent dividend to shareholders of record as of December 29, 2005. The payment date for the dividend was January 26, 2007.
On January 26, 2007 the Company issued a press release announcing earnings for the fourth quarter and year ending December 31, 2006.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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.
COMMUNITY VALLEY BANCORP AND SUBSIDIARIES
CONSOLIDATED FINANCIAL STATEMENTS
AS OF DECEMBER 31, 2006 AND 2005
AND FOR THE YEARS ENDED
DECEMBER 31, 2006, 2005 AND 2004
AND
REPORT OF INDEPENDENT REGISTERED
PUBLIC ACCOUNTING FIRM
REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The management of Community Valley Bancorp is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934.
Management, including the undersigned Chief Executive Officer and Chief Financial Officer, assessed the effectiveness of our internal control over financial reporting presented in conformity with accounting principles generally accepted in the United States of America as of December 31, 2006. In conducting its assessment, management used the criteria issued by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control-Integrated Framework. Based on this assessment, management concluded that, as of December 31, 2006, our internal control over financial reporting was effective based on those criteria.
Management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006, has been audited by Perry-Smith LLP, the independent registered public accounting firm that audited the consolidated financial statements included in this annual report, as stated in their report appearing on page A-4, which expresses unqualified opinions on management’s assessment and on the effectiveness of our internal control over financial reporting as of December 31, 2006.
March 2, 2007
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The Board of Directors
Community Valley Bancorp
We have audited management’s assessment, included in the accompanying Report of Management on Internal Control Over Financial Reporting, that Community Valley Bancorp and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO criteria”). 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 accounting principles generally accepted in the United States of America. 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 accounting principles generally accepted in the United States of America, 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 Community Valley Bancorp and subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also in our opinion, Community Valley Bancorp and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Community Valley Bancorp and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in shareholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2006 and our report dated March 9, 2007 expressed an unqualified opinion.
/s/ Perry-Smith LLP
Sacramento, California
March 9, 2007
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders
Community Valley Bancorp
We have audited the accompanying consolidated balance sheet of Community Valley Bancorp and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2006. 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 audits to obtain reasonable assurance about whether the consolidated 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 consolidated financial position of Community Valley Bancorp and subsidiaries as of December 31, 2006 and 2005 and the consolidated results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Community Valley Bancorp and subsidiaries’ internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 9, 2007 expressed an unqualified opinion on management’s assessment of the effectiveness of Community Valley Bancorp’s internal control over financial reporting and an unqualified opinion on the effectiveness of Community Valley Bancorp’s internal control over financial reporting.
/s/ Perry-Smith LLP
Sacramento, California
March 9, 2007
COMMUNITY VALLEY BANCORP AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
December 31, 2006 and 2005
The accompanying notes are an integral part of these consolidated financial statements.
COMMUNITY VALLEY BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF INCOME
For the Years Ended December 31, 2006, 2005 and 2004
The accompanying notes are an integral part of these consolidated financial statements.
COMMUNITY VALLEY BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY
For the Years Ended December 31, 2006, 2005 and 2004
The accompanying notes are an integral part of these consolidated financial statements.
COMMUNITY VALLEY BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
For the Years Ended December 31, 2006, 2005 and 2004
The accompanying notes are an integral part of these consolidated financial statements.
COMMUNITY VALLEY BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
General
In May 2002, Community Valley Bancorp (“Community Valley”) was incorporated as a bank holding company for the purpose of acquiring Butte Community Bank (the “Bank”) in a one bank holding company reorganization. In 2004, Community Valley changed its status to a Financial Holding Company for the purpose of establishing BCB Insurance Agency LLC (“BCBIA”). The new corporate structure gives Community Valley, the Bank and BCBIA greater flexibility in terms of operation, expansion and diversification.
Founded in 1990, the Bank is a state-chartered financial institution with thirteen branches in ten cities including Chico, Magalia, Oroville, Paradise, Redding, Red Bluff, Colusa, Corning, Marysville, and Yuba City and loan production offices in Citrus Heights and Gridley. The Bank provides traditional deposit and lending services including commercial and construction loans, government guaranteed loans such as those available from the USDA and SBA, merchant services and investment services.
On December 19, 2002, Community Valley formed a wholly-owned subsidiary, Community Valley Bancorp Trust I (the “Trust”), a Delaware statutory business trust, for the purpose of issuing trust preferred securities (see Note 9).
On December 1, 2004, Community Valley formed a wholly-owned subsidiary, BCB Insurance Agency LLC for the purpose of providing insurance related services.
The accounting and reporting policies of Community Valley Bancorp and its subsidiaries (collectively, the “Company”) conform with accounting principles generally accepted in the United States of America and prevailing practice within the banking industry. The more significant of these policies applied in the preparation of the accompanying consolidated financial statements are discussed below.
Segment Information
Management has determined that since all of the banking products and services offered by the Company are available in each branch of the Bank, all branches are located within the same economic environment and management does not allocate resources based on the performance of different lending or transaction activities, it is appropriate to aggregate the Bank branches and report them as a single operating segment. No customer accounts for more than 10 percent of revenues for the Company or the Bank.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of Community Valley and its wholly-owned subsidiaries, Butte Community Bank and BCB Insurance Agency LLC. Significant intercompany transactions and balances have been eliminated in consolidation.
For financial reporting purposes, the Company’s investment in the Trust of $248,000 (see Note 9) is accounted for under the equity method and is included in accrued interest receivable and other assets on the consolidated balance sheet. The junior subordinated debentures issued and guaranteed by the Company and held by the Trust are reflected as debt in the Company’s consolidated balance sheet.
Stock Splits
On March 10, 2005, the Board of Directors declared a two-for-one stock split effective May 16, 2005, for shareholders of record on May 2, 2005. On February 20, 2004, the Board of Directors declared a four-for-three stock split effective March 26, 2004 for shareholders of record on March 2, 2004. All share and per share data has been retroactively adjusted to reflect these stock splits.
Reclassifications
Certain reclassifications have been made to prior years’ balances to conform to classifications used in 2006.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.
Cash and Cash Equivalents
For purposes of the consolidated statement of cash flows, cash and cash equivalents include cash and due from banks and Federal funds sold. Federal funds are generally sold for one-day periods.
Investment Securities
Investment securities are classified into the following categories:
· Available-for-sale securities, reported at fair value, with unrealized gains and losses excluded from earnings and reported, net of taxes, as accumulated other comprehensive (loss) income within shareholders’ equity.
· Held-to-maturity securities, which management has the positive intent and ability to hold, reported at amortized cost, adjusted for the accretion of discounts and amortization of premiums.
Management determines the appropriate classification of its investments at the time of purchase and may only change the classification in certain limited circumstances. All transfers between categories are accounted for at fair value. As of December 31, 2006 and 2005 the Company did not have any investment securities classified as trading and there were no transfers of securities between categories.
Gains or losses on the sale of investment securities are computed using the specific identification method. Interest earned on investment securities is reported in interest income, net of applicable adjustments for accretion of discounts and amortization of premiums.
Investment securities are evaluated for impairment on at least a quarterly basis and more frequently when economic or market conditions warrant such an evaluation to determine whether a decline in their value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline and the intent and ability of the Company to retain its investment in the issues for a period of time sufficient to allow for an anticipated recovery in fair value, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. The term “other than temporary” is not intended to indicate that the decline is permanent, but indicates that the prospects for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.
Loans
Loans are stated at principal balances outstanding, except for loans transferred from loans held for sale which are carried at the lower of principal balance or market value at the date of transfer, adjusted for accretion of discounts. Interest is accrued daily based upon outstanding loan balances. However, when, in the opinion of management, loans are considered to be impaired and the future collectibility of interest and principal is in serious doubt, loans are placed on nonaccrual status and the accrual of interest income is suspended. Any interest accrued but unpaid is charged against income. Payments received are applied to reduce principal to the extent necessary to ensure collection. Subsequent payments on these loans, or payments received on nonaccrual loans for which the ultimate collectibility of principal is not in doubt, are applied first to earned but unpaid interest and then to principal.
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due (including both principal and interest) in accordance with the contractual terms of the loan agreement. An impaired loan is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical matter, at the loan’s observable market price or the fair value of collateral if the loan is collateral dependent. Interest income on impaired loans, if appropriate, is recognized on a cash basis.
Substantially all loan origination fees, commitment fees, direct loan origination costs and purchase premiums and discounts on loans are deferred and recognized as an adjustment of yield, to be amortized to interest income over the contractual term of the loan. The unamortized balance of deferred fees and costs is reported as a component of net loans.
The Company may acquire loans through a business combination or a purchase for which differences may exist between the contractual cash flows and the cash flows expected to be collected due, at least in part, to credit quality. When the Company acquires such loans, the yield that may be accreted (accretable yield) is limited to the excess of the Company’s estimate of undiscounted cash flows expected to be collected over the Company’s initial investment in the loan. The excess of contractual cash flows over cash flows expected to be collected may not be recognized as an adjustment to yield, loss, or a valuation allowance. Subsequent increases in cash flows expected to be collected generally should be recognized prospectively through adjustment of the loan’s yield over its remaining life. Decreases in cash flows expected to be collected should be recognized as an impairment. The Company may not “carry over” or create a valuation allowance in the initial accounting for loans acquired under these circumstances. At December 31, 2006 and 2005, there were no such loans being accounted for under this policy.
Loans Held for Sale, Loan Sales and Servicing Rights
The Company accounts for the transfer and servicing of financial assets based on the financial and servicing assets it controls and liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished.
Servicing rights acquired through 1) a purchase or 2) the origination of loans which are sold with servicing rights retained are recognized as separate assets or liabilities. Servicing assets or liabilities are recorded at the difference between the contractual servicing fees and adequate compensation for performing the servicing, and are subsequently amortized in proportion to and over the period of the related net servicing income or expense. Servicing assets are periodically evaluated for impairment. Fair values are estimated using discounted cash flows based on current market interest rates. For purposes of measuring impairment, servicing assets are stratified based on note rate and term. The amount of impairment recognized, if any, is the amount by which the servicing assets for a stratum exceed their fair value.
Any servicing assets in excess of the contractually specified servicing fees have been reclassified at fair value as an interest-only (IO) strip receivable and treated like an available-for-sale security. The servicing asset, net of any required valuation allowance, and IO strip receivable are included in accrued interest and other assets. At December 31, 2006 and 2005, IO strips were not significant.
Government Guaranteed Loans
Included in the loan portfolio are loans which are 85% to 90% guaranteed by the Small Business Administration (SBA), U.S. Department of Agriculture, Rural Business - Cooperative Service (RBS) and Farm Services Agency (FSA). The guaranteed portion of these loans may be sold to a third party, with the Company retaining the unguaranteed portion. The Company generally receives a premium in excess of the adjusted carrying value of the loan at the time of sale. The Company may be required to refund a portion of the sales premium if the borrower defaults or the loan prepays within ninety days of the settlement date.
The Company’s investment in the loan is allocated between the retained portion of the loan, the servicing asset, the IO strip, and the sold portion of the loan based on their relative fair values on the date the loan is sold. The gain on the sold portion of the loan is recognized as income at the time of sale. The carrying value of the retained portion of the loan is discounted based on the estimated value of a comparable non-guaranteed loan. The servicing asset and IO strip is recognized as discussed above. Significant future prepayments of these loans will result in the recognition of additional amortization of related servicing assets and an adjustment to the carrying value of related IO strips.
The Company serviced SBA, RBS and FSA government guaranteed loans for others totaling $79,675,000 and $70,894,000 as of December 31, 2006 and 2005, respectively.
Mortgage Loans
The Company originates mortgage loans that are either held in the Company’s loan portfolio or sold in the secondary market. Loans held for sale are carried at the lower of cost or market value. Market value is determined by the specific identification method as of the balance sheet date or the date which the purchasers have committed to purchase the loans. At the time the loan is sold, the related right to service the loan is either retained, with the Company recognizing the servicing asset, or released in exchange for a one-time servicing-released premium. Loans subsequently transferred to the loan portfolio are transferred at the lower of cost or market value at the date of transfer. Any difference between the carrying amount of the loan and its outstanding principal balance is recognized as an adjustment to yield by the interest method.
The Company serviced loans for the Federal National Mortgage Association (FNMA) totaling $152,618,000 and $157,210,000 as of December 31, 2006 and 2005, respectively.
Participation Loans
The Company also serviced loans which it has participated with other financial institutions totaling $10,118,000 and $1,540,000 as of December 31, 2006 and 2005, respectively.
Allowance for Loan Losses The allowance for loan losses is maintained to provide for losses related to impaired loans and other losses that can be reasonably expected to occur in the normal course of business. The determination of the allowance for loan losses is based on estimates made by management, to include consideration of the character of the loan portfolio, specifically identified problem loans, potential losses inherent in the portfolio taken as a whole and economic conditions in the Company’s service area.
Classified loans and loans determined to be impaired are evaluated by management for specific risk of loss. In addition, a reserve factor is assigned to currently performing loans based on management’s assessment of the following for each identified loan type: (1) inherent credit risk, (2) historical losses and, (3) where the Company has not experienced losses, the loss experience of peer banks. These estimates are particularly susceptible to changes in the economic environment and market conditions.
The Company’s Board of Directors reviews the adequacy of the allowance for loan losses at least quarterly, to include consideration of the relative risks in the portfolio and current economic conditions. The allowance for loan losses is adjusted based on that review if, in the judgment of the Board of Directors and management, changes are warranted.
The allowance for loan losses is established through a provision for loan losses which is charged to expense. Additions to the allowance for loan losses are expected to maintain the adequacy of the total allowance after loan losses and loan growth. The allowance for loan losses at December 31, 2006 and 2005 reflects management’s estimate of possible losses in the portfolio.
Allowance for Losses Related to Undisbursed Loan Commitments The Company maintains a separate allowance for losses related to undisbursed loan commitments. Management estimates the amount of probable losses by applying the loss factors used in the allowance for loan loss methodology to an estimate of the expected usage and applies the factor to the unused portion of undisbursed lines of credit. The allowance totaled $619,000 and $481,000 at December 31, 2006 and 2005, respectively, and is included in accrued interest payable and other liabilities on the balance sheet.
Premises and Equipment
Premises and equipment are carried at cost. Depreciation is determined using the straight-line method over the estimated useful lives of the related assets. The useful lives of premises are estimated to be thirty to thirty-nine years. Leasehold improvements are amortized over the life of the improvement or the life of the related lease, whichever is shorter. The useful lives of furniture, fixtures and equipment are estimated to be three to ten years. When assets are sold or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts, and any resulting gain or loss is recognized in income for the period. The cost of maintenance and repairs is charged to expense as incurred.
The Company evaluates premises and equipment for financial impairment as events or changes in circumstances indicate that the carrying amount of such assets may not be fully recoverable.
Income Taxes
The Company files its income taxes on a consolidated basis with its subsidiaries. The allocation of income tax expense (benefit) represents each entity’s proportionate share of the consolidated provision for income taxes.
The Company accounts for income taxes using the liability or balance sheet method. Under this method, deferred tax assets and liabilities are recognized for the tax consequences of temporary differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. On the consolidated balance sheet, net deferred tax assets are included in accrued interest receivable and other assets.
Earnings Per Share
Basic earnings per share (EPS), which excludes dilution, is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period, excluding the effect of unallocated shares of the Employee Stock Ownership Plan. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock, such as stock options, result in the issuance of common stock which shares in the earnings of the Company. The treasury stock method has been applied to determine the dilutive effect of stock options in computing diluted EPS.
Comprehensive Income
Comprehensive income is a more inclusive financial reporting methodology that includes disclosure of other comprehensive income (loss) that historically has not been recognized in the calculation of net income. Unrealized gains or losses on the Company’s available-for-sale investment securities and IO strip are the principle source of other comprehensive income or loss. Total comprehensive income and the components of accumulated other comprehensive income (loss) are presented in the consolidated statement of changes in shareholders’ equity.
Stock-Based Compensation
The Company issues stock options under two shareholder approved stock-based compensation plans, the Community Valley Bancorp 1997 and 2000 Stock Option Plans. The Plans do not provided for the settlement of awards in cash and new shares are issued upon exercise of the options. The plans require that the option price may not be less than the fair market value of the stock at the date the option is granted, and that the stock must be paid for in full at the time the option is exercised. The options expire on a date determined by the Board of Directors, but not later than ten years from the date of grant. The vesting period is determined by the Board of Directors and is generally over five years; however, nonstatutory options granted during 1997 vested immediately. Under the 1997 plan, 210,516 shares of common stock remain reserved for issuance to employees and directors, and the related options are exercisable until their expiration. However, no new options will be granted under these plans. Under the Company’s 2000 stock option plan, 508,767 shares of common stock remain reserved for issuance to employees and directors, of which 66,877 shares are available for future grants.
On January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment,” which requires the Company to measure the cost of employees services received in exchange for an award of equity instruments based on the grant date fair value of the award. The Company elected to use the modified prospective transition method of adoption such that SFAS No. 123R applies to the unvested portion of previously issued awards, new awards and to awards modified, repurchased or canceled after the adoption date. Accordingly, commencing January 1, 2006, the Company recognized stock-based compensation for all current award grants and for the unvested portion of previous award grants that are expected to vest based on the grant date fair value. The Company applied the alternative transition method in calculating its pool of excess tax benefits available to absorb future tax deficiencies as provided by FSP FAS 123(R)-3, Transition Election Related to Accounting for the Tax Effects of share-Based Payment Awards. Prior to 2006, the Company accounted for stock-based compensation awards under Accounting Principles Board Opinion No. 25 intrinsic value method, under which no compensation expense was recognized because all historical options granted were at an exercise price equal to the market value of the Company’s stock on the grant date. Prior period financial statements have not been adjusted to reflect fair value stock-based compensation expense under SFAS No. 123R.
As a result of adopting SFAS 123(R), the Company’s income before provision for income taxes and net income for the year ended December 31, 2006 are $175,000 and $163,000, respectively, lower than if it had continued to account for share-based compensation under APB 25. Basic and diluted earnings per share for the year ended December 31, 2006 would have been $.02 higher without the adoption of SFAS 123(R).
Management estimates the fair value of each option award as of the date of the grant using a Black-Sholes-Merton option pricing model. Expected volatility is based on historical volatility of the Company’s stock over a preceding period commensurate with the expected term of the option. The “simplified” method described in SEC Staff Accounting Bulletin No. 107 was used to determine the expected term of the Company’s options for 2006 and 2005. The risk free interest rate for the expected term of the option is based on U.S. Treasury yield curve in effect at the time of the grant. The expected dividends yield was determined based on the budgeted cash dividends of the Company at the time of the grant. In addition to these assumptions, management makes estimates regarding pre-vesting forfeitures that will impact total compensation expense recognized under the Plan.
The following table illustrates the effect on net income and earnings per share for the years ended December 31, 2005 and 2004 as if the Company had applied the fair value recognition provisions of SFAS No. 123 to options granted under the Company’s stock option plan:
The fair value of each option is estimated on the date of grant using the following assumptions:
Impact of New Financial Accounting Standards
Accounting for Servicing of Financial Assets
In March 2006, the Financial Accounting Standards Board (FASB) issued Statement No. 156 (SFAS 156), Accounting for Servicing of Financial Assets - An Amendment of FASB Statement No. 140. SFAS 156 requires that all separately recognized servicing assets and servicing liabilities be initially measured at fair value, if practicable, and permits, but does not require, the subsequent measurement of servicing assets and servicing liabilities at fair value. Under SFAS 156, an entity can elect subsequent fair value measurement of its servicing assets and servicing liabilities by class. An entity should apply the requirements for recognition and initial measurement of servicing assets and servicing liabilities prospectively to all transactions after the effective date. SFAS 156 permits an entity to reclassify certain available-for-sale securities to trading securities provided that they are identified in some manner as offsetting the entity’s exposure to changes in fair value of servicing assets or servicing liabilities subsequently measured at fair value. The provisions of SFAS 156 are effective for an entity as of the beginning of its first fiscal year that begins after September 15, 2006 and the Bank adopted these provisions on January 1, 2007. Management does not expect the adoption of SFAS 156 to have a material impact on the Bank’s financial position or results of operations
Accounting for Uncertainty in Income Taxes
In July 2006,, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement 109 (FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. The Company presently recognizes income tax positions based on management’s estimate of whether it is reasonably possible that a liability has been incurred for unrecognized income tax benefits by applying FASB Statement No. 5, Accounting for Contingencies. FIN 48 prescribes a comprehensive model for recognizing, measuring, presenting and disclosing in the financial statements tax positions taken or expected to be taken in a tax return.
The provisions of FIN 48 will be effective for the Company on January 1, 2007 and are to be applied to all tax positions upon initial application of this standard. Only tax positions that meet the more-likely-than-not recognition threshold at the effective date may be recognized or continue to be recognized upon adoption.
The cumulative effect of applying the provisions of FIN 48, if any, will be reported as an adjustment to the opening balance of retained earnings for he fiscal year of adoption. Management does not expect the adoption to have a material impact on the Company’s financial position or results of operations.
Considering the Effects of Prior Year Misstatements
In September 2006, the Securities and Exchange Commission published Staff Accounting Bulleting No. 108 Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. The interpretations in this Staff Accounting Bulleting are being issued to address diversity in practice in quantifying financial statement misstatements and the potential under current practice to build up improper amounts on the balance sheet. This guidance will apply to the first fiscal year ending after November 15, 2006, or December 31, 2006 for the Company. The adoption of SAB 108 did not have a material impact on the Company’s financial position, results of operations or cash flows and no cumulative adjustment was required..
Fair Value Measurements
In September 2006, the FASB issued Statement No. 157 (SFAS 157), Fair Value Measurements. SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. In this standard, the FASB clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability. In support of this principle, SFAS 157 establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The provisions of SFAS 157 are effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The provisions should be applied prospectively, except for certain specifically identified financial instruments. Management does not expect the adoption of SFAS 157 to have a material impact to the Bank’s financial position or result of operations.
Accounting for Purchases of Life Insurance
In September 2006, the FASB ratified the consensuses reached by the Emerging Issues Task Force (the Task Force) on Issue No. 06-5 (EITF 06-5) Accounting for the Purchases of Life Insurance - Determining the Amount that Could be Realized in Accordance with FASB Technical Bulletin No. 85-4 (FTB 85-4). FTB 85-4 indicates that the amount of the asset included in the balance sheet for life insurance contracts within its scope should be “the amount that could be realized under the insurance contract as of the date of the statement of financial position.” Questions arose in applying the guidance in FTB 85-4 to whether “the amount that could be realized” should consider 1) any additional amounts included in the contractual terms of the insurance policy other than the cash surrender value and 2) the contractual ability to surrender all of the individual-life policies (or certificates in a group policy) at the same time. EITF 06-5 determined that “the amount that could be realized” should 1) consider any additional amounts included in the contractual terms of the policy and 2) assume the surrender of an individual-life by individual-life policy (or certificate by certificate in a group policy). Any amount that is ultimately realized by the policy holder upon the assumed surrender of the final policy (or final certificate in a group policy) shall be included in the “amount that could be realized.” An entity should apply the provisions of EITF 06-5 through either a change in accounting principle through a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption or a change in accounting principle through retrospective application to all prior periods. The provisions of EITF 06-5 are effective for fiscal years beginning after December 15, 2006. Management has not yet completed its evaluation of the impact that EITF 06-5 will have.
Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements
In September 2006, the FASB ratified the consensuses reached by the Task Force on Issue No. 06-4 (EITF 06-4) Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements. A question arose when an employer enters into an endorsement split-dollar life insurance arrangement related to whether the employer should recognize a liability for the future benefits or premiums to be provided to the employee. EITF 06-4 indicates that an employer should recognize a liability for future benefits and that a liability for the benefit obligation has not been settled through the purchase of an endorsement type policy. An entity should apply the provisions of EITF 06-4 either through a change in accounting principle through a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption or a change in accounting principle through retrospective application to all prior periods. The provisions of EITF 06-4 are effective for fiscal years beginning after December 15, 2007. Management has not yet completed its evaluation of the impact that EITF 06-4 will have.
2. INVESTMENT SECURITIES
The amortized cost and estimated fair value of investment securities at December 31, 2006 and 2005 consisted of the following:
Net unrealized gains and (losses)on available-for-sale investment securities totaling $16,000 and $(21,000) were recorded, net of $(7,000) and $8,000 in tax (expenses)benefits, respectively, as accumulated other comprehensive income (loss)within shareholders’ equity at December 31, 2006 and 2005, respectively. There were no sales or transfers of available-for-sale investment securities for the years ended December 31, 2006, 2005 and 2004.
There were no sales or transfers of held-to-maturity investment securities for the years ended December 31, 2006, 2005 and 2004.
Investment securities with unrealized losses at December 31, 2006 and 2005 are summarized and classified according to the duration of the loss period as follows:
U.S. Government Agencies
At December 31, 2006, the Company held 9 U.S. Government agency securities of which 2 were in a loss position for less than twelve months and 2 were in a loss position and had been in a loss position for twelve months or more. The unrealized losses on the Company’s investments in direct obligations of U.S. government agencies were caused by interest rate increases. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized costs of the investment. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company has the ability and intent to hold those investments until a recovery of fair value, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at December 31, 2006.
The amortized cost and estimated fair value of investment securities at December 31, 2006, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because the issuers of securities may have the right to call or prepay obligations with or without prepayment penalties.
Investment securities with amortized costs totaling $3,357,000 and $3,357,000 and fair values totaling $3,370,000 and $3,349,000 were pledged to secure public deposits and treasury, tax and loan accounts at December 31, 2006 and 2005, respectively.
3. LOANS AND ALLOWANCE FOR LOAN LOSSES
Outstanding loans are summarized as follows:
Changes in the allowance for loan losses were as follows:
At December 31, 2006 and 2005, nonaccrual loans totaled $2,282,000 and $9,000, which were considered impaired loans. A valuation allowance of $12,000 was allocated to these loans in 2006 and no allowance was allocated in 2005. The average recorded investment in impaired loans for the years ended December 31, 2006 and 2005 was $1,616,000 and $ 31,000, respectively. Interest foregone on nonaccrual loans totaled $106,000 for the year ended December 31, 2006, and $1,000 for each of the years ended 2005 and 2004. Interest recognized for cash payment received on nonaccrual loans was not significant for the years ended December 31, 2006, 2005 and 2004, respectively.
The Company did not hold any real estate acquired by foreclosure at December 31, 2006 or 2005.
Salaries and employee benefits totaling $1,246,000, $1,766,000 and $1,190,000 have been deferred as loan origination costs for the years ended December 31, 2006, 2005 and 2004, respectively.
4. ACCRUED INTEREST RECEIVABLE AND OTHER ASSETS
Accrued interest receivable and other assets consisted of the following:
Originated mortgage servicing assets totaling $208,000, $142,000 and $515,000 were recognized during the years ended December 31, 2006, 2005 and 2004, respectively. Amortization of mortgage servicing assets totaled $409,000, $417,000 and $381,000 for the years ended December 31, 2006, 2005and 2004, respectively.
5. PREMISES AND EQUIPMENT
Premises and equipment consisted of the following:
Depreciation and amortization included in occupancy and equipment expense totaled $1,662,000, $1,574,000 and $1,313,000 for the years ended December 31, 2006, 2005 and 2004 respectively.
6. INTEREST-BEARING DEPOSITS
Interest-bearing deposits consisted of the following:
Aggregate annual maturities of time deposits at December 31, 2006 are as follows:
Interest expense recognized on interest-bearing deposits consisted of the following:
7. SHORT-TERM BORROWING ARRANGEMENTS
The Company has $15,000,000 in unsecured borrowing arrangements with two of its correspondent banks to meet short-term liquidity needs. There were no borrowings outstanding under these arrangements at December 31, 2006 and 2005.
8. NOTES PAYABLE
Employee Stock Ownership Plan (ESOP) Note
The ESOP obtained financing through a $1,300,000 unsecured line of credit from another financial institution with the Company acting as the guarantor (see Note 15). The note has a variable interest rate, based on an independent index, and a maturity date of April 10, 2014. At December 31, 2006, the interest rate was 8.25%. Advances on the line of credit totaled $1,217,000 and $982,000 at December 31, 2006 and 2005, respectively.
Note Payable
On June 1, 2005, Community Valley Bancorp entered into a short term, unsecured note payable in a principal amount of $800,000 in conjunction with the purchase of real property. The interest rate on the note at December 31, 2005 was 4.5%. The note was paid in full on January 4, 2006.
9. JUNIOR SUBORDINATED DEBENTURES
Community Valley Bancorp Trust I (CVB Trust I) is a Delaware statutory business trust formed by the Company for the sole purpose of issuing trust preferred securities fully and unconditionally guaranteed by the Company. Under applicable regulatory guidance, the amount of trust preferred securities that is eligible as Tier 1 capital is limited to twenty-five percent of the Company’s Tier 1 capital on a pro forma basis. At December 31, 2006, all of the trust preferred securities that have been issued qualify as Tier 1 capital.
In December 2002, the Company issued to CVB Trust I Subordinated Debentures due December 31, 2032. Simultaneously, CVB Trust I issued 8,000 floating rate trust preferred securities, with liquidation values of $1,000 per security, for gross proceeds of $8,000,000. The Subordinated Debentures represent the sole assets of the Trust. The Subordinated Debentures are redeemable by the Company, subject to receipt by the Company of prior approval from the Federal Reserve Bank (FRB), if then required under applicable capital guidelines or policies of the FRB. The Company may redeem the Subordinated Debentures held by CVB Trust I on any December 31st on or after December 31, 2007. The redemption price shall be par plus accrued and unpaid interest, except in the case of redemption under a special event, which is defined in the debenture. The floating rate trust preferred securities are subject to mandatory redemption to the extent of any early redemption of the Subordinated Debentures and upon maturity of the Subordinated Debentures on December 31, 2032.
Holders of the trust preferred securities are entitled to cumulative cash distributions on the liquidation amount of $1,000 per security. Interest rates on the trust preferred securities and Subordinated Debentures are the same and are computed on a 360-day basis. The stated interest rate is the three-month London Interbank Offered Rate (LIBOR) plus 3.30% (8.66% at December 31, 2006) with a maximum rate of 12.5% annually, adjustable quarterly.
Interest expense recognized by the Company for the years ended December 31, 2006, 2005 and 2004 related to the subordinated debentures was $733,000, $592,000 and $438,000 respectively. The amount of deferred costs at December 31, 2006 and 2005 was $48,000 and $96,000, respectively. The amortization of the deferred costs was $48,000 for each of the years ended December 31, 2006, 2005 and 2004.
10. COMMITMENTS AND CONTINGENCIES
Leases
The Company leases certain of its branch offices and certain equipment under noncancellable operating leases. These leases expire on various dates through 2014 and have various renewal options ranging from five to fifteen years. Rental payments include minimum rentals, plus adjustments for changing price indexes. Future minimum lease payments and sublease rental income are as follows:
Rental expense included in occupancy and equipment expense totaled $753,000, $524,000 and $458,000 for the years ended December 31, 2006, 2005 and 2004, respectively. Sublease income included in occupancy expense totaled $144,000, $134,000 and $132,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
Financial Instruments With Off-Balance-Sheet Risk
The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business in order to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized on the consolidated balance sheet.
The Company’s exposure to credit loss in the event of nonperformance by the other party for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and standby letters of credit as it does for loans included on the consolidated balance sheet.
The following financial instruments represent off-balance-sheet credit risk:
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Each customer’s creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management’s credit evaluation of the borrower. Collateral held varies, but may include deposit accounts, accounts receivable, inventory, equipment and deeds of trust on residential real estate and income-producing commercial properties.
Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loans to customers. The fair value of the liability related to these standby letters of credit, which represents the fees received for issuing the guarantees, was not significant at December 31, 2006 and 2005. The Company recognizes these fees as revenues over the term of the commitment or when the commitment is used.
Commercial loan commitments and standby letters of credit represent approximately 15% of total commitments and are generally unsecured or secured by collateral other than real estate and have variable interest rates. Agricultural loan commitments represent approximately 6% of total commitments and are generally secured by crop assignments, accounts receivable and farm equipment and have variable interest rates. Real estate loan commitments represent approximately 64% of total commitments and are generally secured by property with a loan-to-value ratio not to exceed 80%. The majority of real estate commitments also have variable interest rates. Personal lines of credit and home equity lines of credit represent the remaining 15% of total commitments and are generally unsecured or secured by residential real estate and have both variable and fixed interest rates.
Concentrations of Credit Risk
The Company grants real estate mortgage, real estate construction, commercial, agricultural and consumer loans to customers throughout Butte, Sutter, Yuba, Tehama, Shasta, Colusa and Placer Counties.
Although the Company has a diversified loan portfolio, a substantial portion of its portfolio is secured by commercial and residential real estate. However, personal and business income represents the primary source of repayment for a majority of these loans.
In addition, the Company’s real estate and construction loans represent approximately 70% of outstanding loans at both December 31, 2006, and 2005. Collateral values associated with this lending concentration can vary significantly based on the general level of interest rates and both local and regional economic conditions. In management’s opinion, although this concentration has no more than the normal risk of collection, a substantial decline in the performance of the economy in general or a decline in real estate values in the Company’s primary market areas, in particular, could have an adverse impact on the collectibility of these loans.
Correspondent Banking Agreements
The Company maintains funds on deposit with other federally insured financial institutions under correspondent banking agreements. Uninsured deposits totaled $1,345,000 at December 31, 2006.
Federal Reserve Requirements
Banks are required to maintain reserves with the Federal Reserve Bank equal to a percentage of their reservable deposits less vault cash. The Bank’s vault cash fulfilled its reserve requirement at December 31, 2006.
Contingencies
The Company is subject to legal proceedings and claims which arise in the ordinary course of business. In the opinion of management, the amount of ultimate liability with respect to such actions will not materially affect the consolidated financial position or consolidated results of operations of the Company.
11. SHAREHOLDERS’ EQUITY
Dividends
The shareholders of the Company will be entitled to receive dividends when and as declared by its Board of Directors, out of funds legally available for the payment of dividends, as provided in the California General Corporation Law. The California general corporation law prohibits the Company from paying dividends on its common stock unless: (i) its retained earnings, immediately prior to the dividend payment, equals or exceeds the amount of the dividend or (ii) immediately after giving effect to the dividend, the sum of the Company’s assets (exclusive of goodwill and deferred charges) would be at least equal to 125% of its liabilities (not including deferred taxes, deferred income and other deferred liabilities) and the current assets of the Company would be at least equal to its current liabilities, or, if the average of its earnings before taxes on income and before interest expense for the two preceding fiscal years was less than the average of its interest expense for the two preceding fiscal years, at least equal to 125% of its current liabilities. In certain circumstances, the Company may be required to obtain the prior approval of the Federal Reserve Board to make capital distributions to shareholders of the Company.
The California Financial Code restricts the total dividend payment of any bank in any calendar year to the lesser of (1) the bank’s retained earnings or (2) the bank’s net income for its last three fiscal years, less distributions made to shareholders during the same three-year period. At December 31, 2006, retained earnings of $15,642,000 were free of such restrictions. In addition the Company’s ability to pay dividends is subject to certain covenants contained in the indentures relating to Trust Preferred Securities issued by the business trust (see Note 9).
Stock Repurchase Plan
The Board of Directors approved a plan to repurchase up to $3,000,000 of the outstanding common stock of the Company in 2003. Stock repurchases were made from time to time on the open market or through privately negotiated transactions. The timing of purchases and the exact number of shares purchased was dependent on market conditions. The share repurchase program did not include specific price targets or timetables and could have been suspended at any time. During 2006, 143,950 shares were repurchased for $2,498,000 at an average price of $17.35 per share. During 2005, no shares of the Company’s common stock were repurchased. During 2004, 38,470 shares of the Company’s common stock were repurchased for $502,000 at an average price of $13.05 per share.
Stock-Based Compensation
Stock option activity for the years ended December 31, 2006, 2005 and 2004 is summarized as follows:
A summary of options outstanding at December 31, 2006 follows:
The weighted average grant date fair value of options granted during the years ended December 31, 2006, 2005 and 2004 was $3.75, $3.25 and $3.35.
The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the quoted price of the Company’s common stock for options that were in-the-money at December 31, 2006. The aggregate intrinsic value of options outstanding for the year ended December 31, 2006 was $6,438,000. The intrinsic value of options vested for the year ended December 31, 2006 was $6,167,000 and for options vested or expected to vest was $7,820,000. The intrinsic value of options exercised during the years ended December 31, 2006, 2005 and 2004 totaled $1,560,000, $1,383,000 and $618,000, respectively. The total fair value of the shares that vested during the years ended December 31, 2006, 2005 and 2004 totaled $175,000, $390,000 and $347,000, respectively.
The compensation cost charged against income for stock options was $175,000 for the year ended December 31, 2006. Income tax benefits recognized for the year ended December 31, 2006 totaled $489,000. Management’s estimate of expected forfeitures for the remaining non-vested options is approximately 2% and is recognizing compensation costs only for those equity awards expected to vest.
At December 31, 2006, the total compensation cost related to non-vested stock option awards granted to employees under the Company’s stock option plans but not yet recognized was $391,000. Stock option compensation expense is recognized on a straight-line basis over the vesting period of the option. This cost is expected to be recognized over a weighted average remaining period of 2.33 years and will be adjusted for subsequent changes in estimated forfeitures.
SFAS 123(R) requires the cash flows resulting from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as a cash flow from financing activities in the consolidated statement of cash flows. These excess tax benefits for the year ending December 31, 2006 totaled $489,000 for the Company.
Earnings Per Share
A reconciliation of the numerators and denominators of the basic and diluted earnings per share computations is as follows:
All stock options outstanding were included in the computation of diluted earnings per share for the years ended December 31, 2006, 2005 and 2004 as none of those stock options were considered anti-dilutive.
Regulatory Capital
The Company and the Bank are subject to certain regulatory capital requirements administered by the Board of Governors of the Federal Reserve System and the Federal Depository Insurance Corporation (FDIC). Failure to meet these minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company’s and the Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average assets as set forth in the following table. Each of these components is defined in the regulations. Management believes that the Company and the Bank meet all their capital adequacy requirements as of December 31, 2006 and 2005.
In addition, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth below. There are no conditions or events since that notification that management believes have changed the Bank’s category.
12. OTHER NON-INTEREST INCOME AND EXPENSES
Other non-interest income consisted of the following:
Other expenses consisted of the following:
13. INCOME TAXES
The provision for income taxes for the years ended December 31, 2006, 2005 and 2004 consisted of the following:
Deferred tax assets (liabilities) are comprised of the following at December 31, 2006 and 2005:
The Company believes that it is more likely than not that it will realize the above deferred tax assets in future periods; therefore, no valuation allowance has been provided against its deferred tax assets.
The provision for income taxes differs from amounts computed by applying the statutory Federal income tax rate to operating income before income taxes. The items comprising these differences are as follows:
14. RELATED PARTY TRANSACTIONS
During the normal course of business, the Company enters into transactions with related parties, including Directors and executive officers. These transactions include borrowings with substantially the same terms, including rates and collateral, as loans to unrelated parties. The following is a summary of the aggregate activity involving related party borrowers during 2006:
The Company engages a related party for certain construction projects related to the Company’s buildings. Total fees paid to this related party for construction activities for the year ended December 31, 2006 and 2005 were $1,488,000 and $395,000.
15. EMPLOYEE BENEFIT PLANS
Salary Continuation and Retirement Plans
Salary continuation plans are in place for twelve key executives. In addition, a retirement plan is in place for members of the Board of Directors. Under these plans, the directors and executives, or designated beneficiaries, will receive monthly payments for five to twenty years after retirement or death. These benefits are substantially equivalent to those available under insurance policies purchased by the Company on the lives of the directors and executives. In addition, the estimated present value of these future benefits is accrued over the period from the effective dates of the plans until their expected retirement dates. The expense recognized under these plans for the years ended December 31, 2006, 2005 and 2004 totaled $1,111,000, $741,000 and $715,000, respectively.
In connection with these plans, the Company purchased single premium life insurance policies with cash surrender values totaling $9,798,000 and $8,447,000 at December 31, 2006 and 2005, respectively. Income earned on these policies, net of expenses, totaled $331,000, $294,000 and $284,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
Savings Plan
The Butte Community Bank 401(k) Savings Plan commenced January 1, 1993 and is available to employees meeting certain service requirements. Under the plan, employees may defer a selected percentage of their annual compensation. The Bank may make a discretionary contribution to the plan which would be allocated as follows:
· A matching contribution to be determined by the Board of Directors each plan year under which the Bank will match a percentage of each participant’s contribution.
· A basic contribution that would be allocated in the same ratio as each participant’s contribution bears to total compensation.
There were no employer contributions for the years ended December 31, 2006, 2005 or 2004.
Employee Stock Ownership Plan
Under the Butte Community Bank Employee Stock Ownership Plan (“ESOP”), employees who have been credited with at least 1,000 hours of service during a twelve month period and who have attained age eighteen are eligible to participate. The ESOP has funded purchases of the Bank’s common stock through a line of credit from another financial institution (see Note 8). The line of credit is repaid from discretionary contributions to the ESOP determined by the Bank’s Board of Directors. Annual contributions are limited on a participant-by-participant basis to the lesser of $30,000 or twenty-five percent of the participant’s compensation for the year. Employee contributions are not permitted.
As a leveraged ESOP, interest expense is recognized on the line of credit in the Company’s consolidated financial statements. Shares are allocated on the basis of eligible compensation, as defined in the ESOP plan document, in the year of allocation. Benefits generally become 100% vested after seven years of credited service. Employees with at least three, but fewer than seven, years of credited service receive a partial vesting according to a sliding schedule. However, in the event of normal retirement, disability, or death, any unvested portion of benefits vests immediately.
As shares are purchased by the ESOP with proceeds from the line of credit, the Company records the cost of these unearned ESOP shares as a contra-equity account. These amounts are shown as a reduction of shareholders’ equity in the Company’s consolidated balance sheet. As the debt is repaid, the shares are released from unallocated ESOP shares in proportion to the debt service paid during the year and allocated to eligible employees. As shares are released from unallocated ESOP shares, the Company reports compensation expense equal to the current market price of the shares, and the shares are recognized as outstanding for earnings per share computations. Benefits are distributed in the form of qualifying Company securities. However, the Company will issue a put option to each participant upon distribution of the securities which, if exercised, requires the Company to purchase the qualifying securities at fair market value.
During 2006 and 2005, the ESOP purchased 20,750 and 23,637 shares of the Company’s common stock at a cost of $354,000 and $348,000, respectively, using the proceeds from the line of credit to the ESOP. Interest expense of $88,000, $50,000 and $33,000 was recognized in connection with the line of credit during the years ended December 31, 2006, 2005 and 2004, respectively.
Compensation expense of $609,000, $251,000 and $180,000 was recognized for the years ended December 31, 2006, 2005 and 2004.
Allocated and unallocated ESOP shares at December 31, 2006, 2005 and 2004, adjusted for stock splits, were as follows:
16. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
Estimated fair values are disclosed for financial instruments for which it is practicable to estimate fair value. These estimates are made at a specific point in time based on relevant market data and information about the financial instruments. These estimates do not reflect any premium or discount that could result from offering the Company’s entire holdings of a particular financial instrument for sale at one time, nor do they attempt to estimate the value of anticipated future business related to the instruments. In addition, the tax ramifications related to the realization of unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of these estimates.
Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the fair values presented.
The following methods and assumptions were used by the Company to estimate the fair value of its financial instruments at December 31, 2006 and 2005:
Cash and cash equivalents: Cash and cash equivalents include cash and due from banks and Federal funds sold and the carrying amount is estimated to be fair value.
Interest-bearing deposits in banks: The fair values of interest-bearing deposits in banks are estimated by discounting their future cash flows using rates at each reporting date for instruments with similar remaining maturities offered by comparable financial institutions.
Investment securities: For investment securities, fair values are based on quoted market prices, where available. If quoted market prices are not available, fair values are estimated using quoted market prices for similar securities and indications of value provided by brokers.
Loans: Fair values of loans held for sale are estimated using quoted market prices for similar loans or the amount that purchasers have committed to purchase the loans. For variable-rate loans that reprice frequently with no significant change in credit risk, fair values are based on carrying values. The fair values for other loans are estimated using discounted cash flow analyses, using interest rates offered at each reporting date for loans with similar terms to borrowers of comparable creditworthiness adjusted for the allowance for loan losses. The carrying amount of accrued interest receivable approximates its fair value.
Other investments: Other investments include non-marketable equity securities. The carrying value of these investments approximates their fair value.
Bank owned life insurance policies: The fair values of life insurance policies are based on cash surrender values at each reporting date provided by the insurers.
Mortgage servicing assets: The fair value of mortgage servicing assets is estimated using projected cash flows, adjusted for the effects of anticipated prepayments, using a market discount rate.
Deposits: The fair values for demand deposits are, by definition, equal to the amount payable on demand at each reporting date represented by their carrying amount. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow analysis using interest rates offered at each reporting date by the Bank for certificates with similar remaining maturities. The carrying amount of accrued interest payable approximates its fair value.
Notes payable: The notes payable reprice based upon an independent index. The carrying amount of the notes payable approximates its fair value.
Junior subordinated debentures: The fair value of the junior subordinated debentures was determined based on the current market for like-kind instruments of a similar maturity and structure.
Commitments to extend credit and standby letters of credit: Commitments to extend credit are primarily for variable rate loans and standby letters of credit. For these commitments, there is no difference between the committed amounts and their fair values. The fair value of the commitments at each reporting date was not significant and not included in the accompanying table.
The estimated fair values of the Company’s financial instruments are as follows:
17. PARENT ONLY CONDENSED FINANCIAL STATEMENTS
CONDENSED BALANCE SHEET
December 31, 2006 and 2005
17. PARENT ONLY CONDENSED FINANCIAL STATEMENTS
CONDENSED STATEMENT OF INCOME
For the Years Ended December 31, 2006, 2005 and 2004
17. PARENT ONLY CONDENSED FINANCIAL STATEMENTS
CONDENSED STATEMENT OF CASH FLOWS
For the Years Ended December 31, 2006, 2005 and 2004