ITEM 1. BUSINESS
Organizational Structure and Description of Services
Pacific Capital Bancorp (“the Company” or “PCB”) is a community bank holding company providing full service banking including all aspects of consumer and commercial lending, trust and investment advisory services and other consumer and business banking products through its subsidiaries’ retail branches, commercial and wealth management centers and other distribution channels to consumers and businesses primarily located in the central coast of California. The Company is one of three primary providers nationwide of refund anticipation loans (“RALs”) and refund transfer services (“RTs”).
PCB has five wholly-owned subsidiaries. Pacific Capital Bank, National Association (“the Bank” or “PCBNA”), a banking subsidiary and four unconsolidated subsidiaries used as business trusts in connection with issuance of trust-preferred securities as described in Note 14, “Long-term Debt and Other Borrowings” on page 122 of this Form 10-K.
PCBNA has four wholly-owned consolidated subsidiaries:
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Morton Capital Management (“MCM”) and R.E. Wacker Associates, Inc. (“REWA”), two registered investment advisors that provide investment advisory services to individuals, foundations, retirement plans and select institutional clients.
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SBBT RAL Funding Corp. which is utilized as part of the financing of the RAL program as described in Note 7, “RAL and RT Programs”.
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PCB Service Corporation, utilized as a trustee of deeds of trust in which PCBNA is the beneficiary.
In late 2007, PCBNA made an investment in Veritas Wealth Advisors, LLC (“Veritas”), a registered investment advisor. Veritas was organized in late 2007 and commenced operations in the second quarter of 2008. PCBNA’s variable interest of 20% in Veritas includes $1.0 million of equity at risk.
PCBNA also retains ownership in several Low-Income Tax Housing Partnerships that are not consolidated into the Company’s Consolidated Financial Statements.
At December 31, 2008, PCBNA conducted its banking services under five brand names at 51 locations:
(1) PCBNA commenced operations in 1960 as Santa Barbara National Bank (“SBNB”). In 1979, SBNB switched from a national charter to a state charter and changed the name to SBB&T. In 2002, PCBNA was created returning the charter to a national bank by consolidating the two subsidiaries of SBB&T and FNB into PCBNA. In 2007, PCBNA locations which were part of the Pacific Crest Capital Incorporated (“PCCI”) acquisition of 2004 were renamed to the SBB&T brand name.
The brand names retained represent the former names of select acquired independent banks merged into PCBNA. In addition to the retail and business deposits managed by the above banking offices, the Company makes use of brokered deposits and deposits received from the State of California, both of which are administered by the Company’s Treasury department.
During 2008, the Bank opened two new retail branches, the Wood Ranch branch located in Simi Valley, and the Casa Dorinda branch located in Santa Barbara, which are both included in the table above as SBB&T. The Bank also sold two retail branches in October 2008, the Santa Paula branch, which was owned by the Bank and the Harvard branch, which was leased by the Bank and are excluded from the table above.
In November 2008, the Bank opened a third commercial and wealth management center in Torrance which is included in the table above as SBB&T. The first two commercial and wealth management centers were opened during 2007 and reside in Glendale and Calabasas which are excluded from the table above since they do not accept deposits. The commercial and wealth management centers are designed like an office and located within office buildings in the Los Angeles area to meet the needs of middle market companies and high net-worth customers. These centers offer specialized products and services and are staffed with experienced personal bankers who are knowledgeable about commercial and trust and advisory products.
Segments
The Company had four reportable operating segments at December 31, 2008. These segments are determined based on product line and the types of customers serviced. These reportable operating segments are Community Banking, Commercial Banking, Wealth Management and RAL and RT Programs. The administrative and treasury operations of the Company are not considered part of operating activities of the Company and are reported within the All Other segment for financial reporting. The financial results for each segment are based on products and services provided within
each operating segment with various Management assumptions to calculate the indirect credits and charges for funds which also includes an allocation of certain expenses from the All Other segment. These Management assumptions are explained in Note 24, “Segments” of the Consolidated Financial Statements beginning on page 142.
The Community Banking, Commercial Banking and Wealth Management segments represent the banking operations for the Company and are referred to as the “Core Bank” by Management. The banking operations of the Core Bank are similar to the operations of other traditional banks. The Community Banking, Commercial Banking and Wealth Management segments are responsible for collecting deposits, making loans, providing trust and investment advisory services and providing customary banking services. The RAL and RT Programs segment is highly seasonal as a majority of the income is earned in the first quarter of each year. The RAL product generates interest income and the RT product generates non-interest income. The Company has experienced significant growth in RAL and RT Programs over the last several years. The financial impact of the RAL and RT Programs will be discussed throughout the Management Discussion and Analysis (“MD&A”) section of this document.
The income generated by these four reportable segments are driven by the lending and trust and investment advisory products offered to customers. The primary expenses are interest expense on deposits and funding costs and personnel. Deposit products are provided to the customers of the Community Banking, Commercial Banking and Wealth Management segments. These deposit products include checking, savings, money market and certificates of deposit (“CDs”). The following segment discussion outlines the products, services and lending policies for each operating segment.
As of January 1, 2009, the Commercial Banking and Wealth Management segments were combined into one operating segment. The combined segment will be called Commercial and Wealth Management segment. Together, the new segment will provide products and services to meet the needs of middle market companies and high net-worth individuals within the existing footprint of the Company and the adjacent markets. The new combined segment currently has three locations which are specifically designed for serving their target customer base. These locations are in Calabasas, Torrance and Glendale, California. The new combined segment will no longer offer SBA loans as these products service small businesses and will be offered through the Community Banking segment.
Community Banking
Business units in this segment provide residential real estate loans, home equity lines and loans, consumer loans, small business loans and lines, and demand deposit overdraft protection products.
Residential real estate loans consist of first and second mortgage loans secured by trust deeds on one to four unit single family homes. The Company has specific underwriting and pricing guidelines based on the credit worthiness of the borrower and the value of the collateral, including credit score, debt-to-income ratio of the borrower and loan-to-value ratio. The Company extends credit up to a maximum of 80% combined loan-to-value of the first trust deed equity value. Maximum borrower debt-to-income ratios range from 40% to 60% and are determined by various factors. Home equity lines of credit are generally secured by a second trust deed on a single one to four unit family home. The interest rate on home equity lines is a variable index rate while term residential mortgage loans can have either variable or fixed interest rates.
Consumer loans and lines of credit are extended with or without collateral to provide financing for purposes such as the acquisition of recreational vehicles, automobiles, or to provide liquidity. The Company has specific underwriting guidelines which consider the borrower’s credit history, debt-to-income ratio and loan-to-value ratio for secured loans. The consumer loans typically have fixed interest rates.
Small business loans and lines of credit offered through the Community Bank are extended without collateral to small businesses based on historical credit performance of the business along with the principal owners of the business. The loans and lines of credit can have either variable or fixed interest rates and are extended to small businesses in amounts less than $100,000.
Demand deposit overdraft protection products are offered to demand deposit customers to provide additional protection against unforeseen deficit balances in a specific account and the potential related fees. The Company offers these products based on factors such as the customers credit score and history with the Company. These products have fixed interest rates.
Commercial Banking
This business segment offers commercial, industrial, corporate, and real estate loan products, including traditional commercial loans and lines of credit, asset based lending, letters of credit, and Small Business Administration (“SBA”) loans. The Commercial Banking segment also offers the Community Banking segment deposit products as well as deposit products that are for middle market companies such as cash management services, merchant services and certain international services for domestic customers.
Loan products are underwritten and customized to meet specific customer needs. The Company considers several factors in order to extend the loan including the borrower’s historical loan re-payment, company management, and current economic conditions, industry specific issues, capital structure, potential collateral and financial projections.
In making commercial real estate secured loan decisions, the Company considers the purpose of the requested loan and nature of the collateral. Maximum loan-to-value ratios for commercial real estate loans are 75%.
Depending on the product, these loans have fixed or variable interest rates.
SBA loans are extended to small businesses for a variety of purposes, including working capital, business acquisitions, acquisition of real estate, growth capital and equipment financing. The Company focuses on 7(a), 504, and Express loan programs. 7(a) loans provide longer term financing, which are guaranteed 75% to 85% by the SBA depending on term and loan size. SBA 504 loans are typically used for the acquisition or construction of large equipment or real property. These are financing packages comprised of a first and second trust deed loan structure where the debt does not exceed 90% combined loan-to-value. Express loans are unsecured lines of credit or term loans of $100,000 or less and are generally guaranteed by the SBA at 50%. Periodically, the Company sells selected SBA loans into the secondary market. The Company retains servicing rights on the sold guaranteed portion of SBA 7(a) loans.
Wealth Management
Business units in this segment offer a wide range of trust, investment, fiduciary and wealth management services and solutions, including planning and advice. These solutions are provided by the Bank’s Trust and Investment Management group, including MCM and REWA.
The Wealth Management group provides high net worth clients a variety of banking solutions and other services. These include Private Capital Advantage deposit solutions, residential mortgages and lines of credit, investment review, analysis and customized portfolio management for separately managed accounts, full service brokerage, trust and fiduciary services, equity and fixed income management and real estate and specialty asset management. Loans are structured to meet the specific needs of high net worth customers but still adhere to the Company’s underwriting guidelines. The Company’s
underwriting guidelines consider tangible net worth, value of assets that make up this net worth, personal cash flow, past history with the Company, and credit history. These loans may be either secured or unsecured, and may have either fixed or variable interest rates, with lines of credit generally having variable interest rates.
RAL and RT Programs
RALs are a seasonal credit product extended to consumers during the first four months of each calendar year. The purpose of the RAL is to provide consumers with liquidity at the time they file for their tax refund. The Company works with third party tax preparers who facilitate the origination of RALs through an application process. RAL underwriting is based on borrower information as well as certain criteria within the tax return. The source of repayment for the RAL is the Internal Revenue Service (“IRS”).
The Company subjects the RAL application to an automated credit review process utilizing specific predetermined criteria. If the application passes this review, the Company advances the amount of the refund due on the taxpayer’s return up to specified amounts based on certain criteria less the loan fee due to the Company and, if requested by the taxpayer, the fees due for preparation of the return. Each taxpayer signs an agreement permitting the IRS to send the taxpayer’s refund directly to the Company. The refund received from the IRS is used by the Company to pay off the RAL. Any amount due the taxpayer above the amount of the RAL is remitted to the taxpayer. The RAL income is recognized into interest income after the loan balance is collected from the IRS. The fee varies based on the amount of the RAL.
Generally, interest income earned on loans is a function of the outstanding balance multiplied by the rate specified in the loan agreement multiplied by the period of time the loan is outstanding. For RALs, the interest income is unrelated to the length of time the loan is outstanding and there is no explicit interest rate. The flat fee charged is recognized as income when the loan is collected from the IRS. No late fees are charged to customers whose loans are not paid within the expected time frame.
While the loan application form is completed by the taxpayer in the tax preparer’s office, the credit criteria are set by the Company and the underwriting decision is made by the Company. The Company reviews and evaluates all tax returns to determine the likelihood of IRS payment. If any attribute of the tax return appears to fall outside of predetermined parameters, the Company will reject the application and not make the loan.
The Company has entered into two separate contracts with Jackson Hewitt related to the RAL and RT Programs. One of the contracts with Jackson Hewitt is with Jackson Hewitt Inc. and the other is with Jackson Hewitt Technology Services, Inc. collectively referred to as “JH” throughout this Form 10-K.
The Company also has an electronic filing of tax return product called a Refund Transfer or RT. The RT product is also designed to provide taxpayers faster access to funds claimed by a taxpayer as a refund on their tax returns. An RT is in the form of a facilitated electronic transfer or check prepared by taxpayer’s tax preparer.
For more information regarding RALs, refer to Note 7, “RAL and RT Programs” of the Consolidated Financial Statements beginning on page 113.
Employees
At December 31, 2008, the Company employed 1,372 employees. The Company’s employees are not represented by a union or covered by a collective bargaining agreement. Management believes that its employee relations are good.
Acquisitions
Recent mergers and acquisitions of the Company are disclosed in Note 2, “Acquisitions and Dispositions” in the Consolidated Financial Statements on page 101. A summary of acquisitions in the last three years is as follows:
In July 2006, PCBNA acquired MCM, a California-based registered investment advisor for an initial cash payment of approximately $7.0 million. MCM is a wholly owned subsidiary of PCBNA which provides wealth management advisory services.
In January 2008, PCBNA acquired REWA, California-based registered investment advisor for an initial cash payment of approximately $7.0 million. REWA is a wholly owned subsidiary of PCBNA which provides personal and financial investment advisory services to individuals, families and fiduciaries.
Market Area
The Company’s branches are located in eight California counties. These counties include Santa Barbara, Ventura, Monterey, Santa Cruz, Southern Santa Clara, San Benito, San Luis Obispo and Los Angeles. The Company uses separate brand names in various counties for community recognition only, all offices are legal branches of PCBNA, and all banking offices are administered under one management structure.
The Company continues to explore opportunities to expand its footprint into strategically selected markets.
The RAL and RT Programs administrative offices are located in San Diego County, California with transactions conducted with taxpayers located throughout the United States.
Foreign Operations
The Company has no foreign operations. The Company does provide loans, letters of credit and other trade-related services to a number of commercial enterprises that conduct business outside the United States.
Customer Concentration
The Company does not have any customer relationships that individually account for 10% or more of consolidated revenues.
Competition
The banking and financial services business is highly competitive. The increasingly competitive environment faced by banks is a result primarily of changes in laws and regulations (refer to pages 67 through 70 of this Form 10-K), changes in technology and product delivery systems, and the continued consolidation among financial services providers. The Company competes for loans, deposits, trust and investment advisory services and customers with other commercial banks, savings and loan associations, securities and brokerage companies, investment advisors, mortgage companies, insurance companies, finance companies, money market funds, credit unions, and other nonbank financial service providers. Many competitors are much larger in total assets and capitalization, have greater access to capital markets, including foreign-ownership, and/or offer a broader range of financial services.
Economic Conditions, Government Policies, Legislation, and Regulatory Initiatives
The Company’s profitability, like most financial institutions, is primarily dependent on interest rate differentials. The difference between the interest rates paid on interest-bearing liabilities, such as
deposits and other borrowings, and the interest rates received on interest-earning assets, such as loans to customers and securities held in the investment portfolio, comprise the major portion of earnings. These rates are highly sensitive to many factors that are beyond our control, such as inflation, recession and unemployment, and the impact which future changes in domestic and foreign economic conditions might have on the Company which cannot be predicted. A more detailed discussion of the Company’s interest rate risk and the mitigation of interest rate risk begin on pages 62 and 75.
The Company’s business is also influenced by the monetary and fiscal policies of the Federal government and the policies of regulatory agencies, particularly the Board of Governors of the Federal Reserve System (“FRB”). The FRB implements national monetary policies (with objectives such as curbing inflation and combating recession) through its open-market operations in U.S. Government securities, by adjusting the required level of reserves for depository institutions subject to its reserve requirements, and by varying the target Federal funds and discount rates applicable to borrowings by depository institutions. The actions of the FRB in these areas influence the growth of bank loans, investments, and deposits and also affect interest earned on interest-earning assets and interest paid on interest-bearing liabilities. The nature and impact of any future changes in monetary and fiscal policies on the Company cannot be predicted.
From time to time, Federal and State legislation is enacted which may have the effect of materially increasing the cost of doing business, limiting or expanding permissible activities, or affecting the competitive balance between banks and other financial service providers. Several proposals for legislation that could substantially intensify the regulation of the financial services industry (including a possible comprehensive overhaul of the financial institutions regulatory system) are expected to be introduced and possibly enacted in the new Congress in response to the current economic downturn and financial industry instability. The Company cannot predict whether or when potential legislation will be enacted, and if enacted, the effect that it, or any implementing regulations and supervisory policies, would have on the Company’s financial condition or results of operations. In addition, the outcome of any investigations initiated by state authorities or litigation raising issues such as whether state laws are preempted by Federal law may result in additional laws and regulations that require changes in the Company’s operations and increased compliance costs.
Dramatic negative developments in the latter half of 2007 in the subprime mortgage market and the securitization markets for such loans, together with volatility in oil prices and other factors, have resulted in uncertainty in the financial markets in general and a related economic downturn, which continued through 2008 and anticipated to continue through 2009. Dramatic declines in the housing market, with decreasing home prices and increasing delinquencies and foreclosures, have negatively impacted the credit performance of mortgage and construction loans and resulted in significant write-downs of assets by many financial institutions. In addition, the values of real estate collateral supporting many commercial and residential loans have declined and may continue to decline. General downward economic trends, reduced availability of commercial credit and increasing unemployment have negatively impacted the credit performance of commercial and consumer credit, resulting in additional write-downs. Concerns over the stability of the financial markets and the economy have resulted in decreased lending by many financial institutions to their customers and to each other. This market turmoil and tightening of credit has led to increased commercial and consumer delinquencies, lack of customer confidence, increased market volatility and widespread reduction in general business activity. Competition among depository institutions for deposits has increased significantly. Bank and bank holding company stock prices have been negatively affected as has the ability of banks and bank holding companies to raise capital or borrow in the debt markets compared to recent years. Bank regulators have been very aggressive in responding to concerns and trends identified in examinations, and this has resulted in the increased issuance of formal and informal enforcement orders and other supervisory actions requiring action to address credit quality, liquidity and risk management and capital adequacy, as well as other safety and soundness concerns.
On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted to restore confidence and stabilize the volatility in the U.S. banking system and to encourage financial institutions to increase their lending to customers and to each other. Initially introduced as the Troubled Asset Relief Program (“TARP”), the EESA authorized the United States Department of the Treasury (“U.S. Treasury”) to purchase from financial institutions and their holding companies up to $700 billion in mortgage loans, mortgage-related securities and certain other financial instruments, including debt and equity securities issued by financial institutions and their holding companies. Initially, $350 billion was made immediately available to the U.S. Treasury. On January 15, 2009, the remaining $350 billion was released to the U.S. Treasury.
On October 14, 2008, the U.S. Treasury announced its intention to inject capital into nine large U.S. financial institutions under the TARP Capital Purchase Program (the “TARP CPP”), and since has injected capital into many other financial institutions, including the Company. The U.S. Treasury initially allocated $250 billion towards the TARP CPP. On November 21, 2008, the Company completed the sale to the U.S. Treasury of $180.6 million of preferred stock and warrants as part of the TARP CPP. Pursuant to the terms of the Securities Purchase Agreement-Standard Terms (“Securities Purchase Agreement”), the Company issued and sold to the U.S. Treasury (i) 180,634 shares of the Company’s Series B Fixed Rate Cumulative Perpetual Preferred Stock, having a liquidation preference of $1,000 per share (the “Series B Preferred Stock”) and (ii) a warrant (the “Warrant”) to purchase up to 1,512,003 shares of the Company’s common stock, no par value. Under the terms of the TARP CPP, the Company is prohibited from increasing dividends on its common stock, and from making certain repurchases of equity securities, including its common stock, without the U.S. Treasury’s consent. Furthermore, as long as the preferred stock issued to the U.S. Treasury is outstanding, dividend payments and repurchases or redemptions relating to certain equity securities, including the Company’s common stock, are prohibited until all accrued and unpaid dividends are paid on such preferred stock, subject to certain limited exceptions. Restrictions related to the payment of dividends on common stock are disclosed in the “Capital Resources” section on page 59 of this Form 10-K.
In order to participate in the TARP CPP, financial institutions were required to adopt certain standards for executive compensation and corporate governance. These standards generally apply to the Chief Executive Officer, Chief Financial Officer and the three next most highly compensated senior executive officers. The standards include (1) ensuring that incentive compensation for named senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution; (2) required clawback of any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate; (3) prohibition on making golden parachute payments to senior executives; and (4) agreement not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive. The Company has complied with these requirements and will continue to comply.
The bank regulatory agencies, U.S. Treasury and the Office of Special Inspector General, also created by the EESA, have issued guidance and requests to the financial institutions that participated in the TARP CPP to document their plans and use of TARP CPP funds and their plans for addressing the executive compensation requirements associated with the TARP CPP. The Company has received and will respond to that request.
On February 10, 2009, the U.S. Treasury and the Federal bank regulatory agencies announced in a Joint Statement a new Financial Stability Plan which would include additional capital support for banks under a Capital Assistance Program, a public-private investment fund to address existing bank loan portfolios and expanded funding for the FRB’s pending Term Asset-Backed Securities Loan Facility to restart lending and the securitization markets.
On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was signed into law by President Obama. The ARRA includes a wide variety of programs intended to stimulate the
economy and provide for extensive infrastructure, energy, health, and education needs. In addition, the ARRA imposes certain new executive compensation and corporate expenditure limits on all current and future TARP recipients, including the Company, until the institution has repaid the U.S. Treasury, which is now permitted under the ARRA without penalty and without the need to raise new capital, subject to the U.S. Treasury’s consultation with the recipient’s appropriate regulatory agency.
The AARA executive compensation standards are more stringent than those currently in effect under the TARP CPP or those previously proposed by the U.S. Treasury. The new standards include (but are not limited to); (i) prohibitions on bonuses, retention awards and other incentive compensation, other than restricted stock grants which do not fully vest during the TARP CPP period up to one-third of an employee’s total annual compensation, (ii) prohibitions on golden parachute payments for departures, (iii) an expanded clawback of bonuses, retention awards, and incentive compensation if payment is based on materially inaccurate statements of earnings, revenues, gains or other criteria, (iv) prohibitions on compensation plans that encourage manipulation of reported earnings, (v) retroactive review of bonuses, retention awards and other compensation previously provided by TARP CPP recipients if found by the U.S. Treasury to be inconsistent with the purposes of TARP CPP or otherwise contrary to public interest, (vi) required establishment of a company-wide policy regarding “excessive or luxury expenditures,” and (vii) inclusion in a participant’s proxy statements for annual shareholder meetings of a nonbinding “Say on Pay” shareholder vote on the compensation of executives.
On February 23, 2009, the U.S. Treasury and the Federal bank regulatory agencies issued a Joint Statement providing further guidance with respect to the Capital Assistance Program announced February 10, 2009, including: (i) that should the “stress test” assessments of the major banks initiated February 25, 2009 indicate that an additional capital buffer is warranted, institutions will have an opportunity to turn first to private sources of capital otherwise; the temporary capital buffer will be made available from the government; (ii) such additional government capital will be in the form of mandatory convertible preferred shares, which would be converted into common equity shares only as needed over time to keep banks in a well-capitalized position and can be retired under improved financial conditions before the conversion becomes mandatory; and (iii) previous capital injections under the TARP CPP will also be eligible to be exchanged for the mandatory convertible preferred shares. The conversion of preferred shares to common equity shares would enable institutions to maintain or enhance the quality of their capital by increasing their tangible common equity capital ratios; however, such conversions would necessarily dilute the interests of existing shareholders.
On February 25, 2009, the first day the Capital Assistance Program was initiated, the U.S. Treasury released the actual terms of the program, stating that the purpose of the Capital Assistance Program is to restore confidence throughout the financial system that the nation’s largest banking institutions have a sufficient capital cushion against larger than expected future losses, should they occur due to a more severe economic environment, and to support lending to creditworthy borrowers. Under the terms of the Capital Assistance Program, eligible U.S. banking institutions with assets in excess of $100 billion on a consolidated basis are required to participate in coordinated supervisory assessments, which are forward-looking “stress test” assessments to evaluate the capital needs of the institution under a more challenging economic environment. Should this assessment indicate the need for the bank to establish an additional capital buffer to withstand more stressful conditions, these institutions may access the Capital Assistance Program immediately as a means to establish any necessary additional buffer or they may delay the Capital Assistance Program funding for six months to raise the capital privately. Eligible U.S. banking institutions with assets below $100 billion may also obtain capital from the Capital Assistance Program. The Capital Assistance Program is an additional program from the TARP CPP and is open to eligible institutions regardless of whether they participated in the TARP CPP. The deadline to apply to participate in the Capital Assistance Program is May 25, 2009. Recipients of capital under the Capital Assistance Program will be subject to the same executive compensation requirements as if they had received TARP CPP.
The EESA also increased FDIC deposit insurance on most accounts from $100,000 to $250,000. In addition, the FDIC has implemented two temporary liquidity programs to (i) provide deposit insurance for the full amount of most non-interest bearing transaction accounts (the “Transaction Account Guarantee”) through the end of 2009 and (ii) guarantee certain unsecured debt of financial institutions and their holding companies through June 2012 under a temporary liquidity guarantee program (the “Debt Guarantee Program” and together the “TLGP”). Financial institutions had until December 5, 2008 to opt out of these two programs. The Company and the Bank have elected to participate in these programs, but has not yet issued any debt under the Debt Guarantee Program.
Regulation and Supervision
The Company and its subsidiaries are extensively regulated and supervised under both Federal and certain State laws. A summary description of the laws and regulations which relate to the Company’s operations are discussed on pages 67 through 75.
Available Information
The Company maintains an Internet website at http://www.pcbancorp.com. The Company makes available its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, and other information related to the Company free of charge, through this site as soon as reasonably practicable after it electronically files those documents with, or otherwise furnishes them to, the SEC. The Company’s internet website and the information contained therein or connected thereto are not intended to be incorporated into this annual report on Form 10-K.
ITEM 1A.
ITEM 1A. RISK FACTORS
RISK MANAGEMENT
Investing in our common stock involves various risks which are specific to the Company, our industry and our market area. Several risk factors regarding investing in our common stock are discussed below. This listing should not be considered as all-inclusive. If any of the following risks were to occur, we may not be able to conduct the Company’s business as currently planned and the financial condition or operating results could be negatively impacted. The Company’s Chief Audit Executive and Chief Credit Officer in conjunction with other members of the Company’s Management under the direction and oversight of the Board of Directors lead the Company’s risk management process. 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.
Difficult Economic Conditions
The Company’s success depends, to a certain extent, upon economic and political conditions, local and national, as well as governmental monetary policies. Conditions such as inflation, recession, unemployment, changes in interest rates, money supply and other factors beyond the Company’s control may adversely affect the Company’s asset quality, deposit levels and loan demand and, therefore, earnings.
Dramatic declines in the housing market beginning in the latter half of 2007, with falling home prices and increasing foreclosures, unemployment and underemployment, have negatively impacted the credit performance of mortgage loans and resulted in significant write-downs of asset values by financial institutions. The resulting write-downs to assets of financial institutions have caused many
financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to seek government assistance or bankruptcy protection. Bank failures and liquidation or sales by the FDIC as receiver have also increased.
The capital and credit markets, including the fixed income markets, have been experiencing volatility and disruption for more than fifteen months. In some cases, the markets have produced downward pressure on stock prices and credit capacity for certain issuers without regard to those issuers’ financial strength.
Many lenders and institutional investors have reduced and, in some cases, ceased to provide funding to borrowers, including to other financial institutions because of concern about the stability of the financial markets and the strength of counterparties. It is difficult to predict how long these economic conditions will exist, which of the Company’s markets, products or other businesses will ultimately be most affected, and whether Management’s actions will effectively mitigate these external factors. Accordingly, the decrease in funding sources and lack of available credit, lack of confidence in the financial sector, decreased consumer confidence, increased volatility in the financial markets and reduced business activity could materially and adversely affect the Company’s business, financial condition and results of operations.
As a result of the challenges presented by economic conditions, the Company may face the following risks in connection with these events:
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Inability of the Company’s borrowers to make timely repayments of their loans, or decreases in value of real estate collateral securing the payment of such loans resulting in significant credit losses, which could result in increased delinquencies, foreclosures and customer bankruptcies, any of which could have a material adverse effect on the Company’s operating results.
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Increased regulation of the Company’s industry, including heightened legal standards and regulatory requirements or expectations imposed in connection with EESA and ARRA. Compliance with such regulation will likely increase the Company’s costs and may limit the Company’s ability to pursue business opportunities.
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Further disruptions in the capital markets or other events, including actions by rating agencies and deteriorating investor expectations, may result in an inability to borrow on favorable terms or at all from other financial institutions.
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Increased competition among financial services companies due to the recent consolidation of certain competing financial institutions and the conversion of certain investment banks to bank holding companies, which may adversely affect the Company’s ability to market its products and services.
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Further increases in FDIC insurance premiums due to the market developments which have significantly depleted the Deposit Insurance Fund of the FDIC and reduced the ratio of reserves to insured deposits.
In view of the concentration of the Bank’s operations and the collateral securing the loan portfolio in California, as well as the concentration in commercial real estate loans, we may be particularly susceptible to the adverse economic conditions in the state of California and in the eight counties mentioned above where the Company’s business is concentrated.
Enactment of EESA and ARRA
EESA, which established TARP, was signed into law on October 3, 2008. As part of TARP, the U.S. Treasury established the TARP CPP to provide up to $700 billion of funding to eligible financial
institutions through the purchase of capital stock and other financial instruments for the purpose of stabilizing and providing liquidity to the U.S. financial markets. Then, on February 17, 2009, the ARRA was signed into law as a sweeping economic recovery package intended to stimulate the economy and provide for broad infrastructure, energy, health, and education needs. There can be no assurance as to the actual impact that EESA or its programs, including the TARP CPP, and ARRA or its programs, will have on the national economy or financial markets. The failure of these significant legislative measures to help stabilize the financial markets and a continuation or worsening of current financial market conditions could materially and adversely affect the Company’s business, financial condition, results of operations, access to credit or the trading price of its common shares.
There have been numerous actions undertaken in connection with or following EESA and ARRA by the FRB, Congress, U.S. Treasury, the SEC and the Federal bank regulatory agencies in efforts to address the current liquidity and credit crisis in the financial industry that followed the sub-prime mortgage market meltdown which began in late 2007. These measures include homeowner relief that encourages loan restructuring and modification; the temporary increase in FDIC deposit insurance from $100,000 to $250,000, the establishment of significant liquidity and credit facilities for financial institutions and investment banks; the lowering of the Federal funds rate; emergency action against short selling practices; a temporary guaranty program for money market funds; the establishment of a commercial paper funding facility to provide back-stop liquidity to commercial paper issuers; and coordinated international efforts to address illiquidity and other weaknesses in the banking sector. The purpose of these legislative and regulatory actions is to help stabilize the U.S. banking system. EESA, ARRA and the other regulatory initiatives described above may not have their desired effects. If the volatility in the markets continues and economic conditions fail to improve or worsen, the Company’s business, financial condition and results of operations could be materially and adversely affected.
Changes in Legislation and Regulation of Financial Institutions
The financial services industry is extensively regulated. PCBNA is subject to extensive regulation, supervision and examination by the OCC and the FDIC. As a holding company, the Company is subject to regulation and oversight by the FRB. The Company is now also subject to supervision, regulation and investigation by the U.S. Treasury and SIGTARP under EESA by virtue of its participation in the TARP CPP. Federal and State regulation is designed primarily to protect the deposit insurance funds and consumers, and not to benefit the Company’s shareholders. Such regulations can at times impose significant limitations on the Company’s operations. Regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the imposition of restrictions on the operation of an institution, the classification of assets by the institution and assessment of the adequacy of an institution’s allowance for loan losses. Proposals to change the laws governing financial institutions are frequently raised in Congress and before bank regulatory authorities. Changes in applicable laws or policies could materially affect the Company’s business, and the likelihood of any major changes in the future and their effects are impossible to determine. Moreover, it is impossible to predict the ultimate form any proposed legislation might take or how it might affect the Company.
Strength and Stability of Other Financial Institutions
The actions and commercial soundness of other financial institutions could affect the Company’s ability to engage in routine funding transactions. Financial services to institutions are interrelated as a result of trading, clearing, counterparty or other relationships. The Company has exposure to different industries and counterparties, and executes transactions with various counterparties in the financial industry, including brokers and dealers, commercial banks, investment banks, mutual and hedge funds, and other institutional clients. Recent defaults by financial services institutions, and even rumors or questions about one or more financial services institutions or the financial services industry in general, have led to market-wide liquidity problems and could lead to losses or defaults by the
Company or by other institutions. Many of these transactions expose the Company to credit risk in the event of default of its counterparty or client. In addition, the Company’s credit risk may increase when the collateral held by it cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the loan or derivative exposure due to the Company. Any such losses could materially and adversely affect the Company’s results of operations.
Unprecedented Market Volatility
The capital and credit markets have been experiencing volatility and disruption for more than a year. In recent months, the volatility and disruption has reached unprecedented levels. In some cases, the markets have produced downward pressure on stock prices and credit availability for certain issuers seemingly without regard to those issuers’ underlying financial strength. If current levels of market disruption and volatility continue or worsen, there can be no assurance that the Company will not experience an adverse effect, which may be material, on the Company’s ability to access capital and on the business, financial condition and results of operations.
The market price for our common shares has been volatile in the past, and several factors could cause the price to fluctuate substantially in the future, including:
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announcements of developments related to our business;
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fluctuations in our results of operations;
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sales of substantial amounts of our securities into the marketplace;
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general conditions in our markets or the worldwide economy;
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a shortfall in revenues or earnings compared to securities analysts’ expectations;
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changes in analysts’ recommendations or projections and
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disclosure of adverse regulatory developments.
Estimating the Allowance for Loan Losses
The allowance for loan losses may not be adequate to cover actual losses. A significant source of risk arises from the possibility that the Company could sustain losses because borrowers, guarantors, and related parties may fail to perform in accordance with the terms of their loans. The underwriting and credit monitoring policies and procedures that the Company has adopted to address this risk may not prevent unexpected losses. These losses could have a material adverse effect on the Company’s business, financial condition, results of operations and cash flows. Management maintains an allowance for loan and lease losses to provide for loan defaults and non-performance. The allowance is also appropriately increased for new loan growth. Management believes that the allowance for loan losses is adequate to cover current losses. Management cannot guarantee that the allowance for loan losses will not increase further or that regulators will not require the Company to increase this allowance.
Risks Associated with the RAL and RT Programs
Risks associated with the RAL and RT Programs include credit, the availability of sufficient funding at reasonable rates, risks associated with the IRS, litigation, and regulatory or legislative risk.
The Company has traditionally utilized a securitization facility to fund its RAL and RT Programs. For additional discussion on the securitization facility for the RAL Program refer to page 36 of the MD&A and Note 7, “RAL and RT Programs” of the Consolidated Financial Statements. For the 2009 RAL season, however, the Company was not able to secure a securitization facility as a result of the current economic conditions and the crisis in the U.S. credit markets. In place of a securitization facility, the
Company purchased $1.28 billion of brokered CDs and entered into a syndicated funding line of approximately $524 million which may be drawn upon as needed throughout the 2009 RAL season. There can be no assurance that the Company will have access to a securitization facility or similar alternative sources of funding in future periods. In addition, while the Company expects that the transaction volumes, product mix and loss rates for the 2009 RAL season will be similar to 2008, the profitability of the RAL and RT Programs in 2009 is expected to be lower than in prior years due to an increase in funding costs and reduced recoveries of prior year charged-off RALs.
There is increased legislative and regulatory focus on RALs, including proposed state and Federal legislation to limit interest rates or fees, to curtail sharing of taxpayer information, to impose additional costs and rules on the RAL business and to otherwise limit or prohibit RALs. State attorneys general have also initiated public inquiries in response to consumer advocate complaints into the RAL product and the practices of the tax preparers offering RALs. We cannot determine whether such legislative or regulatory initiatives will be adopted or predict the impact such initiatives would have on the Company’s results.
Liquidity Risk
Liquidity is essential to the Company’s business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a material adverse effect on the Company’s liquidity. The Company’s access to funding sources in amounts adequate to finance our activities could be impaired by factors that affect us specifically or the financial services industry in general. Factors that could detrimentally impact the Company’s access to liquidity sources include a decrease in the level of the Company’s business activity due to a market downturn or adverse regulatory action against us. The Bank’s ability to acquire deposits or borrow could also be impaired by factors that are not specific to the Company, such as a severe disruption of the financial markets or negative views and expectations about the prospects for the financial services industry as a whole as the recent turmoil faced by financial institutions in the domestic and worldwide credit markets deteriorates.
Interest Rate Risk
The banking industry is subject to interest rate risk and variations in interest rates may negatively affect the Company’s financial performance. A substantial portion of the Bank’s income is derived from the differential or “spread” between the interest earned on loans, securities and other interest-earning assets, and interest paid on deposits, borrowings and other interest-bearing liabilities. Because of the inherent differences in the maturities and repricing characteristics of the Bank’s interest-earning assets and interest-bearing liabilities, changes in interest rates do not produce equivalent changes in interest income earned on interest-earning assets and interest paid on interest-bearing liabilities. Fluctuations in interest rates could adversely affect the Bank’s interest rate spread and, in turn, the Company’s profitability. In addition, loan origination volumes are affected by market interest rates. Rising interest rates, generally, are associated with a lower volume of loan originations while lower interest rates are usually associated with higher loan originations. Conversely, in rising interest rate environments, loan repayment rates may decline and in falling interest rate environments, loan repayment rates may increase. In addition, in a rising interest rate environment, we may need to accelerate the pace of rate increases on the Bank’s deposit accounts as compared to the pace of future increases in short-term market rates. Accordingly, changes in levels of market interest rates could materially and adversely affect the Bank’s net interest spread, asset quality and loan origination volume.
Concentration of Commercial Real Estate Loans and Commercial Business Loans
At December 31, 2008, $2.0 billion or 35.2%, of our loan portfolio consisted of commercial real estate loans, including loans for the acquisition and development of property. Commercial real estate loans
constitute a greater percentage of our loan portfolio than any other loan category, including residential real estate loans secured by one to four family units,(“one to four family”) which totaled $1.1 billion or 19.1%, of our total loan portfolio at December 31, 2008. In addition, at December 31, 2008, $1.2 billion or 20.1%, of our loan portfolio consisted of commercial loans. Commercial real estate loans and commercial loans generally expose a lender to greater risk of non-payment and loss than one to four family loans because repayment of the loans often depends on the successful operation of the property and/or the income stream of the borrower. Commercial loans expose us to additional risks since they are generally secured by business assets that may depreciate over time. Such loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to one to four family loans. Also, many of our commercial borrowers have more than one loan outstanding with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss compared to an adverse development with respect to a one to four family loan. Changes in economic conditions that are out of the control of the borrower and lender could impact the value of the security for the loan, the future cash flow of the affected property or borrower, or the marketability of a construction project with respect to loans originated for the acquisition and development of property. Additionally, any decline in real estate values may be more pronounced with respect to commercial real estate properties than residential real estate properties. While we intend to reduce the concentration of such loans in the Bank’s loan portfolio, there can be no assurance that Management will be successful in doing so.
Competition from Financial Service Companies
The Company faces increased strong competition from financial services companies and other companies that offer banking services. The Company conducts most of its operations in California. Increased competition in its markets may result in reduced loans and deposits. Ultimately, the Company may not be able to compete successfully against current and future competitors as many competitors offer some of the banking services that the Bank offers in service areas. These competitors include national banks, regional banks and other community banks. The Company also faces competition from many other types of financial institutions, including savings institutions, industrial banks, finance companies, brokerage firms, insurance companies, credit unions, mortgage banks and other financial intermediaries. In particular, the Bank’s competitors include major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous locations and mount extensive promotional and advertising campaigns. Areas of competition include interest rates for loans and deposits, efforts to obtain loan and deposit customers and a range in quality of products and services provided, including new technology-driven products and services. If the Bank is unable to attract and retain banking customers, it may be unable to continue loan growth and level of deposits.
Operational Risk
Operational risk represents the risk of loss resulting from the Company’s operations, including but not limited to, the risk of fraud by employees or persons outside the Company, the execution of unauthorized transactions, transaction processing errors by employees, and breaches of internal control system and compliance requirements. This risk of loss also includes the potential legal actions that could arise as a result of an operational deficiency or as a result of noncompliance with applicable regulatory standards, adverse business decisions or their implementation and customer attrition due to negative publicity.
Operational risk is inherent in all business activities and the management of this risk is important to the achievement of the Company’s objectives. In the event of a breakdown in the internal control system, improper operation of systems or improper employee actions, the Company could suffer financial loss, face regulatory action and suffer damage to its reputation. The Company manages operational risk through a risk management framework and its internal control processes. The Company believes that it
has designed effective methods to minimize operational risks. Business disruption could occur in the event of a disaster and there is no absolute assurance that operational losses would not occur.
Reputation Risk
Reputation risk, or the risk to the Company’s earnings and capital from negative publicity or public opinion, is inherent in Company’s business. Negative publicity or public opinion could adversely affect the Bank’s ability to keep and attract customers and expose us to adverse legal and regulatory consequences. Negative public opinion could result from our actual or perceived conduct in any number of activities, including lending practices, corporate governance, regulatory compliance, mergers and acquisitions, and disclosure, sharing or inadequate protection of customer information, and from actions taken by government regulators and community organizations in response to that conduct.
Goodwill Impairment
At a minimum, Management is required to assess goodwill and other intangible assets annually for impairment. Goodwill is recognized when a Company acquires a business and the purchased assets and liabilities are recorded at fair value. The fair value of most financial assets and liabilities are determined by estimating the discounted anticipated cash flows from or for the instrument using current market rates applicable to each asset and liability. Excess of consideration paid to acquire a business over the fair value of the net assets is recorded as goodwill. The calculation of goodwill and the determination of impairment is an estimate subject to ongoing review based on certain factors such as declines in stock price, adverse economic conditions in the U.S. and international financial markets, unprecedented lack of liquidity, uncertainty regarding future economic policy and banking regulation changes and negative market sentiment towards the banking industry in general, and additional impairment may be assessed in the future periods. If an impairment of goodwill is assessed, this could have a material affect on the Company’s results of operations and capital levels.
Dividends from the Bank
The availability of dividends from PCBNA is limited by various statutes and regulations. It is possible, depending upon the financial condition of PCBNA and other factors, that the OCC could assert that payment of dividends or other payments is an unsafe or unsound practice. In addition, the payment of dividends by other subsidiaries is also subject to the laws of the subsidiary’s state of incorporation, and the Company’s right to participate in a distribution of assets upon a subsidiary’s liquidation or reorganization is subject to the prior claims of the subsidiary’s creditors. In the event that PCBNA was unable to pay dividends to the Company, we in turn would likely have to reduce or stop paying dividends on the Company’s common shares. The Company’s failure to pay dividends on the Company’s common shares could have a material adverse effect on the market price of the Company’s common shares. Additional information regarding dividend restrictions is included in the section captioned Regulation and Supervision on page 67.
Restrictions Resulting from Participation in the TARP CPP
Pursuant to the terms of the Securities Purchase Agreement, the Company’s ability to declare or pay dividends on any of the Company’s shares is limited. Specifically, the Company may be unable to declare dividend payments on common shares, junior preferred shares or pari passu preferred shares if the Company is in arrears on the payment of dividends on the Series B Preferred Stock. Further, the Company is not permitted to increase dividends on our common shares above the amount of the last quarterly cash dividend per share declared prior to October 14, 2008 ($0.22 per share) without the U.S. Treasury’s approval until November 21, 2011, unless all of the Series B Preferred Stock has been redeemed or transferred by the U.S. Treasury to unaffiliated third parties. In addition, the Company’s
ability to repurchase its shares is restricted. The consent of the U.S. Treasury generally is required for the Company to make any stock repurchase (other than in connection with the administration of any employee benefit plan in the ordinary course of business and consistent with past practice) until November 21, 2011, unless all of the Series B Preferred Stock has been redeemed or transferred by the U.S. Treasury to unaffiliated third parties. Further, common shares, junior preferred shares or pari passu preferred shares may not be repurchased if the Company is in arrears on the payment of Series B Preferred Stock dividends. The terms of the Securities Purchase Agreement allow the U.S. Treasury to impose additional restrictions, including those on dividends and including unilateral amendments required to comply with changes in applicable Federal law.
In addition, pursuant to the terms of the Securities Purchase Agreement, the Company adopted the U.S. Treasury’s current standards for executive compensation and corporate governance for the period during which the U.S. Treasury holds the equity securities issued pursuant to the Securities Purchase Agreement, including the common shares which may be issued upon exercise of the Warrant. These standards generally apply to the Company’s Chief Executive Officer, Chief Financial Officer and the three next most highly compensated senior executive officers. The standards include (i) ensuring that incentive compensation plans and arrangements for senior executive officers do not encourage unnecessary and excessive risks that threaten the Company’s value; (ii) required clawback of any bonus or incentive compensation paid (or under a legally binding obligation to be paid) to a senior executive officer based on materially inaccurate financial statements or other materially inaccurate performance metric criteria; (iii) prohibition on making “golden parachute payments” to senior executive officers; and (iv) agreement not to claim a deduction, for Federal income tax purposes, for compensation paid to any of the senior executive officers in excess of $500,000 per year. In particular, the change to the deductibility limit on executive compensation will likely increase the overall cost of the Company’s compensation programs in future periods.
The adoption of the ARRA on February 17, 2009 imposed certain new executive compensation and corporate expenditure limits on all current and future TARP recipients, including the Company, until the institution has repaid the U.S. Treasury, which is now permitted under the ARRA without penalty and without the need to raise new capital, subject to the U.S. Treasury’s consultation with the recipient’s appropriate regulatory agency. The executive compensation standards are more stringent than those currently in effect under the TARP CPP or those previously proposed by the U.S. Treasury. The new standards include (but are not limited to) (i) prohibitions on bonuses, retention awards and other incentive compensation, other than restricted stock grants which do not fully vest during the TARP period up to one-third of an employee’s total annual compensation, (ii) prohibitions on golden parachute payments for departure from a company, (iii) an expanded clawback of bonuses, retention awards, and incentive compensation if payment is based on materially inaccurate statements of earnings, revenues, gains or other criteria, (iv) prohibitions on compensation plans that encourage manipulation of reported earnings, (v) retroactive review of bonuses, retention awards and other compensation previously provided by TARP recipients if found by the Treasury to be inconsistent with the purposes of TARP or otherwise contrary to public interest, (vi) required establishment of a company-wide policy regarding “excessive or luxury expenditures,” and (vii) inclusion in a participant’s proxy statements for annual shareholder meetings of a nonbinding “Say on Pay” shareholder vote on the compensation of executives.
Future Sales of Securities
Under certain circumstances, the Company’s Board of Directors has the authority, without any vote of the Company’s shareholders, to issue shares of the Company’s authorized but unissued securities, including common shares authorized and unissued under the Company’s stock option plans or additional shares of preferred stock. In the future, we may issue additional securities, through public or private offerings, in order to raise additional capital. It is also possible that the Company’s regulators
will require the Company to raise additional capital. Any such issuance would dilute the percentage of ownership interest of existing shareholders and may dilute the per share value of the common shares or any other then-outstanding class or series of the Company’s securities.
Anti-Takeover Provisions
Various provisions of the Company’s articles of incorporation and bylaws and certain other actions the Company has taken could delay or prevent a third-party from acquiring the Company even if doing so might be beneficial to the Company’s shareholders. These include, among other things, a shareholder rights plan and the authorization to issue “blank check” preferred stock by action of the Company’s Board of Directors acting alone, thus without obtaining shareholder approval. The Bank Holding Company Act of 1956, as amended, and the Change in Bank Control Act of 1978, as amended, together with Federal regulations, require that, depending on the particular circumstances, either regulatory approval must be obtained or notice must be furnished to the appropriate regulatory agencies and not disapproved prior to any person or entity acquiring “control” of a national bank, such as PCBNA. These provisions may prevent a merger or acquisition that would be attractive to shareholders and could limit the price investors would be willing to pay in the future for the Company’s common stock.
Dependence on Personnel
Competition for qualified employees and personnel in the banking industry is intense and there are a limited number of qualified persons with knowledge of, and experience in, the California banking industry. The process of recruiting personnel with the combination of skills and attributes required to carry out the Company’s strategies is often lengthy. In addition, EESA, TARP CPP and the ARRA has imposed significant limitations on executive compensation for recipients of TARP funds, such as PCB, which may make it more difficult for the Company to retain and recruit key personnel. The Company’s success depends to a significant degree upon the Company’s ability to attract and retain qualified management, loan origination, finance, administrative, marketing and technical personnel and upon the continued contributions of the Company’s management and personnel. In particular, the Company’s success has been and continues to be highly dependent upon the abilities of key executives, including the Company’s President, and certain other employees.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
The Company’s executive offices are located at 1021 Anacapa Street, Santa Barbara, California. In addition, the Company occupies five administrative premises for support department operations in Santa Barbara, Ventura, Monterey and Los Angeles counties. These offices include human resources, information technology, loan and deposit operations, finance and accounting, and other support functions. In addition, the Company has several locations that are leased and owned for storage and parking, that are not included in the number of leased or owned properties below.
Of the Company’s 51 branches, 38 are leased and 13 are owned. In addition, the Company owns the master lease on a retail shopping center where one of its retail branches offices is located. This lease is classified as a capital lease in the Company’s Consolidated Financial Statements.
The Company also occupies 17 loan production offices that include administrative support. Of the 17 locations, 15 are leased and two are owned. The California offices are located in Santa Barbara,
Monterey, San Benito, South Santa Clara, San Diego, San Luis Obispo, Orange, Sacramento and Los Angeles Counties. These production offices originate various loan products including SBA, RALs, commercial real estate, residential real estate, commercial, consumer and private banking.
The Company continually evaluates the suitability and adequacy of the Company’s offices and has a program of relocating or remodeling them as necessary to maintain efficient and attractive facilities. Management believes that its existing facilities are adequate for its present purposes.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company has been named in lawsuits filed by customers and others. These lawsuits are described in Note 18, “Commitments and Contingencies” in the Consolidated Financial Statements beginning on page 131. The Company does not expect that these suits will have any material impact on its financial condition or operating results.
The Company is involved in various other litigation of a routine nature that is being handled and defended in the ordinary course of the Company’s business. In the opinion of Management, based in part on consultation with legal counsel, the resolution of these litigation matters will not have a material impact on the Company’s financial condition or operating results.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
The Company’s common stock trades on The NASDAQ Global Select Market under the symbol “PCBC”. The following table presents the high and low sales prices of the Company’s common stock for each quarterly period for the last two years as reported by The NASDAQ Global Select Market:
Dividends
The Company declares cash dividends to its shareholders each quarter. The Company’s dividend policy is disclosed in the Capital Resources section on page 59 of this Form 10-K. The following table presents cash dividends declared per share for the last two years:
The Company funds the dividends paid to shareholders primarily from dividends received from PCBNA. For discussion on restrictions on the declaration and payment of dividends refer to the Capital Resources Section of the MD&A and Regulation and Supervision discussion of “Dividends and Other Transfer of Funds”.
Holders
There were approximately 18,488 shareholders of record at December 31, 2008. This number includes an estimate of the number of shareholders whose shares are held in the name of brokerage firms or other financial institutions. The Company is not provided with the exact number or identities of these shareholders, but has estimated the number of such shareholders from the number of shareholder documents requested by these firms for distribution to their customers.
Based on filings with the SEC by institutional investors, approximately 53.9% of the Company’s shares are owned by these institutions. These institutions may be investing for their own accounts or acting as investment managers for other investors.
Share Repurchase
In August 2007, the Company’s Board of Directors approved a share repurchase program. The share repurchase program authorized the repurchase of $25.0 million of the Company’s common stock and was fully executed by the end of December 2007. This repurchase program replaced the previous share repurchase plan approved in August 2003. At December 31, 2008, there were no shares remaining to be repurchased.
Stock Performance
The following graph shows a five year comparison of cumulative total returns for the Company’s common stock, the Standard & Poor’s 500 stock Index and the NASDAQ Bank Index, each of which assumes an initial value of $100 and reinvestment of dividends.
Securities Authorized for Issuance Under Equity Compensation Plans
The following table provides information at December 31, 2008 with respect to shares of Company common stock that may be issued under our existing equity compensation plans, including the 2008 Equity Incentive Plan, 2002 Stock Plan and the 2005 Directors’ Stock Plan.
(a) Included in column (a) are unexercised stock options granted to directors and employees through current and expired option plans. This amount includes unvested restricted stock granted.
(b) This is the weighted-average exercise price of all stock options and restricted stock that is outstanding.
(c) Securities remaining available for future issuance are for the 2008 Equity Incentive Plan and the 2002 Stock Plan.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table compares selected financial data for 2008 with the same data for the four prior years. The Company’s Consolidated Financial Statements and the accompanying notes presented in Item 8 and Management’s Discussion and Analysis in Item 7
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FINANCIAL OVERVIEW AND HIGHLIGHTS
Pacific Capital Bancorp is a community bank holding company which provides full service banking, trust and investment advisory services and lending through its wholly-owned subsidiaries.
The following discussion should be read in conjunction with the Company’s financial statements and the related notes provided under “Item 8 - Consolidated Financial Statements and Supplementary Data.”
FINANCIAL RESULTS HIGHLIGHTS OF 2008
Net loss for the Company was $22.8 million or $23.8 million of net loss available to common shareholders, or $0.52 per diluted share for 2008 compared to net income of $100.9 million or $2.14 per diluted share for 2007. Net income decreased $123.6 million for fiscal year 2008 compared to 2007.
The significant factors impacting earnings of the Company during 2008 were:
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Provision for loan losses of $218.3 million due to the downturn in the economy, which served to i) increase allowance to total loans from 83 basis points to 244 basis points during the year, and ii) cover approximately $121 million in loan net charge-offs or write downs during the year.
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A 400 basis point decrease in the Federal Open Market Committee of the Federal Reserve System (“FOMC”)’s Federal funds interest rate decreasing from 4.25% at December 31, 2007 to 0.25% at December 31, 2008, which resulted in a decline in the net interest margin from 5.24% at December 31, 2007 to 4.81% at December 31, 2008.
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Increased volumes in the RAL and RT Programs products which increased profitability in this segment from $47.1 million of income before tax for the year ended December 31, 2007 to $118.0 million before tax for the year ended December 31, 2008.
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A goodwill impairment charge of $22.1 million was recognized in the third quarter of 2008.
The impact to the Company from these items, and others of both a positive and negative nature, will be discussed in more detail as they pertain to the Company’s overall comparative performance for the year ended December 31, 2008 throughout the analysis sections of this report.
FINANCIAL RESULTS HIGHLIGHTS OF 2007
The significant factors impacting earnings of the Company during 2007 were:
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During 2007 the Company implemented strategic balance sheet initiatives which included the sale of its $254.0 million leasing loan portfolio, $221.8 million of its indirect auto loan portfolio and a conversion of $284.5 million of residential real estate loans to securities. Despite these transactions, interest income from loans increased $23.9 million, or 4.7% for 2007 compared to 2006. This increase was primarily due to strong loan growth.
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Increased cost of funds which resulted in a $31.6 million increase in interest expense for 2007 compared to 2006.
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A $55.3 million increase in net loan losses related to the RAL program for 2007 compared to 2006 due to increased tax fraud.
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A 100 basis point decrease in the FOMC’s target Federal funds rate from 5.25% to 4.25%, the combination of a flattening, and even inverted, yield curve and intense competition for both loans and deposits continued to compress interest margins, which resulted in a decline in net interest margin to 5.24% from 5.76%.
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Company wide efforts to control expenses while striving to improve service levels to customers, which resulted in improvement in the Company’s efficiency ratio to 49.91% for 2007 from 58.13% for the year ended December 31, 2006.
FINANCIAL RESULTS HIGHLIGHTS OF 2006
The significant factors impacting earnings of the Company during 2006 were as follows:
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$8.8 million recognized loss recorded on securities that were sold as part of the Company’s balance sheet management strategy in the first quarter of 2007.
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$9.3 million asset write-down related to obsolete software.
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$1.8 million gain on sale of the Company’s San Diego branch.
Net interest income from the RAL Program increased to $109.8 million from $61.7 million in 2005. In addition to higher transaction volume, this increase was due to the changes in the contract with JH. The offset to this increase in revenue is the non-interest expense increase of $54.7 million for the marketing and technology fee paid to JH in 2006.
RESULTS OF OPERATIONS
INTEREST INCOME
The Company’s primary source of income is interest income. The following tables present a summary of interest income and the increases and decreases within the interest income line items for the three years ended December 31, 2008, 2007 and 2006:
Interest income for the year ended December 31, 2008 was $519.3 million, a decrease of $64.3 million or 11.0% when comparing interest income for 2008 to 2007. This decrease was mostly attributable to the FOMC reducing the Federal funds rate by 400 basis points since December 31, 2007 which impacted the entire loan portfolio, except RALs. The increase in nonaccrual loans also contributed to the decrease of interest income for loans. Commercial and consumer loans accounted for $36.9 million of the decrease in interest income due to the large number of those loans having adjustable interest rates. In addition, in 2007, the Company sold the indirect auto and leasing loan portfolios and discontinued the Holiday Loan product, which contributed $22.9 million of interest income in 2007 and $49.7 million of interest income in 2006.
Interest income by operating segment for the year ended 2008 compared to 2007, decreased for all operating segments. The largest decrease in interest income was in the Community Banking segment with a decrease of $43.9 million. This decrease was primarily caused by the sale of the indirect auto and leasing loan portfolios in 2007 and the discontinuation of the Holiday Loan product in 2007.
Interest income for the year ended December 31, 2007 was $583.6 million, an increase of $19.1 million or 3.4% when comparing interest income for 2007 and 2006. This increase was mostly attributable to the growth in commercial and residential real estate loans offset by a reduction in Collateralized Mortgage Obligations (“CMO”) and Mortgage Backed Securities (“MBS”) interest income and balances.
Interest income by operating segment for the year ended 2007 compared to 2006, increased for the Commercial Banking and Wealth Management segments by $27.1 million or 12.8% and $620,000 or 5.6%, respectively. This increase was partially offset by decreased interest income from the Community Banking and RAL and RT Programs segments of $4.3 million and $145,000, respectively.
INTEREST EXPENSE
Interest expense is incurred from interest paid on deposits and borrowings. The following tables present a summary of interest expense and the increases and decreases within the interest expense line items for the three years ended December 31, 2008, 2007 and 2006:
Interest expense in 2008 was $178.8 million a decrease of $43.6 million or 19.6% when compared to 2007. This decrease is mostly attributable to the FOMC decreasing interest rates by 400 basis points since December 31, 2007 which mainly impacted the interest rates paid on deposits. While the Bank was successful in growing deposits during 2008, the interest paid on deposits decreased by 110 basis points when comparing the year ending December 31, 2008 to 2007.
Interest expense in 2007 was $222.4 million, an increase of $31.6 million, or 16.6% over 2006. This increase is due to higher interest rates paid on deposits and a reliance on wholesale borrowings such as Federal Home Loan Bank of San Francisco (“FHLB”) advances and overnight Federal funds purchased
to fund loan growth. Deposit growth was outpaced by loan growth as the Company faced continued competition for deposits from other financial institutions and brokerage firms during 2007 and 2006.
NET INTEREST MARGIN
The net interest margin is reported on a fully tax equivalent (“FTE”) basis. A tax equivalent adjustment is added to reflect that interest earned on certain municipal securities and loans which are exempt from Federal income tax. The following tables set forth the average balances and interest income on a fully tax equivalent basis and interest expense for the previous three years.
(1) Income and yield calculations are presented on a fully taxable equivalent basis.
(2) Average securities balances are based on amortized historical cost, excluding Statement of Financial Accounting Standard (“SFAS”) 115 adjustments to fair value, which are included in other assets.
(3) Nonaccrual loans are included in loan balances. Interest income includes related fee income.
(Continued)
(1) Income and yield calculations are presented on a fully taxable equivalent basis.
(2) Average securities balances are based on amortized historical cost, excluding SFAS 115 adjustments to fair value, which are included in other assets.
(3) Nonaccrual loans are included in loan balances. Interest income includes related fee income.
The following table set forth the change in average balances and interest income on a fully tax equivalent basis and interest expense for the last three years.
Note: Income amounts are presented on a fully taxable equivalent basis.
The change not solely due to volume or rate has been prorated into rate and volume components.
The FTE net interest margin decreased to 4.81% for the year ended December 31, 2008 from 5.24% for the year ended December 31, 2007. The FTE net interest income decreased to $346.7 million in 2008 from $366.2 million in 2007, a decrease of $19.5 million. This decrease was driven by the FOMC’s 400 basis point decrease in the Federal funds rate since December 31, 2007. The FOMC rate decrease primarily impacted the interest-bearing liabilities and loans excluding RALs.
The FTE net interest margin decreased to 5.24% for the year ended December 31, 2007 from 5.76% for the year ended December 31, 2006. The FTE net interest income decreased to $366.2 million in 2007 from $380.0 million in 2006, a decrease of $13.8 million. The significant drivers of these decreases were the increase in loan growth and increased reliance of other borrowings to fund the loan growth and increased rates paid on deposits. The average balance of total net loans increased by $605.0 million. This increase caused interest income on loans to increase $50.9 million while the rates paid on loans decreased, which decreased interest income by $27.1 million. The average balance of other borrowings increased by $290.9 million. This increase accounted for $15.3 million of the $18.8
million increase in interest expense on other borrowings. Interest expense paid on deposits increased by $14.8 million due to increased rates paid on deposits of 38 basis points.
PROVISION FOR LOAN LOSSES
Quarterly, the Company determines the amount of allowance for loan losses (“ALL”) adequate to provide for losses inherent in the Company’s loan portfolios. The provision for loan losses is determined by the net change in the allowance for loan losses. For a detailed discussion of the Company’s allowance for loan losses, refer to the “Significant Accounting Policies” discussion in Note 1, of the Consolidated Financial Statements or in the “Critical Accounting Policies section” starting on page 64.
A summary of the provision for loan losses for the comparable years ended December 31, 2008 and 2007 are as follows:
Provision for loan losses was $218.3 million for the year ended December 31, 2008 compared to $113.3 million for the year ended December 31, 2007, an increase of $105.1 million. The increased provision for loan losses was driven by the slowing economy which caused the Core Bank’s loan portfolio to experience higher than anticipated loan losses partially offset by increased recoveries for RALs due to enhanced credit screening procedures put in place for the 2008 RAL season. The increase in provision for losses for the Core Bank was driven by net charge-offs of $99.7 million during 2008 and an increase in nonaccrual loans of $148.2 million since December 31, 2007. A majority of the increase in net charge-offs and nonaccrual loans were from the construction loan portfolio. During 2008, the Bank also modified its ALL policy to enhance its use of qualitative factors in determining required allowance levels. These changes were made in large part due to the deteriorating conditions in the economy, which drove a significant portion of the increase in provision.
During 2008, RAL had net charge-offs of $21.8 million compared to $92.0 million of net charge-offs in 2007, a reduction of $70.2 million which is reported in the RAL and RT Program segment. The Commercial Banking segment’s provision for loan losses was $147.7 million, an increase of $138.4 million when comparing the year ended December 31, 2008 to 2007. The Commercial Banking segment holds a majority of the construction loan portfolio causing this increase.
A summary of the provision for loan losses for the comparable years ended December 31, 2007 and 2006 are as follows:
The provision for loan losses totaled $113.3 million in 2007, an increase of $48.6 million or 75.1% compared to 2006. The increased provision is due to the increased incidences of fraud in the RAL program which increased by $55.3 million for 2007 compared to 2006. The Company incurred larger than anticipated losses as a result of improved fraud screening by the IRS in 2007. The IRS made changes to its fraud detection system and penalty collection practices for the 2007 tax season which have both contributed to the increased losses on RALs. The RAL pre-file product also experienced higher losses due to the new IRS fraud detection system. The RAL pre-file product is a RAL product that was offered in advance of the taxpayer’s filing of their tax return, primarily in the month of January, for a portion of the anticipated refund amount. A RAL pre-file loan is repaid once a RAL or RT is funded by the IRS. In 2007, the Company decided to no longer offer the RAL pre-file product. The Company has also identified a high concentration of losses associated with certain tax preparers and RAL customers possessing certain characteristics.
The provision for loan losses excluding RALs declined by $6.7 million in 2007 compared to 2006 as a result of the sale of the higher risk indirect auto and leasing portfolios in the second quarter of 2007.
Excluding the RAL and RT Programs discussed above, provision for loan losses for the other operating segments declined by $6.7 million for the year ended 2007 compared to 2006. The Community Banking segment provision declined by $10.5 million but was partially offset by an increase of $3.8 million in provision for the Commercial Banking segment.
NON-INTEREST INCOME
Non-interest income primarily consists of fee income received from servicing deposit relationships, trust and investment advisory fees, RT fees earned from processing tax refunds, fees and commissions earned on certain transactions, unrealized gains and losses on the trading portfolio, impairment of available-for-sale (“AFS”) MBS and realized gains and losses on sold and called securities and gains and losses on the sale or disposal of assets.
The following tables present a summary of non-interest income and the related changes between the periods presented:
Total non-interest income was $176.1 million for the year ended December 31, 2008 compared to $184.6 million for the same period in 2007, a decrease of $8.5 million or 4.6%. Excluding the prior year gain on sale of the leasing portfolio in June 2007 of $24.3 million, the non-interest income for the comparable periods increased by $15.8 million for 2008 compared to 2007. This increase was primarily due to increased RT fees of $22.7 million. A summary of the significant activity within non-interest income by type is presented below.
Refund transfer fees
RT fees totaled $68.7 million for the year ended December 31, 2008 compared to $46.0 million in 2007 and $44.9 million in 2006. The increase in RT fees occurred primarily due to increased volume of RTs in 2008 as a result of the increased fraud screening of RALs. When a RAL is not approved for processing, a RT is offered to the taxpayer. The number of RT transactions increased by 1.5 million, or 30.8% when comparing the year ended December 31, 2008 to December 31, 2007.
Net gain on sale of RALs
The following table presents a summary of the gain on sale of RALs for the three years ended December 31, 2008, 2007 and 2006:
The Company recorded a net gain on sale of tax refund loans of $44.6 million, $41.8 million and $43.2 million for the years ended December 31, 2008, 2007 and 2006, respectively. These gains relate to the sale of RALs through a securitization and are discussed in Note 7, “RAL and RT Programs” of these Consolidated Financial Statements and below.
The securitization capacity was $1.60 billion in 2008, the largest since the Company started utilizing the securitization facility seven years ago. In 2007 and 2006, the capacity was $1.50 billion and $1.10
billion, respectively. The capacity had increased over the last few years to accommodate the annual increase in RAL balances each year. The gain on the securitization was much larger in 2008, 2007 and 2006 than in prior years due to a contract change with JH beginning with the 2006 RAL season. The gain is calculated in part by the total fees earned by the company on the loans sold into the securitization. Starting in 2006, the Company received 100% of the fees on RALs, while in prior years there was a fee splitting agreement between the Company and JH. Additional expense related to this contract change is recorded in non-interest expense as program and technology fees.
All loans sold into the securitization are either fully repaid or repurchased by the Bank at the termination of the securitization in mid-February of each calendar year, consistent with the terms of the Securitization Agreement. At March 31, these repurchased loans are reported in the balance sheet as RAL loans and become subject to the same charge-off criteria as RALs retained on the balance sheet since origination. Charge-offs and recoveries are recorded through the allowance for loan losses subsequent to the end of the first quarter of each calendar year.
The securitization of RALs also changes how some of the income and expenses are accounted for. All of the cash flows associated with the RALs sold to the Company’s securitization partners are reported net as a gain on sale of RALs. The gain on the securitization of RALs is further explained in Note 7, “RAL and RT Programs” within our Consolidated Financial Statements on page 115.
For the 2009 RAL season, the Company was not able to utilize the same securitization facility as it had in previous years due to the current economic conditions. In place of the securitization, the Bank will utilize lines of credit and brokered CDs. The Company expects that the transaction volumes, product mix and loss rates for the 2009 RAL season to be similar to 2008. However, the profitability is expected to be lower than in prior years due to an increase in funding costs and reduced recoveries of prior year charged-off RALs.
Net gain on sale of leasing portfolio
In June 2007, the Company sold the leasing loan portfolio for a gain on sale of $24.3 million. The gain is disclosed as a separate line item of non-interest income. The details related to this sale are described in Note 6, “Loan Sales and Transactions” of the Consolidated Financial Statements.
Loss on securities, net
Loss on securities, net for the year ended December 31, 2008 was $3.3 million, an increase of $2.2 million compared to 2007. The increase in the loss on securities of $2.2 million was attributed to increased impairment of MBS held in the AFS portfolio of $2.8 million and realized losses on the future positions held of $4.9 million resulting from declining interest rates as described in Note 22, “Derivative Instruments” on page 137 of the Consolidated Financial Statements. These losses were offset by an increase in the market value of trading securities of $5.1 million and realized gain on sale of trading securities of $2.4 million which were caused by the decrease in interest rates during 2008.
Net loss on securities for the year ending December 31, 2007 and 2006 were $1.1 million and $8.6 million, respectively. These losses are mostly attributed to the Company’s impairment losses on securities in the fourth quarter of each year. In December 2007, Management changed intent to no longer hold certain impaired AFS MBS securities to maturity or ultimate recovery. As a result of this decision, a $3.0 million impairment was taken on the $250.4 million AFS MBS portfolio at December 31, 2007. At December 31, 2006, Management made the decision to sell the 2003 and 2004 leveraging strategy portfolio and realized an $8.8 million impairment loss due to a decision to sell this portfolio in 2006. Additional discussion regarding the impairments taken on securities and the activity in the securities portfolio is disclosed in the “Investment Securities” section of the MD&A and in Note 4, “Securities” of the Consolidated Financial Statements.
NON-INTEREST EXPENSES
The following tables present a summary of non-interest expense and the related changes between the periods presented:
Non-interest expense is comprised of expense incurred for the operations of the Company. The most significant are those expenses attributed to employee salaries and benefits.
Salaries and benefits
The following table summarizes the components of salaries and benefits expense for the three years ended December 31, 2008, 2007 and 2006.
Salaries and benefits were $127.9 million for the year ended December 31, 2008 compared to $128.3 million for the same period in 2007. The slight decrease in salary and benefits is due to a decrease in benefit and commission expense offset by an increase in performance related bonuses of $1.9 million.
The $2.5 million decrease in salary and benefits expense for the year ended December 31, 2007 compared to December 31, 2006 was mostly attributed to decreases in benefit costs and bonus expense of $3.0 million and $3.2 million, partially offset by a $1.7 million increase in severance compensation. The increased severance was primarily due to staff reductions in conjunction with the sale of indirect auto and leasing loan portfolios as well as strategic re-alignments within the business units.
Refund program marketing and technology fees
The refund program and marketing technology fees paid to JH were $46.3 million, $44.5 million and $54.7 million for the years ended December 31, 2008, 2007 and 2006, respectively. The refund program marketing and technology fees are associated with the RAL and RT Programs’ activity. Starting with the 2006 RAL season, a revised contract with JH was entered into where the Company agreed to pay a fixed fee to JH for program and technology services which are reported in this line item. In exchange for paying the program and technology fee to JH the Company received 100% of the interest and fee income related to the RAL and RT Programs and also assumed 100% of the loan losses associated with the RAL Program.
The reduction in the refund program marketing and technology fee paid for 2007 compared to 2006 is due to fewer transactions processed in 2007 than in 2006.
Pursuant to the terms of the Program Agreement, PCBNA pays a fixed annual program fee to JH in exchange for marketing rights. JH designates the number of offices that will process RALs and RTs for PCBNA. The designated group of offices represents the market available to PCBNA in a given year. As the market share may change each year, the program fee is correspondingly adjusted to reflect the value of the market share. The fee is calculated based on forecasted RAL and RT volumes. To the extent volumes are significantly different than forecast, the fees paid under the Program Agreement are adjusted accordingly. PCBNA paid a Program Agreement fee of $23.9 million, $24.0 million and $23.0 million for approximately 68%, 60% and 70% of JH volume in 2008, 2007 and 2006, respectively.
Pursuant to the terms of the Technology Agreement, PCBNA pays a fixed technology fee to JH for processing services. In the event the actual annual business volume acquired by PCBNA is different than the predictive factors used to derive the technology payment, PCBNA has a contractual right to adjust the fees paid under the Technology Agreement. PCBNA paid a fixed technology fee of $21.2 million, $20.5 million and $26.0 million in 2008, 2007 and 2006, respectively.
Net Occupancy Expense
Net occupancy expense increased in 2008 and 2007 by $3.5 million and $2.3 million, respectively. The increase in 2008 is due to the following: new retail branches opened in Wood Ranch in Simi Valley and Casa Dorinda in Santa Barbara; a new commercial and wealth management banking center in Torrance; the addition of REWA office space; and a new office in San Diego for the RAL and RT operations.
The Company is reviewing all of the retail branch locations to ensure that they meet the strategic initiatives of the Company and continue to meet the needs of the Bank’s customers. Currently, one of the Santa Maria and one of the Lompoc retail locations are scheduled to close in March and April of 2009, respectively. Both closings are pending regulatory approval and, both communities have retail
branches that are within five miles or less of the locations scheduled to be closed. In addition, with the sale of the Santa Paula and Harvard retail branches in October 2008, the Company anticipates net occupancy expense to decrease in future periods.
The increase in 2007 is the result of opening new locations, including the Madrone Village branch, two new commercial banking offices and three new administrative offices as well as a full year of the Paso Robles location added in 2006.
Goodwill Impairment
In the third quarter of 2008, the Company concluded that goodwill was impaired and recorded $22.1 million impairment. Goodwill is tested for impairment during the third quarter of each year or if Management determines there is a triggering event which may indicate a need to review goodwill for impairment. Given this current economic downturn and the ongoing events within the banking industry, Management has deemed it prudent to assess Goodwill for impairment on a quarterly basis for the foreseeable future. The year-end goodwill analysis did not result in any additional goodwill impairment. All goodwill impairment testing is performed by an independent third party in conjunction with Management.
In order to determine the fair value of each reporting unit in the third quarter of 2008, the Company reviewed the capitalized earnings of each reporting unit, the outlook of the current economic environment and took into consideration the transaction multiples of publicly traded financial institutions adjusted for a change in control. When the fair value of a reporting unit is less than its carrying value, the Company is required to utilize a Step 2 valuation approach in accordance with SFAS 142. All of the Company’s reporting units passed Step 1 of the annual SFAS 142 impairment analysis in the third quarter of 2008, except the Commercial Banking segment. The Step 2 goodwill impairment analysis of the Commercial Banking segment required the Step 1 fair value of the reporting unit to be allocated to all of the fair values of the underlying tangible and intangible assets and liabilities for purposes of calculating the fair value of goodwill. This allocation resulted in a $22.1 million goodwill impairment. The goodwill impairment calculation is an estimate subject to ongoing review as certain circumstances may cause additional impairment to be assessed in the future. For additional information on the accounting and estimates used in the annual review of goodwill, refer to the Critical Accounting Policies within the MD&A of this Form 10-K on page 65 and in Note 1, “Significant Accounting Polices” of the Consolidated Financial Statements.
Other expense
The table below summarizes the significant items included in other expense.
Other expense was $109.1 million for the year ended December 31, 2008, an increase of $37.9 million or 53.2% compared to the year-ended December 31, 2007. This increase was mostly attributable to increases in other expenses of $17.4 million. The increase in the other expense line item as disclosed above was primarily from the following items: $4.0 million accrued expense related to payments to MCM, a decrease in deferred loan origination expense in accordance with SFAS 91 of $3.3 million, an increase in litigation settlements of $3.0 million which is mostly related to the lawsuit disclosed in Note 18, “Commitments and Contingencies” as the Canieva Hood and Congress of California Seniors v. Santa Barbara Bank & Trust, Pacific Capital Bank, N.A., and Jackson-Hewitt, Inc. lawsuit, an increase in regulatory assessment payments paid to the Office of the Comptroller of Currency (“OCC”) and Federal Deposit Insurance Corporation (“FDIC”) of $2.8 million and an increase of $1.2 million for printed forms and supplies.
The Company recorded additional expense of $7.2 million during 2008 to increase the off-balance sheet reserve due to the downturn of the economy, the reserve was increased for unfunded loan commitments and letters of credits as disclosed in Note 5, “Loans” of this Form 10-K. The increase in RAL and RT developer performance fees of $7.1 million is the result of contractual volume incentives fee due to the increased volume for the 2008 RAL season. The increase in software expense of $3.1 million is mostly attributed to additional depreciation expense associated with capitalized software.
Total other expenses declined by $28.3 million, or 28.5% to $71.2 million for the year ended December 31, 2007 compared to the year ended December 31, 2006. The majority of this decline was generated from the strategic cost cutting initiatives of the Company, specifically declines in software and consulting expenses. Total software expense for 2007 compared to 2006 declined by $16.3 million, or 51.6% mostly from the $9.3 million of capitalized software written off in December 2006 as it was deemed obsolete or no longer in use. Legal, accounting and audit expenses for the comparable periods decreased by $2.8 million, or 38.8%.
PROVISION FOR INCOME TAXES
Provision for income taxes for the year ended December 31, 2008 was a tax benefit of $18.6 million compared to tax expense of $56.2 million for the year ended December 31, 2007. The decrease in tax expense (or increase in tax benefit) of $74.8 million for the comparable periods was primarily the result of lower pretax income. Pretax loss for the year ended December 31, 2008 was $41.3 million compared to pretax income of $157.1 million for the year ended December 31, 2007. This decrease in pretax income for the comparable periods was primarily due to an increased provision for loan losses and to $22.1 million of goodwill impairment in 2008. The decrease in pretax income, combined with an increase in low income housing partnership tax credits, increased the effective tax rate to 44.9% compared with 35.8% for the year ended December 31, 2007.
The effective rates during all periods differed from the applicable statutory Federal (35%) and State (10.84%) tax rates due to various factors, including tax-exempt interest income, the $22.1 million goodwill impairment charge and low income housing partnership tax credits of $5.1 million.
For additional information related to the Company’s provision for income taxes for the years ended December 31, 2008, 2007 and 2006, refer to Note 16, “Income Taxes” of the Consolidated Financial Statements.
BALANCE SHEET ANALYSIS
CASH AND CASH EQUIVALENTS
Cash and cash equivalents was $1.94 billion at December 31, 2008 compared to $141,000 at December 31, 2007. This increase is a result of additional brokered CDs purchased during the fourth quarter of 2008 for the funding of the 2009 RAL season. In addition, the FRB started paying interest on the cash left in the Bank’s correspondent bank account starting in the fourth quarter of 2008. In previous years, a minimal amount of cash was left at the FRB as interest was not paid on the cash so, any excess cash was invested in short-term investments to obtain interest income.
INVESTMENT SECURITIES
The investment security portfolio of the Company is utilized as collateral for borrowings, required collateral for public agencies and trust customers deposits, Community Reinvestment Act (“CRA”) support, and to manage liquidity, capital and interest rate risk.
At December 31, 2008, 2007 and 2006 the Company held the following investment securities.
Total investment securities held by the Company increased $68.9 million at December 31, 2008 compared to 2007. This increase is mostly attributable to the securities placed in the MBS held in the trading portfolio and purchases of U.S. Agency and municipal securities.
Trading
At December 31, 2008 and 2007, the Company held $213.9 million and $146.9 million, respectively of securities classified as trading. In January 2008 and October 2008, the Company transferred residential real estate loans held in the Company’s loans held for investment portfolio of $67.6 million and $13.9 million, respectively into MBS increasing the balance in this portfolio. The Company placed these securities into the trading portfolio to provide Management the ability to sell these securities should the Bank require additional liquidity. In December 2007, the Company converted $285.1 million of fixed rate mortgage loans held for investment to $285.1 million of MBS. The Company designated $146.9 million of the securities received as trading which were subsequently sold in January 2008.
The table below summarizes the maturity distribution of the securities portfolio at December 31, 2008.
The timing of the payments for MBS and CMO securities is estimated based on the contractual terms of the underlying loans adjusted for estimated prepayments. Issuers of certain investment securities have retained the right to call these securities before contractual maturity.
The table above presents the tax equivalent weighted average yields of investment securities held by the Company at December 31, 2008. State and municipal securities are tax-exempt for Federal tax purposes and this tax-exempt interest makes up almost all of the amounts shown for the line captioned “non-taxable interest from securities and loans” in the net interest margin table on pages 31 and 32 within the line item, “non-taxable interest from securities and loans” of the net interest margin table. Management is aware of one asset backed security held in the investment portfolio that has some sub-prime loans as the underlying collateral, however, this security is rated AAA, and all principal and interest payments are current.
Sales of Investment Securities
The Company sold $123.6 million and $317.6 million of investment securities during the years ended December 31, 2008 and 2007, respectively. The Company sold no investment securities in 2006. For the years ended December 31, 2008 and 2007, and 2006, net gains or (losses) on the sales and calls of securities were ($127,000), $1.9 million and $151,000, respectively.
In 2008, 2007, and 2006 respectively, $515.0 million, $234.6 million and $128.4 million of investment securities matured or were called prior to contractual maturity. A detailed summary of gains and losses on investment securities is included in Note 4, “Securities” of the Consolidated Financial Statements.
Included in the net loss on securities transactions at December 31, 2008 and 2007 are MBS impairment losses of $5.8 million and $3.0 million, respectively. The impairment loss recognized on these MBS is a result of Management’s change in intent to no longer necessarily hold MBS investment securities classified as available-for-sale in a temporary loss position until full recovery or maturity. This change in intent was to provide more flexibility to manage the Company’s liquidity, capital and interest rate risk. As a result of this change, future unrealized losses on AFS MBS will be recognized as impairment losses in the statement of operations, while unrealized gains will be recognized in other comprehensive income (“OCI”).
In December 2006, the Company decided to sell securities purchased in 2003 and 2004 as part of a leveraging strategy. While not liquidated until early 2007, the Company recognized an $8.8 million impairment loss in the fourth quarter of 2006. By the time the sale was executed in the first quarter of 2007, the securities had recovered a portion of their value due to changes in interest rates and the Company recognized a $1.6 million gain, for a total net loss recognized of $7.2 million. The proceeds from the sale were used to reduce wholesale borrowings and to reinvest in higher yielding securities
The securities portfolios are managed by the finance department to maximize funding and liquidity needs of the Company. The interest income on investment securities is included in the “All Other” segment reported in Note 24, “Segments” of the Consolidated Financial Statements.
Derivative Instruments
The Company has policies and procedures that permit limited types and amounts of derivative instruments to help manage interest rate risk. At December 31, 2008, the Company had $50.0 million of U.S. Treasury future contracts and the Company has entered into interest rate swap agreements with customers to mitigate their interest rate risk exposure associated with the loan they have with the Bank. Refer to Note 22, “Derivative Instruments” of the Consolidated Financial Statements.
LOAN PORTFOLIO
Through the Company’s banking subsidiary, PCBNA, a full range of lending products and banking services are offered to households, professionals, and businesses. The Company offers its lending products through its four operating business segments: Community Banking, Commercial Banking, Wealth Management and RAL and RT Programs. The products offered by these segments include commercial, consumer, commercial and residential real estate loans and SBA guaranteed loans.
The table below summarizes the distribution of the Company’s loans held for investment at the year end indicated.
The loan balances in the above table include net deferred or unamortized loan origination, extension, and commitment fees and deferred loan origination costs. These deferred amounts are amortized over the lives of the loans.
Net Growth in the Loan Portfolio
The loan portfolio at December 31, 2008 was $5.76 billion, an increase of $405.7 million since December 31, 2007. This increase was from the commercial real estate loan portfolio which increased $463.5 million during 2008. This increase was offset with a decrease in the construction and land portfolio of $98.0 million. The commercial real estate loan portfolio is from the Commercial Banking segment as well as a majority of the construction and land loan portfolios. Due to the high concentration of commercial real estate loans, the Company plans to aggressively reduce its concentrations in commercial real estate loans and will make less commercial real estate loans in 2009, participating with other investors when needed. During 2008, the Company sold SBA loans for a gain on sale of $1.2 million, residential real estate loans for a gain on sale of $756,000 and various other types of loans in conjunction with the sale of two branches in October 2008. A more detailed discussion regarding these sales is in Note 6, “Loan Sales and Transactions” of the Consolidated Financial Statements.
The Company’s total loan portfolio decreased by $359.7 million or 6.3% from $5.72 billion at December 31, 2006 to $5.36 billion at December 31, 2007. The majority of this decrease was due to strategic loan sales mostly offset by overall loan growth in the remaining portfolio.
During 2007, the Company completed three significant loan portfolio transactions totaling $761.0 million. All of the loan transactions were from the Community Banking segment. A summary of the loan carrying value at the time of transaction is as follows:
n
$221.8 million of indirect auto loans sold in May 2007
n
$254.7 million sale of all leasing loans in June 2007
n
$284.5 million of fixed rate residential real estate loans converted to MBS Securities in December 2007
The indirect auto loans were sold in May 2007 at a net loss of $850,000. The leasing loan portfolio was sold in June 2007 for a net gain of $24.3 million. The sale of the indirect auto and leasing loan portfolios were part of the Company’s strategic balance sheet management in 2007 as well as these products were offered outside the Company’s market footprint and relied on third parties for origination of these loans. The residential real estate loans were converted into MBS in December 2007. A detailed discussion of these loan transactions is included on page 112 within Note 6, “Loan Sales and Transactions” of the Consolidated Financial Statements.
The growth in loans during prior years 2004 through 2006 was primarily from residential real estate loans with increases of $265.4 million, $226.6 million, $92.6 million when comparing each of the respective years 2006, 2005, 2004 respectively. With residential real estate values increasing at rapid rates on the central coast of California during 2004 through 2006, residential real estate had significant growth during those periods. The loan growth was also supplemented with the acquisitions of FBSLO in 2005 and PCCI in 2004.
During 2005 the Company purchased FBSLO, which had approximately $217.2 million of loans, and in 2004 purchased PCCI, which had approximately $419.0 million in loans. Without the acquisition of FBSLO, loan growth would have been $617.8 million or 15.2% in 2005 and without the acquisition of PCCI, loan growth would have been $462.4 million or 14.5% in 2004.
Loans Held for Sale
At December 31, 2008, loans held for sale were $11.1 million. A majority of the loans held for sale were SBA loans. The remainder of the loans were residential real estate loans which were originated for sale. In the third quarter of 2008, the Company began to originate residential real estate loans for sale. All residential real estate loans held for sale at December 31, 2008 were sold by the end of January 2009.
At December 31, 2007, the Company held $68.3 million of loans held for sale. Loans held for sale are reported at the lower of cost or market. All the loans held for sale at December 31, 2007 were residential mortgage loans. The majority of these loans, $68.2 million, related to the transfer of residential real estate loans that were transferred into MBS which settled in January 2008.
Loans by Segments and Category
Community Banking
The Community Banking segment’s assets increased by $249.9 million when comparing December 31, 2008 to December 31, 2007. This increase was partially related to the increase in home equity loans of $54.3 million and residential real estate loans of $22.9 million. In 2007, the Community Banking segment assets decreased by $606.6 million or 16.6% primarily due to the loan transactions of $761.0 million in 2007.
Home equity lines continue to have increases in growth with a majority of the growth occurring in 2008, 2005 and 2004. In 2005, home equity loans saw the largest percentage increase of 50.5%. The increase in home equity loans was attributed to aggressive marketing efforts during 2005 and 2004. FBSLO contributed $15.5 million of the 2005 growth in the home equity category.
Within the consumer loan portfolio were the indirect auto loan portfolio and Holiday loans. Prior to the sale of the indirect auto loan portfolio and discontinuance of the Holiday loan product in 2007, these portfolios were the main sources of growth in consumer loans in prior years. As of December 31, 2006 and 2005, Holiday loans accounted for $86.3 million and $57.6 million of the consumer loans. Holiday loans were seasonal since they are all funded in the fourth quarter of each year and they are either paid off or charged-off during the first quarter of the following year. Holiday loans were offered by professional tax preparers to their clients. After experiencing a high loan loss rate on Holiday loans, the Company decided in 2007 to no longer originate these products.
The leasing portfolio was sold in 2007. Prior to the sale of the leasing portfolio, this portfolio experienced strong growth in 2005.
Commercial Banking
The Commercial Banking segment offers a complete line of commercial and industrial and real estate loan products, including SBA loans, traditional commercial loans and lines of credit, asset based lending, and letters of credit. Business units in this group also serve the real estate industry through land acquisition and development loans, construction loans for development of both commercial and residential subdivisions.
Before making these loans, the Company will review a number of factors including the customer’s historical performance, management, economic conditions facing the customer, capital structure, and any available collateral. Loans in the Commercial Banking segment may have fixed or variable interest rates, depending on the product.
The Commercial Banking segment assets grew by $362.3 million, or 9.8% in 2008 compared to 2007. This growth is mostly attributable to the growth in commercial real estate loans during 2008. When comparing the asset growth in 2007 to 2006, the Commercial Banking segment grew $455.0 million or 14.1%. The loan growth in 2007 and 2006 was across all commercial loan categories with commercial real estate loans leading the loan growth of $146.5 million in 2007 and $260.8 million in 2006.
In 2007, Management determined that the SBA loans should be moved to the Commercial Banking segment from the Community Banking segment. As of December 31, 2008, 2007, and 2006 SBA loans are included in this segment for comparability. In 2009, the SBA loans will be moved back to the Community Banking segment as the Community Banking segment is focusing on servicing small businesses while the Commercial Banking group is focusing on the business relationships within mid-market businesses.
Wealth Management
Business units in this group service customers that meet a certain level of income and liquidity criteria and are considered to have high net-worth. There is not a specific loan category related to Wealth Management segment as the Banks existing loan products are tailored to the meet the needs of the segment’s customers. The Wealth Management segment was combined with the Commercial Banking segment as of January 1, 2009 as both segments work with customers with high net-worth and who are owners of mid-market businesses.
RAL and RT Programs
No RALs were outstanding at December 31 of any year. All RALs are repaid or charged-off at December 31 of each year. RALs are a seasonal credit product extended to consumers during the first four months of any calendar year. The purpose of the RAL is to provide consumers with liquidity at the time they file for their tax refund. The Company works with third party tax preparers who facilitate the origination of RALs through an application process. RAL underwriting is based on information about the borrower as well as certain elements within the tax return. The source of repayment for the RAL is the IRS when it refunds the borrower’s excess tax payments.
In 2006, the Company and JH entered into two new contracts, a program contract and a technology services contract. These contracts provided for JH to reduce the proportion of its transactions directed to the Company from approximately the 80% proportion for 2005 to approximately 75% in the 2008 tax season, and changed the method by which JH was compensated for the services it provides to the Company. The fee-splitting arrangement provided for in the earlier contract is eliminated, and, under the new contracts with JH is compensated for services through fixed fees for program and technology services.
The change in the contracts had a substantial impact on the amount of revenue, but little impact on pre-tax income as the amount of the fixed fees is approximately equal to what would have been shared with JH under the previous contract. While the “economics” are virtually the same under the new contracts as under the old, the presentation is different. Under the previous contract, the fees were recognized net of the amount of the fee split with JH. Under the new contracts, the whole amount of the revenue from the RALs and RTs are recognized by the Company and the program and technology service fees are shown as expenses.
The following table summarizes maturities and interest rates types for each loan category.
ALLOWANCE FOR LOAN LOSSES
The Company established an estimated reserve for inherent loan losses and records the change in this estimate through charges to current period earnings.
Allocation of the Allowance for Loan Loss
The table below summarizes the estimated allowance for loan loss by loan type:
Total allowance for loan losses increased by $96.1 million at December 31, 2008 compared to December 31, 2007. The increase is attributed to the deteriorating economic environment. The primary drivers of the increased ALL are increased historical loss rates due to higher levels of charge-offs and increased problem loans requiring specific ALL reserves. The increased charge-offs and problem loans were mainly from the construction and development loans.
All changes in the risk profile of the various components of the loan portfolio are reflected in the allowance assignment. There is no assignment of allowance to RALs at December 31, 2008 as all unpaid RALs were charged-off prior to year-end.
The decrease in allowance for loan losses of $19.8 million, or 30.7% at December 31, 2007 compared to 2006 was primarily attributed to the loan portfolio sales during 2007. The loan portfolios sold consisted of higher risk loans and contributed a decrease of $20.6 million to the required ALL at the time of sale.
Allowance for Loan Losses-RALs
A RAL is charged-off when Management determines that payment from the IRS is unlikely. The Company does not receive formal notification from the IRS regarding the denial of any tax refund claims. As a result, Management relies on prior years experience with IRS payment patterns to determine expected collection time frames. Prior years experience has indicated that payment from the IRS becomes unlikely after tax refund payments are 4-6 weeks past due from the expected payment date. The IRS payment patterns have varied from year to year, so the Company has utilized the most recent period payment patterns to predict current year payments. As a result of the Company’s collection experience in conjunction with regulatory requirements, all RALs are charged off prior to December 31 each year.
Recoveries on RALs occur due to unexpected payments from the IRS, the taxpayer directly, or during a subsequent RAL season through a new request procedure from the charged-off RAL customer. Some recoveries on prior year charge-offs occur when the taxpayer returns to a tax preparer that offers RALs or RTs through the Company. If the Company accepts the application for a RAL on the new refund claim or for an RT, the amount of the prior year’s charged-off loan will be deducted from the proceeds of the current year RAL or RT.
Reserve for Off-Balance Sheet Commitments
The table below summarizes the loss contingency related to loan commitments.
The Company has exposure to credit losses from extending loan commitments and letters of credit as well as from unfunded loans. Because the available funds have not yet been disbursed on these commitments and letters of credit, the face amount is not included in the outstanding balance reported for loans and leases. Consequently, any amount provided for credit losses related to these instruments is not included in the allowance for loan losses reported in the table above, but is instead accounted for as a loss contingency estimate. The changes to this liability have been recorded in other non-interest expense.
The Company recorded additional expense of $6.9 million during 2008 to increase the off-balance sheet reserve due to the downturn of the economy.
LOAN LOSSES
The table below summarizes the charge-offs and recoveries by loan category and credit loss ratios for the years presented:
(1) The amounts reported in 2008 and 2007 are from loan sales and transfers. In August 2005, the Company acquired FBSLO and in March 2004 the Company acquired PCCI.
Total charge-offs increased $16.7 million, or 11.6% for 2008 compared to 2007. The increased charge-offs were driven by the slowing economy which caused the Core Bank’s loan portfolio to experience higher than anticipated loan losses partially offset by decreased charge-offs for RALs due to enhanced credit screening procedures put in place for the 2008 RAL season. The majority of the Core Bank charge-offs were from the construction loan and commercial and industrial loan portfolios.
Total charge-offs increased by $57.5 million, or 66.1% in 2007 compared to 2006 due to an increase in RAL charge-offs of $56.6 million. The increase in RAL charge-offs was the result of increased losses in the RAL pre-file product and losses related to incidences of tax related fraud affecting RAL loans. Due to the higher loss rates on the RAL pre-file product and holiday loans, the Company discontinued these products. The increased loss rates experienced in the 2007 RAL program also caused Management to modify and enhance its underwriting criteria and fraud identification processes.
The increase in RAL charge-offs in 2004 and 2005 was the result of contract changes with JH. In the revised contract with JH, the Company assumed 100% of the credit risk associated with the RAL Program and, in exchange, the Company received a larger portion of the interest income and fees.
The Company is one of three major banks in the country that have national RAL Programs. Therefore, for comparability, charge-offs amounts and ratios for the Company are shown both with total loans and “other loans” which exclude RALs. In order to compare the ratio of net charge-offs to average loans to our peers, it is best to compare the ratio of net charge-offs to average loans excluding RALs. Exclusive of RALs, the ratio of net charge-offs to average loans over the last five years has varied from 0.14% to 1.76%
The ratio of allowance for loan losses to total loans for the years ended December 31, 2008, 2007 and 2006 was 2.44%, 0.84%, 1.13%, 1.14% and 1.33% , respectively. At December 31 of each year, the Company’s ratio of allowance for loan losses to total loans is lower than in previous quarters throughout the year primarily due to the seasonality of the RAL program.
NONACCRUAL, PAST DUE, AND RESTRUCTURED LOANS
The table below summarizes the Company’s nonaccrual and past due loans for the last five years.
Nonaccrual Loans
When a borrower discontinues making payments as contractually required by the note, the Company must determine whether it is appropriate to continue to accrue interest. Generally, the Company places loans in a nonaccrual status and ceases recognizing interest income when the loan has become delinquent by more than 90 days and/or when Management determines that the repayment of principal and collection of interest is unlikely. The Company may decide that it is appropriate to continue to accrue interest on certain loans more than 90 days delinquent if they are well secured by collateral and collection is in process.
When a loan is placed in a nonaccrual status, any accrued but uncollected interest for the loan is reversed out of interest income in the period in which the status is changed. Subsequent payments received from the customer are applied to principal and no further interest income is recognized until the principal has been paid in full or until circumstances have changed such that payments are again consistently received as contractually required. In the case of commercial customers, the pattern of payment must also be accompanied by a positive change in the financial condition of the borrower.
The increase in nonaccrual loans of $114.4 million is mostly attributed to the economic downturn that occurred during the latter part of 2008. A majority of this increase is associated with the construction loan portfolio which had nonaccrual loans of $101.2 million at December 31, 2008. The Company had restructured loans (“TDR”) of $33.7 million compared to no TDR loans at December 31, 2007. The economic downturn has also contributed to this increase. Several of the TDR loans were also from the construction loan portfolio and account for $28.2 million of the restructured loans. The Company had foreclosed collateral of $7.1 million and $3.4 million as of December 31, 2008 and 2007, respectively. The increase in foreclosed collateral is mostly land and commercial buildings which consists of $6.1 million of the $7.1 million balance at December 31, 2008.
The increase in nonaccrual loans of $62.4 million at December 31, 2007 compared to 2006 was mostly attributable to $45.1 million related to two large commercial relationships. At the end of 2008 the balance of these relationships was $24.8 million.
Foreclosed Collateral
Foreclosed collateral consists of other real estate owned (“OREO”) obtained through foreclosure for all five years presented in the table above. The Company held OREO at fair value less estimated costs to sell at December 31, 2008, 2007, 2006, 2005 and 2004 of $7.1 million, $3.4 million, $2.9 million, $2.9 million, and $2.9 million, respectively.
The table below sets forth the amounts of foregone interest income from nonaccrual loans for the last five years.
OTHER ASSETS
Other assets at December 31, 2008 were $390.3 million, an increase of $106.1 million since December 31, 2007. This increase is attributed to the following items:
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An increase in the deferred tax asset of $51.2 million which is primarily attributable to an increase in the Company’s loan loss provision. The 2008 loan loss provision, while not currently deductible, will result in a future tax benefit as the loans are charged off.
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A $24.1 million increase in the carrying value of the interest rate swaps due to an increased number of customer swaps agreements entered into and changes in market values.
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An $11.9 million increase in FHLB stock required for the increase in FHLB borrowings.
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A $6.0 million addition to corporate taxes receivable resulting from expected refunds from current and amended tax fillings.
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An increase in OREO properties of $3.7 million due to the decline in the economy.
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Increased investment of low-income housing partnerships of $3.6 million.
DEPOSITS
The average balance of deposits by category and the average effective interest rates paid on deposits is summarized for the years ended December 31, 2008, 2007 and 2006 in the table below.
Total deposits increased to $6.59 billion at December 31, 2008 from $4.96 billion at December 31, 2007, an increase of $1.63 billion or 32.8%. This increase was primarily from CDs as the Bank had marketing campaigns offering attractive interest rates to increase deposit growth and attract new customers. The Company has also increased Broker CDs by $1.14 billion during the fourth quarter of 2008 in preparation for funding the 2009 RAL Program. The Broker CDs are reported in the time certificates of deposit less than $100,000. In addition, in the fourth quarter of 2008, the Bank became a member of Certificate of Deposit Account Registry Service (“CDARS”) which provides FDIC insurance for large deposits which has also increased deposits in 2008. As disclosed in the table above, the interest rates paid on deposits decreased significantly over 2008 due to the decrease in interest rates by the FOMC.
In October 2008, the Company sold $54.4 million of deposits and associated buildings and equipment from the Santa Paula and Harvard branches. The Company recorded a $3.1 million gain on sale related to this transaction.
Certificates of Deposit of $100,000 or More
The table below discloses the distribution of maturities of Certificates of Deposit of $100,000 or more at December 31, 2008, 2007 and 2006:
LONG TERM DEBT AND OTHER BORROWINGS
Long-term debt and other borrowings increased $334.6 million or 23.8% from $1.41 billion at December 31, 2007. This increase was caused by the Bank’s strong loan growth during 2008. Included in this increase are short-term FHLB advances of $230.0 million which are due to be repaid in one year or less.
OTHER LIABILITIES
Other liabilities were $113.5 million at December 31, 2008 compared to $63.9 million at December 31, 2007, an increase of $49.6 million or 77.6%. The significant items attributed to this increase were:
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$25.9 million increase in the carrying value of the interest rate swaps due to an increased number of customer swaps agreements entered into and changes in market values,
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$8.2 million increase in the post retirement benefits liability due to lower than projected returns on the Voluntary Employees’ Beneficiary Association (“VEBA”) assets and benefit costs increased at a higher rate than projected for 2008,
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$7.4 million increase in accrued interest which is mostly from the growth in deposits as average deposits increased $151.3 million for the comparable periods and,
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$6.9 million increase in reserve for off balance sheet commitments due to the current economic conditions, the Company has increased this reserve.
CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS
The Company has entered into a number of transactions, agreements, or other contractual arrangements whereby it has obligations that must be settled by cash or contingent obligations that must be settled by cash in the event certain specified conditions occur. The table below lists the Company’s contractual obligations.
(1) As of December 31, 2008, the Company’s liability associated with the capital lease was $9.9 million, as reported in Note 14, “Long-term Debt and Other Borrowings of the Consolidated Financial Statements. In the table above, the future capital lease obligation is reported.
Other commitments and obligations: In addition to the contractual obligations above, as a financial service provider, we routinely enter into commitments to extend credit to customers. The same credit practices are used in extending these commitments as in extending loans to our customers. These commitments are described in Note 5, “Loans” of our Consolidated Financial Statements. The Company also provides postretirement benefit plans to eligible retirees as described in Note 15, “Postretirement Benefits” of our Consolidated Financial Statements and, there are obligations and commitments associated with those plans.
Off-balance Sheet Reserve: As explained in Note 1, “Significant Accounting Policies” and Note 5, “Loans” of the Consolidated Financial Statements the Company must establish a reserve for off-balance sheet commitments for known or estimated losses relating to letters of credit or other unfunded loan commitments.
The Company has derivative instruments as disclosed in Note 22, “Derivative Instruments” of the Consolidated Financial Statements.
CAPITAL RESOURCES
As of December 31, 2008, the Company and PCBNA exceeded the guidelines and definitions for being deemed “well-capitalized” under the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”).
Capital Adequacy Standards
The Company and PCBNA are subject to various regulatory capital requirements administered by the Federal banking agencies. Failure to meet minimum capital requirements as specified by the regulatory framework for prompt corrective action could cause the regulators to initiate certain mandatory or discretionary actions that, if undertaken, could have a direct material effect on the Company’s financial statements. For additional information regarding the Company’s capital refer to Note 19, “Shareholders’ Equity” and Note 20, “Regulatory Capital Requirements” of the Consolidated Financial Statements.
The Company’s and PCBNA capital ratios as of December 31, 2008 and 2007 were as follows:
The minimum capital ratios the Company must maintain under the regulatory requirements to meet the standard of “adequately capitalized” and the minimum amounts and ratios required to meet the regulatory standards of “well capitalized” are in the table above at December 31, 2008 and 2007. Based on discussions with the OCC following the conclusion of the Bank’s most recent examination, Management expects the OCC to establish a minimum Tier 1 risk based capital ratio of 8.5% and a minimum total risk based capital ratio of 11%. Management expects that the Bank will continue to be deemed well capitalized notwithstanding the establishment of these expected minimum capital ratios.
Management also plans to maintain a capital plan in conjunction with discussions it has held with the OCC. This capital plan will be based on a rolling twelve month forecast, stressed accordingly for market conditions and the Company’s balance sheet conditions. If any capital shortfalls become apparent, Management will immediately activate contingency plans to address any such shortfalls, which may include additional capital raising, asset sales or other means as necessary, including the option of participating in the Capital Assistance Program. At this time, the Company significantly exceeds the expected minimum capital ratios, though conditions could change at any time given industry conditions.
Risk-weighted assets are computed by applying a weighting factor from 0% to 100% to the carrying amount of the assets as reported in the balance sheet and to a portion of off-balance sheet items such as loan commitments and letters of credit. The definitions and weighting factors are all contained in the regulations. However, the capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Pacific Capital Bancorp is the parent company and sole owner of PCBNA. However, there are legal limitations on the amount of dividends, which may be paid by PCBNA to PCB. The amounts, which may be paid as dividends by a bank are determined based on the bank’s capital accounts and earnings in prior years. As of December 31, 2008, PCBNA would have been permitted to pay up to $276.9 million to Pacific Capital Bancorp.
Availability of Capital
As a result of recent market disruptions, the availability of capital (principally to financial services companies) has become significantly restricted. While some companies have been successful in raising additional capital, the cost of the capital has been substantially higher than the prevailing market rates prior to the market volatility. Management cannot predict when or if the markets will return to more favorable conditions.
The Company received $180.6 million pursuant to the TARP CPP on November 21, 2008 as disclosed in Note 19, “Shareholders’ Equity” of the Consolidated Financial Statements.
There are four primary considerations Management must keep in mind in managing capital levels and ratios. The first is the Company must be able to meet the credit needs of our customers when they need to borrow. The second consideration is that the Company must be prepared to sell some of the loans it originates in order to manage capital targets. The third consideration is to divest of underperforming divisions or business lines. The fourth consideration is that as loan demand picks up in an improving economy, raising additional capital may be necessary. Management proactively maintains a capital plan which focuses on maximizing capital through a variety of sources including balance sheet make-up, the accretion or dilution of its various business lines, dividend payout ratios, and additional sources of capital where prudent. In 2008, via Management’s capital planning strategies, the Company raised $7.2 million in capital through the issuance of common stock through its Direct Stock Purchase Plan in the open market. Through the Direct Stock Purchase Plan, the Company has the ability to issue 4,500,000 shares of common stock. In 2007, the Company sold two underperforming divisions, the Indirect Auto Lending business and the Equipment Leasing business in line with its capital planning strategies.
In addition to the capital generated from the operations of the Company, a secondary source of capital growth has been the exercise of employee and director stock options. In 2008, the increase to capital from the exercise of options (net of shares surrendered as payment for exercises and taxes) was $287,000 or 0.2% of the net growth in shareholders’ equity in the year compared to $5.1 million or 10.1% in 2007. At December 31, 2008, there were approximately 1,415,000 options outstanding and
exercisable at less than the then-current market price of $16.88, with an average exercise price of $25.32. This represents a potential addition to capital of $35.8 million, if all options were exercised with cash. In addition, except for those options expiring in 2009, the options are likely to be exercised over a number of years since options generally have a ten year term.
In addition, the Company received $180.6 million pursuant to the TARP CPP on November 21, 2008 as disclosed in Note 19, “Shareholders’ Equity” of the Consolidated Financial Statements.
Dividends
The Company’s Board of Directors (“BOD”) has the responsibility for oversight and approval for the declaration of dividends and in January 2009, they adopted a new dividend policy. The new policy gives the Chief Financial Officer (“CFO”) the responsibility for recommending dividend payments that meet the Company’s and Bank’s capital objectives within the regulatory and statutory limitations. When quarterly dividends are recommended by the CFO, the following items are taken into consideration: the Company’s near and long-term earnings capacity, current and future capital position, the dividend payout ratio, and dividend yield. The new policy also changes the declaration and payment dates for all prospective dividends to be paid on the last business day of each quarter. The BOD approved the new dividend policy so to ensure sound capital management and to take into consideration the guidelines required under the TARP CPP.
With the new dividend policy described above, the BOD approved a reduction of the quarterly dividend to $0.11 per share effective for its March 31, 2009 payment date. The Company’s dividend payout ratio over the last three years has been 169.2% for 2008, 41.1% for 2007 and, 43.8% for 2006.
Under the terms of the TARP CPP, for so long as any Series B Preferred Stock remains outstanding, the Company is permitted to declare and pay dividends on its common stock only if all accrued and unpaid dividends for all past dividend periods on the Series B Preferred Stock are fully paid. Until the third anniversary of the sale of the Series B Preferred Stock, unless such shares have been transferred by the U.S. Treasury or redeemed in whole, any increase in dividends on the Company’s common stock above the amount of the last quarterly cash dividend per share declared prior to October 14, 2008 ($0.22 per share) will require prior approval of the U.S. Treasury. The terms of the Company’s agreement with the U.S. Treasury allow for additional restrictions, including those on dividends, to be imposed by the U.S. Treasury, including unilateral amendments required to comply with legislative changes. Under the ARRA, the Company may repay the U.S. Treasury without penalty and without the need to raise new capital, subject to the U.S. Treasury’s consultation with the appropriate regulating agency, in which event these restrictions would no longer apply.
The Bank can make dividend payments to the Company as required to fund the operating needs, debt service, and quarterly dividends of the Company as declared and approved by the Company’s BOD. For additional discussion on restrictions on the declaration and payment of dividends, refer to “Regulation and Supervision, Dividends and Other Transfer of Funds” on page 69
Impact of RAL and RT Programs on Capital Adequacy
Formal measurement of the capital ratios for the Company and PCBNA are done at each quarter-end. However, the Company does more frequent estimates of its capital classification during late January and early February of each year because of the large volume of RALs. RALs are 100% risk weighted and due to the large volume of RALs in January and February, Management monitors the Company’s capital ratios daily during these months. Management estimates that, if a formal computation of capital ratios were done, on certain days during those weeks it and PCBNA may be classified as adequately capitalized, rather than well-capitalized. The Company has discussed this with its regulators and creditors.
Management was not able to set-up a securitization facility for the 2009 RAL season due to the current economic conditions and current credit crisis the U.S. economy is currently experiencing. The securitization assisted in removing RALs from the Bank’s balance sheet to assist with maintaining their capital ratios at an adequately capitalized level. In preparation for the 2009 RAL season and to replace the unavailability of a securitization facility, the Bank raised $1.28 billion through wholesale funding sources, broker CDs and entered into a syndicated funding line of $524 million which may be drawn upon as needed throughout the RAL season.
In Note 7, “RAL and RT Programs” in the Consolidated Financial Statements is a description of the securitization that the Company utilized as one of its sources for funding RALs. In 2008, the RAL securitization was a true sale of loans to other financial institutions, and except for the capital that must be allocated for the small-retained interest kept by the Company, the sales reduce the impact of RALs on the capital ratios for the Company.
LIQUIDITY
Liquidity is the ability to effectively raise funds on a timely basis to meet cash needs of our customers and the Company, whether it be to handle fluctuations in deposits, to provide for customers’ credit needs, or to take advantage of investment opportunities as they are presented in the market place.
The Company’s objective, managed through the Company’s Asset and Liability Committee (“ALCO”), is to ensure adequate liquidity at all times by maintaining adequate liquid assets, the ability to raise deposits and liabilities, and having access to additional funds via the capital markets.
The Company manages the adequacy of its liquidity by monitoring and managing its immediate liquidity, intermediate liquidity, and long term liquidity. ALCO monitors and sets policy and related targets to ensure the Company maintains adequate liquidity. The monitoring of liquidity is done over the various time horizons, to avoid over dependence on volatile sources of funding and to provide a diversified set of funding sources. These targets are increased during certain periods to accommodate any liquidity risks of special programs like RALs.
During 2008, liquidity was a major focus of the Bank as traditional sources of liquidity changed. In particular, the securitization market seized in the latter half of the year which was a major funding source for the RAL Program. As a risk management measure to compensate for this and other potential funding and liquidity changes in the future, Management developed and expanded its use of a twelve month rolling cash position analysis so that changes in liquidity sources and related needs could be identified and addressed well in advance of any issues or shortfalls. At this time, no shortfalls have been identified for the foreseeable future, though results could change depending on industry conditions.
Short-term liquidity is the ability to raise funds on an overnight basis. Sources of short-term liquidity include, but are not limited to, Federal funds, FHLB short-term advances, the Federal Reserve Bank Discount Window and repurchase agreements.
Intermediate liquidity is the ability to raise funds during the next few months to meet cash obligations over those next few months. Sources of intermediate liquidity include maturities or sales of securities, term repurchase agreements, broker CDs and term advances from the FHLB.
Long-term liquidity is the ability to raise funds over the entire planning horizon to meet cash needs anticipated due to strategic balance sheet changes. Long-term liquidity sources include: initiating special programs to increase core deposits in expanded market areas; reducing the size of securities portfolios; taking long-term advances with the FHLB; securitizing or selling loans; and accessing capital markets for the issuance of debt or equity.
Federal funds purchased and overnight repos are used to balance short-term mismatches between cash inflows from deposits, loan repayments, and maturing securities and cash outflows to fund loans, purchase securities and deposit withdrawals. During the first quarter of each year, they may also be used to provide a portion of the short-term funding needed for the RAL Program. Beginning in late January, the IRS pays weekly refunds to the Company. This allows the Company to repay up to all of its overnight borrowing and still have an excess of cash that must be invested.
For the Company, the most significant challenge relating to liquidity management is providing sufficient liquidity to fund the large amount of RALs, primarily in late January and early February of each year. In addition to the discussion above the following considerations are kept in mind in providing the needed liquidity:
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Using a large number of institutions so as to not become overly reliant on a limited number of sources or a particular type of funding vehicle;
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Using a mixture of committed and uncommitted lines so as to assure a minimum amount of funding in the event of tight liquidity in the markets; and
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Arranging for approximately 30% more funding than anticipated on the peak-funding days for RALs.
The securitization of RALs has historically assisted in the management of the Company’s capital position during the RAL season by selling some RALs to third parties. In addition, the securitization program represented yet another source of liquidity as the proceeds from the sales are lent out to new RAL customers. For the 2009 RAL season, the Company was not able to secure a securitization facility with the current economic conditions causing difficulty within the credit markets. In place of the securitization facility, the Company purchased $1.28 billion of broker CDs and entered into a syndicated funding through a syndicated funding line of $524 million which is collateralized with RALs and may be drawn upon as needed throughout the RAL season. The Company will also utilize the Bank’s wholesale lending sources.
RALs present the Company with some special funding and liquidity needs. Additional funds are needed for RAL lending only for the very short period of time that RALs are outstanding. The season starts in January and continues into April, but even within that time frame, RAL originations are highly concentrated in the last week of January and first two weeks of February. The Company must arrange for a significant amount of very short-term borrowing capacity. A portion of the need can be met by borrowing overnight from other financial institutions through the use of Federal funds purchased and repurchase agreements. These two sources match the short-term nature of the RALs and therefore are an efficient source of funding. However, they are not sufficient to meet the total need for funds, and other sources like advances from the FHLB and brokered deposits must be used. Extensive funding planning is accomplished prior to the RAL season to make effective and efficient use of various funding sources. The increased use of broker CDs to pre-fund the RAL program expanded the cash position of the Bank by approximately $1.3 billion and contributed to the growth of the balance sheet at December 31, 2008.
As disclosed in Note 7, “RAL and RT Programs” of the Consolidated Financial Statements, the Company has also securitized some of the RALs.
As of December 31, 2008, the Company’s liquidity ratio, which is the ratio of liquid assets of cash and cash equivalents, investment securities from the trading and AFS portfolios, Federal funds sold and loans held for sale divided by short-term liabilities of demand deposits, repurchase agreements and Federal funds purchased was 101.3%, compared to 44.8% at December 31, 2007. The Company’s liquidity ratio increased in December 2008 compared to December 2007 as a result of the funds received from the TARP CPP. Total available liquidity as of December 31, 2008 was $3.34 billion.
At December 31, 2008, the Company had available borrowing capacity of $1.88 billion at the FHLB and $1.01 billion of borrowing capacity with the FRB. This borrowing capacity is utilized to fund loans when loan growth outpaces deposit growth.
Recent Market and Regulatory Developments
Recent market conditions have made it difficult or uneconomical to access the capital markets. As a result, the United States Congress, the U.S. Treasury, and the FDIC have announced various programs designed to enhance market liquidity and bank capital.
In response to the ongoing financial crisis affecting the banking system and financial markets, EESA was signed into law on October 3, 2008, and established TARP. As part of TARP, the U.S. Treasury established the TARP CPP to provide up to $700 billion of funding to eligible financial institutions through the purchase of mortgages, mortgage-backed securities, capital stock and other financial instruments for the purpose of stabilizing and providing liquidity to the U.S. financial markets. On November 21, 2008, the Company completed the sale to the U.S. Treasury of $180.6 million of Series B Preferred Stock as part of the TARP CPP.
Separately, the FDIC announced its temporary liquidity guarantee program (“TLGP”) pursuant to which the FDIC will guarantee the payment of certain newly-issued senior unsecured debt of insured depository institutions (“Debt Guarantee”) and funds held at FDIC-insured depository institutions in noninterest-bearing transaction accounts in excess of the current standard maximum deposit insurance amount of $250,000 (“Transaction Account Guarantee”). Both guarantees were provided to eligible institutions, including the Company, at no cost through December 5, 2008. Participation in the TLGP subsequent to December 5, 2008 is optional.
The Company has elected to participate in the TLGP subsequent to December 5, 2008. The Transaction Account Guarantee is effective for the Company through January 1, 2010. Under the Debt Guarantee, qualifying senior unsecured debt newly issued by the Company during the period from October 14, 2008 to June 30, 2009, inclusive, is covered by the FDIC guarantee. The maximum amount of debt that eligible institutions can issue under the guarantee is 125% of the par value of the entity’s qualifying senior unsecured debt, excluding debt to affiliates that was outstanding as of September 30, 2008 (or if no such debt was outstanding at September 30, 2008, then 2% of the entity’s consolidated total liabilities at September 30, 2008), and scheduled to mature by June 30, 2009. The FDIC will provide guarantee coverage until the earlier of the eligible debt’s maturity or June 30, 2012. Based on the Bank’s consolidated total liabilities at September 30, 2008, it may issue up to $139.4 million in debt under the TLGP.
Participants in the Debt Guarantee Program will be assessed an annualized fee of 75 basis points for its participation, and an annualized fee of 10 basis points for its participation in the Transaction Account Guarantee. To the extent that these initial assessments are insufficient to cover the expense or losses arising under TLGP, the FDIC is required to impose an emergency special assessment on all FDIC-insured depository institutions as prescribed by the Federal Deposit Insurance Act.
INTEREST RATE RISK
With such a large proportion of the Company’s income derived from net interest income, it is important to understand how the Company is subject to interest rate risk.
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In general, for a given change in interest rates, the amount of the change in value up or down is larger for instruments with longer remaining maturities. For instance, the shape of the yield curve may affect new loan yields and funding costs differently.
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The remaining maturity of various assets or liabilities may shorten or lengthen as interest rates change. For example, if long-term mortgage interest rates decline sharply, higher fixed rate mortgages may prepay, or pay down, faster than anticipated, thus increasing cash flows and reducing interest income.
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Repricing frequencies and maturity profiles for assets and liabilities may occur at different times. For example, in a falling rate environment, if assets reprice faster than liabilities there will be an initial decline in earnings. Moreover, if assets and liabilities reprice at the same time, they may not be by the same increment. For instance, if the Federal funds rate increased 50 bps, demand deposits may rise by 10 bps, whereas prime based loans will instantly rise 50 bps.
Monthly evaluations, monitoring and management of interest rate risk (including market risk, mismatch risk and basis risk) compare our most likely rate scenario, base case, with various earnings simulations using many interest rate scenarios. These scenarios differ in the direction of interest rate changes, the degree of change over time, the speed of change and the projected shape of the yield curve. These results are prepared by the Company’s Treasury department and presented to the ALCO each month for further consideration. The Company does not have a significant amount of derivative instruments.
Financial instruments do not respond in a parallel fashion to rising or falling interest rates. This causes asymmetry in the magnitude of changes in net interest income and net economic value resulting from the hypothetical increases and decreases in rates. It is therefore mandatory to monitor interest rate risk and adjust our funding strategies to mitigate adverse effects of interest rate shifts on the Company’s balance sheet. While derivative instruments are effective hedging tools, the Company has been successful at maintaining its interest rate risk profile within policy limits strictly from pro-active deposit pricing and funding strategies. In the future, however, other strategies may be implemented to manage interest rate risk. These strategies may include, but may not be limited to, utilizing interest rate derivatives, buying or selling loans or securities, extending maturities of borrowings and deposits and entering into other interest rate risk management instruments and techniques.
For detailed of evaluating net interest income and economic value of equity discussion is in Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” beginning on page 75.
CRITICAL ACCOUNTING POLICIES
A number of critical accounting policies are used in the preparation of the Company’s consolidated financial statements. The Company’s accounting policies for significant balance sheet and statement of operation accounts are disclosed in Note 1, “Summary of Significant Accounting Policies” to the Consolidated Financial Statements beginning on page 87. Management believes that a number of these are critical to the understanding of the Company’s financial condition and results of operation because they involve estimates, judgment, or are otherwise less subject to precise measurement and because the quality of the estimates materially impact those results. This section is intended (1) to identify those critical accounting policies used in the preparation of the Consolidated Financial Statements; (2) to clarify the methodology used in determining these estimates; (3) to identify assumptions used in determining these estimates; and (4) to provide insight to the potential impact those estimates have on the presentation of the Company’s financial condition, changes in financial condition and results of operations.
The preparation of Consolidated Financial Statements in accordance with Generally Accepted Accounting Principles (“GAAP”) requires Management to make certain estimates and assumptions that affect the amounts of reported assets and liabilities as well as contingent assets and liabilities as of the date of these financial statements. Some of these critical estimates concern past events that are uncertain or otherwise not subject to direct measurement. Others involve predictions regarding future
events. As events occur and these estimates and assumptions are confirmed or are shown to require adjustment, they affect the reported amounts of revenues and expenses during the reporting period(s). Although Management believes these estimates and assumptions to be reasonably accurate, actual results may differ.
These critical accounting policies include:
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Allowance for loan losses
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Accounting for income taxes
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Goodwill and other intangible assets
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RAL and RT Programs
Allowance for loan losses
Credit risk is inherent in the business of extending loans and leases to borrowers. The Company establishes an estimated reserve for these inherent loan losses and records the change in this estimate through charges to current period earnings. These charges are recorded as provision for loan losses. All specifically identifiable and quantifiable losses are charged off against the allowance when realized. The allowance for loan losses is Management’s estimate of loan losses inherent within the loan portfolio at each balance sheet date.
The Company formally determines the adequacy of the allowance on a quarterly basis. This determination is based on the periodic assessment of the credit quality or “grading” of loans. Loans are initially graded when originated. Loans are re-graded at renewal, when identified facts demonstrate change in risk of nonpayment, or if the loan becomes delinquent. Re-grading of larger problem loans will occur at least quarterly.
After reviewing the grades in the loan portfolio, the second step is to assign or allocate a portion of the allowance to groups of loans and to individual loans to cover Management’s estimate of the loss that may be present in these loans. The estimation of probable losses takes into consideration the loan grade and other factors such as:
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loan balances
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loan pool segmentation
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historical loss analysis
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identification, review, and valuation of impaired loans
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change in the economy upon the lending activities
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change in the concentrations of the lending activities
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change in the growth of the lending activities
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change in the delinquencies and classified loan trends of the lending activities
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change in the control environments upon the lending activities
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change in the management and staffing effectiveness upon the lending activities
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change in the loan review effectiveness upon the lending activities
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change in the underlying collateral values upon the lending activities
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change in the competition/regulatory/legal issues upon the lending activities
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change related to unanticipated events upon the lending activities
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change and additional valuation for structured financing and syndicated national credits
GAAP, banking regulations, and sound banking practices require that the Company record this estimate of unrecognized losses in the form of an allowance for loan losses. When loans are determined to be uncollectible, losses are recognized and accounted for as charge-offs against this allowance. A secured consumer loan which includes residential real estate loans that are 120 days past due will be charged-off down to the fair value of the collateral. If a consumer loan is unsecured, after the loan is 120 days past due, the loan will be charged-off. For commercial Loans, these would include commercial and industrial loans and loans secured by commercial real estate, as soon as deterioration of the borrower’s credit quality is identified, the loan is put on nonaccrual. If the commercial loan is secured, the loan is charged-off down to the collateral’s fair value. When the Company recovers an amount on a loan previously charged-off, the recovery increases the amount of allowance for loan losses.
Accounting for Income Taxes
The Company is subject to the income tax laws of the U.S. and those states and municipalities in which it has business operations. These tax laws are complex and subject to different interpretations by the taxpayer and the relevant governmental taxing authorities. The Company must make judgments and interpretations about the application of these inherently complex tax laws when determining the provision for income taxes. Disputes over interpretations of the tax laws may be settled with the taxing authorities upon examination or audit.
The Company regularly assesses the likelihood of assessments in each of the taxing jurisdictions resulting from current and subsequent years’ examinations. In accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”, the Company is required to establish reserves for potential losses that may arise from tax audits. The Company has determined that no such reserves are required at this time.
See Notes 16, “Income Taxes” of the Consolidated Financial Statements for additional information relating to income taxes.
Goodwill and Other Intangible Assets
When a Company acquires a business the purchased assets and liabilities are recorded at fair value and intangible assets are identified. The fair value of most financial assets and liabilities are determined by estimating the discounted anticipated cash flows from or for the instrument using current market rates applicable to each asset and liability. Excess of consideration paid to acquire a business over the fair value of the net assets is recorded as goodwill.
At a minimum, Management is required to assess goodwill and other intangible assets annually for impairment. The goodwill impairment calculation is an estimate subject to ongoing review as certain circumstances may cause additional impairment to be assessed in the future. The assessment of goodwill involves reviewing the capitalized earnings of each reporting unit, the outlook of the current economic environment, the transaction multiples of publicly traded financial institutions adjusted for a change in control, estimating cash flows for future periods and estimating the fair value of the reporting unit to which the goodwill is allocated. When the fair value of a reporting unit is less than its carrying value, the Company is required to utilize a Step 2 valuation approach in accordance with SFAS 142.
The Step 2 valuation approach compares the carrying value to the fair values of the underlying tangible and intangible assets and liabilities for purposes of calculating the fair value of goodwill. This process is
the same as when the Company purchases another Company in accordance with SFAS 141, Business Combinations (“SFAS 141”). SFAS 141 provides guidance for allocating the purchase price to assets and liabilities and identifying and qualifying intangible assets.
During the third quarter of 2008, the Company was required to go to Step 2 in accordance with SFAS 142, Goodwill and Other Intangible Assets (“SFAS 142”) for the Commercial Banking segment and this resulted in a $22.1 million goodwill impairment recorded in the third quarter of 2008. The largest component of the Step 2 approach was the valuation of the loan portfolio. When valuing the loan portfolio, there were several factors utilized in calculating the valuation. These factors were the present value of discounted cash flows for the underlying loans based on the contractual terms, prepayments of the scheduled cash flows, discount rates in the current market for the loans, the cost of funds to fund the loans, servicing costs, credit and non-performance risk and liquidity of the underlying loans in the current market.
During the fourth quarter of 2008 and continuing into 2009, our stock price, along with the stock prices of other public regional banking institutions, declined significantly and resulted in a decrease in the Company’s market capitalization subsequent to our annual goodwill impairment testing date. Although changes in market capitalization generally serve as a reasonable indicator of the changes in the aggregate estimated fair value of the reporting units of the Company does not believe that the most recent decline in our market capitalization is indicative or representative of any further potential goodwill impairment. Management believes this decline is primarily attributable to the general adverse conditions in the U.S. and international financial markets, unprecedented lack of liquidity, uncertainty regarding future economic policy and banking regulation changes, and negative market sentiment towards the banking industry in general. Accordingly, Management assessed goodwill for impairment during the fourth quarter of 2008 and concluded that there is no further impairment at December 31, 2008.
A discussion of the Company’s goodwill and other intangible assets is discussed under “Management’s Discussion and Analysis of Financial Condition and Results of Operations: Non-Interest Expenses-Goodwill Impairment“- earlier in this document, and in Note 10, “Goodwill and Other Intangible Assets” of the Consolidated Financial Statements.
RAL and RT Programs
RAL Interest Income
RAL interest income varies based on the amount of the loan and not the time the loan is outstanding. The larger the loan, the larger the amount at risk from nonpayment and therefore the fee varies by the amount of funds advanced due to the increased credit risk rather than the length of time that the loan is outstanding. Nonetheless, because the customer signs a loan application and note, the Company reports the fees as interest income.
RT Fees
When customers do not choose or do not qualify for a RAL, they may still benefit from an expedited payment of their income tax refund. An RT is an electronic transfer of an income tax refund directly to the taxpayer. The Company acts as a conduit from the IRS to the taxpayer enabling an expedited delivery of the taxpayer’s income tax refund. There is no credit risk or borrowing cost for the Company because RTs are only delivered to the taxpayer upon receipt of the refund directly from the IRS. Payment of an RT is made in one of two ways. The Company either authorizes the tax preparer to provide a check directly to the taxpayer or the Company deposits the refund into a taxpayer’s account. Fees earned on RTs are recognized as fee income within non-interest income.
Refund Anticipation Loan Securitization
The Company has utilized a securitization facility for the last seven years for RALs but will not be using one for the 2009 RAL season. The securitization is active only during the first quarter and terminated prior to the end of the first quarter, there are no balances, retained interests, or servicing assets to be accounted for or disclosed December, 31. There are no balances related to RALs, securitized or otherwise, recorded on the balance sheet at December 31 of each year.
The Company sold some of its RALs through a securitization each year during the months of January and February. The Bank accounted for these sales in accordance with the provisions of SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” To be accounted for as a sale, SFAS 140 requires that (1) assets transferred be isolated from the transferor-put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership; (2) each transferee has the right to pledge or exchange the assets it received; and (3) the transferor does not maintain control over the transferred assets through either (i) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or (ii) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call.
The first requirement of SFAS 140 is satisfied through the sale of the RALs from the Company to a wholly-owned subsidiary of the Bank, SBBT RAL Funding Corp. This special purpose entity will then sell the loans to other banks. By the structure of the purchase agreements between the Bank and this special purpose entity, the ability of the Company or its creditors to reach the assets is judged to be remote. This conclusion is supported by a legal opinion obtained each year by the Company. The second requirement of SFAS 140 is satisfied because the purchase agreements with SBBT RAL Funding Corp. and the other banks give such other banks the right to pledge or exchange the RALs. The third requirement of SFAS 140 is satisfied because there is no requirement that the Company repurchase RALs other than those that did not meet the underwriting criteria in the purchase agreement and were therefore inadvertently included among the sold loans.
The Company has concluded that the loan sales satisfy the criteria for sale treatment under SFAS 140.
All loans sold into the securitization are either fully repaid or repurchased by the Bank at the termination of the securitization in mid-February of each calendar year consistent with the terms of the Securitization Agreement. At March 31, these repurchased loans are reported in the balance sheet as RAL loans and become subject to the same charge-off criteria as RALs retained on the balance sheet since origination. As such, charge-offs and recoveries are recorded through the allowance for loan losses subsequent to the end of the first quarter of each calendar year.
Loans sold through the securitization are subject to more strict underwriting criteria and their historical loss rates are lower.
REGULATION AND SUPERVISION
General
The Company and its subsidiaries are extensively regulated and supervised under both Federal and certain State laws. Regulation and supervision by Federal or State banking agencies is intended primarily for the protection of depositors and the Deposit Insurance Fund (“DIF”) administered by the FDIC and not for the benefit of Company shareholders. Set forth below is a summary description of key laws and regulations which relate to the Company’s operations. These descriptions are qualified in their entirety by reference to the applicable laws and regulations. The federal and state agencies regulating the financial services industry also frequently adopt changes to their regulations and implementing policies.
The Company
As a bank holding company, the Company is subject to regulation and examination by the FRB under the Bank Holding Company Act of 1956, as amended, (“BHCA”). The Company is required to file with the FRB periodic reports and such additional information as the FRB may require.
The FRB may require the Company to terminate an activity or terminate control of or liquidate or divest certain subsidiaries, affiliates or investments if the FRB believes the activity or the control of the subsidiary or affiliate constitutes a significant risk to the financial safety, soundness or stability of any bank subsidiary. The FRB also has the authority to regulate provisions of certain bank holding company debt, including the authority to impose interest ceilings and reserve requirements on such debt. Under certain circumstances, the Company must file written notice and obtain FRB approval prior to purchasing or redeeming its equity securities. Further, the Company is required by the FRB to maintain certain levels of capital.
The Company is required to obtain prior FRB approval for the acquisition of more than 5% of the outstanding shares of any class of voting securities or substantially all of the assets of any bank or bank holding company. Prior FRB approval is also required for the merger or consolidation of a bank holding company with another bank holding company. Similar state banking agency approvals may also be required. Certain competitive, management, financial and other factors are considered by the bank regulatory agencies in granting these approvals.
With certain exceptions, bank holding companies are prohibited from acquiring direct or indirect ownership or control of more than 5% of the outstanding voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or furnishing services to subsidiaries. However, subject to prior notice or FRB approval, bank holding companies may engage in, or acquire shares of companies engaged in, those nonbanking activities determined by the FRB to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.
FRB regulations require that bank holding companies serve as a source of financial and managerial strength to subsidiary banks and commit resources as necessary to support each subsidiary bank. A bank holding company’s failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the FRB to be an unsafe and unsound banking practice or a violation of FRB regulations or both. The FRB’s bank holding company rating system also emphasizes risk management and evaluation of the potential impact of nondepository entities on safety and soundness.
Securities Registration
The Company’s securities are registered with the SEC under the Exchange Act of 1934, as amended. As such, the Company is subject to the information, proxy solicitation, insider trading, corporate governance, and other requirements and restrictions of the Exchange Act.
The Sarbanes-Oxley Act
The Company is subject to the accounting oversight and corporate governance requirements of the Sarbanes-Oxley Act of 2002, including:
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required executive certification of financial presentations;
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increased requirements for board audit committees and their members;
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enhanced disclosure of controls and procedures and internal control over financial reporting;
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enhanced controls on, and reporting of, insider trading; and
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increased penalties for financial crimes and forfeiture of executive bonuses in certain circumstances.
The Bank
The Bank, as a nationally chartered bank, is subject to primary supervision, periodic examination, and regulation by the OCC. To a lesser extent, the Bank is also subject to certain regulations promulgated by the FRB. If, as a result of an examination of the Bank, the OCC should determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, or other aspects of the Bank’s operations are unsatisfactory or that the Bank or its Management is violating or has violated any law or regulation, the OCC and separately the FDIC as insurer of the Bank’s deposits, have the authority to:
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require affirmative action to correct any conditions resulting from any violation or practice
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direct an increase in capital and establish higher minimum capital ratios
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restrict the Bank’s growth geographically, by products and services or by mergers and acquisitions
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enter into informal nonpublic or formal public memoranda of understanding or written agreements; enjoin unsafe and unsound practices and issue cease and desist orders to take corrective action
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remove officers and directors and assess civil monetary penalties
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take possession and close and liquidate the Bank.
Various requirements and restrictions under the laws of the State of California and Federal banking laws and regulations affect the operations of the Bank. State and Federal statues and regulations relate to many aspects of the Bank’s operations, including reserves against deposits, ownership of deposit accounts, interest rates payable on deposits, loans, investments, mergers and acquisitions, borrowings, dividends, locations of branches and other offices and capital requirements. Furthermore, the Bank is required to maintain certain levels of capital. The regulatory capital requirements, as well as the actual capitalization ratios for PCBNA and for the Company on a consolidated basis as of December 31, 2008 are presented in detail in Note 20, “Regulatory Requirements” in the Consolidated Financial Statements. Also refer to “Capital Resources” discussion starting on page 57 within the MD&A of this 10-K. As of December 31, 2008 both the Company and PCBNA exceeded the minimum capital requirements to be considered “well capitalized”.
In September, 2007, the SEC and the FRB finalized joint rules required by the Financial Services Regulatory Relief Act of 2006 to implement exceptions provided for in the Gramm-Leach-Bliley Act of 1999 (“GLBA”) for securities activities which banks may conduct without registering with the SEC as a securities broker or moving such activities to a broker-dealer affiliate. The FRB’s final Regulation R provides exceptions for networking arrangements with third party broker dealers and authorizes compensation for bank employees who refer and assist retail and high net worth bank customers with their securities, including sweep accounts to money market funds, and with related trust, fiduciary, custodial and safekeeping needs. The final rules, which will not be effective until 2009, are not expected to have a material effect on the current securities activities which the Bank and its subsidiaries now conduct for customers.
Dividends and Other Transfer of Funds
The Company is a legal entity separate and distinct from the Bank. The Company’s ability to pay cash dividends is limited by California law. Under California law, our shareholders may receive dividends
when and as declared by the Board of Directors out of funds legally available for such purpose. With certain exceptions, a California corporation may not pay a dividend to its shareholders unless (i) its retained earnings equal at least the amount of the proposed dividend, or (ii) after giving effect to the dividend, the corporation’s assets would equal at least 1.25 times its liabilities and, for corporations with classified balance sheets, the current assets of the corporation would be at least equal to its current liabilities or, if the average of the earnings of the corporation before taxes on income and before interest expense for the two preceding fiscal years was less than the average of the interest expense of the corporation for those fiscal years, at least equal to 1.25 times its current liabilities.
Dividends from the Bank constitute the principal source of income to the Company. The Bank is subject to various statutory and regulatory restrictions on its ability to pay dividends. Under such restrictions, the amount available for payment of dividends to the Company by the Bank without prior regulatory approval totaled $276.9 million at December 31, 2008. In addition, the banking agencies have the authority to prohibit the Bank from paying dividends, depending upon the Bank’s financial condition, if such payment is deemed to constitute an unsafe or unsound practice. Furthermore, under the Federal Prompt Corrective Action regulations, the FRB may prohibit a bank holding company from paying any dividends if the holding company’s bank subsidiary is classified as “undercapitalized.”
Additionally, it is FRB policy that bank holding companies should generally pay dividends on common stock only out of income available over the past year, and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. It is also FRB policy that bank holding companies should not maintain dividend levels that undermine the company’s ability to be a source of strength to its banking subsidiaries. In consideration of the current financial and economic environment, the FRB has indicated that bank holding companies should carefully review their dividend policy and has discouraged payment ratios that are at maximum allowable levels unless both asset quality and capital are very strong.
Under the terms of the TARP CPP, for so long as any Series B Preferred Stock remains outstanding, the Company is permitted to declare and pay dividends on its common stock only if all accrued and unpaid dividends for all past dividend periods on the Series B Preferred Stock are fully paid. Until the third anniversary of the sale of the Series B Preferred Stock, unless such shares have been transferred by the U.S. Treasury or redeemed in whole, any increase in dividends on the Company’s common stock above the amount of the last quarterly cash dividend per share declared prior to October 14, 2008 ($0.22 per share) will require prior approval of the U.S. Treasury. The terms of the Company’s agreement with the U.S. Treasury allow for additional restrictions, including those on dividends, to be imposed by the U.S. Treasury, including unilateral amendments required to comply with legislative changes. Under the ARRA, the Company may repay the U.S. Treasury without penalty and without the need to raise new capital, subject to the U.S. Treasury’s consultation with the appropriate regulating agency, in which event these restrictions would no longer apply. The Company could also consider participating in the Capital Assistance Program.
Capital Requirements
At December 31, 2008, the Company and the Bank’s capital ratios exceed the minimum percentage requirements for “well capitalized” institutions. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations; Capital Resources” and Note 20, “Regulatory Capital Requirements” of the Consolidated Financial Statements for further information regarding the regulatory capital guidelines as well as the Company’s and the Bank’s actual capitalization as of December 31, 2008.
The Federal banking agencies have adopted risk-based minimum capital guidelines for bank holding companies and banks which are intended 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 which are recorded as off-balance sheet items. The risk-based capital ratio is determined by classifying assets and certain off-balance sheet financial instruments into weighted categories, with higher levels of capital being required for those categories perceived as representing greater risk. Under the capital guidelines, a banking organization’s total capital is divided into tiers. “Tier I capital” includes common equity and trust-preferred securities, subject to certain criteria and quantitative limits. The Series B Preferred Stock issued in conjunction with the TARP CPP also qualifies as Tier 1 Capital. The risk-based capital guidelines require a minimum ratio of qualifying total capital to risk-adjusted assets of 8% and a minimum ratio of Tier I capital to risk-adjusted assets of 4%.
An institution’s risk-based capital, leverage capital and tangible capital ratios together determine the institution’s capital classification. An institution is treated as well capitalized if its total capital to risk-weighted assets ratio is 10.00% or more; its core capital to risk-weighted assets ratio is 6.00% or more; and its core capital to adjusted total assets ratio is 5.00% or more and the institution is not subject to any written agreement, order, capital directive or prompt corrective action directive to meet and maintain a specific capital level for any capital measure. In addition to the risk-based guidelines, the Federal bank regulatory agencies require banking organizations to maintain a minimum amount of Tier I capital to total assets, referred to as the leverage ratio. For a banking organization rated “well-capitalized,” the minimum leverage ratio of Tier I capital to total assets must be 3%.
The current risk-based capital guidelines are based upon the 1988 capital accord of the International Basel Committee on Banking Supervision. A new international accord, referred to as Basel II, which emphasizes internal assessment of credit, market and operational risk; supervisory assessment and market discipline in determining minimum capital requirements, became mandatory for large international banks outside the U.S. in 2008, and is optional for others, and must be complied with in a “parallel run” for two years along with the existing Basel I standards. In January 2009, the Basel Committee proposed to reconsider regulatory-capital standards, supervisory and risk-management requirements and additional disclosures in the final new accord in response to recent worldwide developments.
In July 2008, the U.S. Federal banking agencies issued a proposed rule that would give banking organizations, which do not use the Basel II advanced approaches, the option to implement a new risk-based capital framework. This framework would adopt the standardized approach of Basel II for credit risk, the basic indicator approach of Basel II for operational risk, and related disclosure requirements. While this proposed rule generally parallels the relevant approaches under Basel II, it diverges where United States markets have unique characteristics and risk profiles, most notably with respect to risk weighting residential mortgage exposures. A definitive final rule has not been issued. The U.S. banking agencies have indicated, however, that they will retain the minimum leverage requirement for all U.S. banks.
The Federal Deposit Insurance Act (“FDI Act”) gives the Federal banking agencies the additional broad authority to take “prompt corrective action” to resolve the problems of insured depository institutions that fall within any undercapitalized category, including requiring the submission of an acceptable capital restoration plan. The Federal banking agencies have also adopted non-capital safety and soundness standards to assist examiners in identifying and addressing potential safety and soundness concerns before capital becomes impaired. The guidelines set forth operational and managerial standards relating to: (i) internal controls, information systems and internal audit systems, (ii) loan documentation, (iii) credit underwriting, (iv) asset quality and growth, (v) earnings, (vi) risk management, and (vii) compensation and benefits.
FDIC Deposit Insurance
The FDIC is an independent federal agency that insures deposits, up to prescribed statutory limits, of federally insured banks and savings institutions and safeguards the safety and soundness of the banking and savings industries. The FDIC insures the Bank’s customer deposits through the DIF up to prescribed limits for each depositor. Pursuant to the EESA, the maximum deposit insurance amount has been increased from $100,000 to $250,000 through 2009. The amount of FDIC assessments paid by each DIF member institution is based on its relative risk of default as measured by regulatory capital ratios and other supervisory factors. Pursuant to the Federal Deposit Insurance Reform Act of 2005, the FDIC is authorized to set the reserve ratio for the DIF annually at between 1.15% and 1.50% of estimated insured deposits. The FDIC may increase or decrease the assessment rate schedule on a semi-annual basis. In an effort to restore capitalization levels and to ensure the DIF will adequately cover projected losses from future bank failures, the FDIC, in October 2008, proposed a rule to alter the way in which it differentiates for risk in the risk-based assessment system and to revise deposit insurance assessment rates, including base assessment rates. First quarter 2009 assessment rates were increased to between 12 and 50 cents for every $100 of domestic deposits, with most banks paying between 12 and 14 cents.
On February 27, 2009, the FDIC approved an interim rule to institute a one-time special emergency assessment of 20 cents per $100 in domestic deposits on June 30, 2009, to be collected by September 30, 2009, to restore the DIF reserves depleted by recent bank failures. The interim rule also permits the FDIC to impose an additional special emergency assessment after June 30, 2009 of up-to-10 basis points, if necessary. The FDIC also adopted amendments to its restoration plan for the DIF to implement changes to the risk-based assessment system and set assessment rates to provide that most banks will now pay initial base rates ranging from 12 cents per $100 to 16 cents per $100 on an annual basis, beginning on April 1, 2009. Changes to the assessment system include higher rates for institutions that rely significantly on secured liabilities, which may increase the FDIC’s loss in the event of failure without providing additional assessment revenue. Assessments will also be higher for institutions that rely significantly on brokered deposits but, for well-managed and well-capitalized institutions, only when accompanied by rapid asset growth.
Additionally, by participating in the FDIC’s Temporary Liquidity Guarantee Program, banks temporarily become subject to an additional assessment on deposits in excess of $250,000 in certain transaction accounts and additionally for assessments from 50 basis points to 100 basis points per annum depending on the initial maturity of the debt. Further, all FDIC-insured institutions are required to pay assessments to the FDIC to fund interest payments on bonds issued by the Financing Corporation (“FICO”), an agency of the Federal government established to recapitalize the predecessor to the DIF. The FICO assessment rates, which are determined quarterly, averaged 0.0113% of insured deposits in fiscal 2008. These assessments will continue until the FICO bonds mature in 2017.
The FDIC may terminate a depository institution’s deposit insurance upon a finding that the institution’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices that pose a risk to the DIF or that may prejudice the interest of the bank’s depositors. The termination of deposit insurance for the Bank would also result in the revocation of the Bank’s charter by the OCC.
Loans-to-One Borrower Limitations
With certain limited exceptions, the maximum amount of obligations, secured or unsecured, that any borrower (including certain related entities) may owe to a national bank at any one time may not exceed 15% of the unimpaired capital and surplus of the Bank, plus an additional 10%, of unimpaired capital and surplus for loans fully secured by readily marketable collateral. The Bank has established internal loan limits which are lower than these legal lending limits. At December 31, 2008, PCBNA’s loans-to-one-borrower limit was $115.7 million based upon the 15% of unimpaired capital and surplus measurement.
Extensions of Credit to Insiders and Transactions with Affiliates
The Federal Reserve Act and FRB Regulation O place limitations and conditions on loans or extensions of credit to:
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a bank or bank holding company’s executive officers, directors and principal shareholders (i.e., in most cases, those persons who own, control or have power to vote more than 10% of any class of voting securities);
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any company controlled by any such executive officer, director or shareholder; or
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any political or campaign committee controlled by such executive officer, director or principal shareholder.
Such loans:
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must comply with loan-to-one-borrower limits
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require prior full board approval when aggregate extensions of credit to the person exceed specified amounts
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must be made on substantially the same terms (including interest rates and collateral) and follow credit-underwriting procedures no less stringent than those prevailing at the time for comparable transactions with non-insiders
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must not involve more than the normal risk of repayment or present other unfavorable features
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must in the aggregate not exceed the bank’s unimpaired capital and unimpaired surplus.
The Bank also is subject to certain restrictions imposed by Federal Reserve Act Sections 23A and 23B and FRB Regulation W on any extensions of credit to, or the issuance of a guarantee or letter of credit on behalf of, any affiliates, the purchase of, or investments in, stock or other securities thereof, the taking of such securities as collateral for loans, and the purchase of assets of any affiliates. Affiliates include parent holding companies, sister banks, sponsored and advised companies, financial subsidiaries and investment companies whereby the Bank’s affiliate serves as investment advisor. Sections 23A and 23B and Regulation W generally:
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prevent any affiliates from borrowing from the Bank unless the loans are secured by marketable obligations of designated amounts
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limit such loans and investments to or in any affiliate individually to 10.0% of the Bank’s capital and surplus
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limit such loans and investments to or in any affiliate in the aggregate to 20.0% of the Bank’s capital and surplus
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require such loans and investments to or in any affiliate to be on terms and under conditions substantially the same or at least as favorable to the Bank as those prevailing for comparable transactions with nonaffiliated parties.
Additional restrictions on transactions with affiliates may be imposed on the Bank under the FDI Act prompt corrective action provisions and the supervisory authority of the Federal and State banking agencies.
USA PATRIOT Act and Anti-Money Laundering Compliance
The USA PATRIOT Act of 2001 and its implementing regulations significantly expanded the anti-money laundering and financial transparency laws, including the Bank Secrecy Act. The Bank has adopted comprehensive policies and procedures to address the requirements of the USA PATRIOT Act. Material deficiencies in anti-money laundering compliance can result in public enforcement actions by the banking agencies, including the imposition of civil money penalties and supervisory restrictions on growth and expansion. Such enforcement actions could also have serious reputation consequences for the Company and the Bank.
Consumer Laws
The Bank and the Company are subject to many Federal and State consumer protection statutes and regulations and laws prohibiting unfair or fraudulent business practices, untrue or misleading advertising and unfair competition, including:
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The Home Ownership and Equity Protection Act of 1994, or (“HOEPA”), requires extra disclosures and consumer protections to borrowers from certain lending practices, such as practices deemed to be “predatory lending.”
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Privacy policies are required by Federal and State banking laws regulations which limit the ability of banks and other financial institutions to disclose nonpublic information about consumers to nonaffiliated third parties.
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The Fair Credit Reporting Act, as amended by the Fair and Accurate Credit Transactions Act, or the “FACT Act”, requires financial firms to help deter identity theft, including developing appropriate fraud response programs, and gives consumers more control of their credit data.
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The Equal Credit Opportunity Act, or (“ECOA”), generally prohibits discrimination in any credit transaction, whether for consumer or business purposes, on the basis of race, color, religion, national origin, sex, marital status, age (except in limited circumstances), receipt of income from public assistance programs, or good faith exercise of any rights under the Consumer Credit Protection Act.
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The Truth in Lending Act, or (“TILA”), requires that credit terms be disclosed in a meaningful and consistent way so that consumers may compare credit terms more readily and knowledgeably.
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The Fair Housing Act regulates many lending practices, including making it unlawful for any lender to discriminate in its housing-related lending activities against any person because of race, color, religion, national origin, sex, handicap or familial status.
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The CRA, requires insured depository institutions, while operating safely and soundly, to help meet the credit needs of their communities; directs the Federal regulatory agencies, in examining insured depository institutions, to assess a bank’s record of helping meet the credit needs of its entire community, including low- and moderate-income neighborhoods, consistent with safe and sound banking practices and 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, mergers or acquisitions, or holding company formations. In its last examination for CRA compliance, as of September 11, 2007, the Bank was rated “outstanding.”
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The Home Mortgage Disclosure Act, or “HMDA”, includes a “fair lending” aspect that requires the collection and disclosure of data about applicant and borrower characteristics as a way of identifying possible discriminatory lending patterns and enforcing anti-discrimination statutes.
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The Real Estate Settlement Procedures Act, or “RESPA”, requires lenders to provide borrowers with disclosures regarding the nature and cost of real estate settlements and prohibits certain abusive practices, such as kickbacks.
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The National Flood Insurance Act, or “NFIA”, requires homes in flood-prone areas with mortgages from a Federally regulated lender to have flood insurance.
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The Americans with Disabilities Act , in conjunction with similar California legislation, requires employers with 15 or more employees and all businesses operating “commercial facilities” or “public accommodations” to accommodate disabled employees and customers.
These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits, making loans, collecting loans,
and providing other services. Failure to comply with these laws and regulations can subject the Bank to various penalties, including but not limited to enforcement actions, injunctions, fines or criminal penalties, punitive damages to consumers, and the loss of certain contractual rights.
Regulation of Nonbank Subsidiaries
Nonbank subsidiaries may be subject to additional or separate regulation and supervision by other state, federal and self-regulatory bodies.
MCM and REWA, operating subsidiaries of PCBNA, are registered investment advisors subject to regulation and supervision by the SEC. Further, the banking agencies expect banking organizations in their oversight role over functionally regulated subsidiaries, such as registered investment advisors, to assure appropriate controls are maintained that include:
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establishing alternative sources of emergency support from the parent holding company, non-bank affiliates or external third parties prior to seeking support from the bank
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instituting effective policies and procedures for identifying potential circumstances triggering the need for financial support and the process for obtaining such support
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implementing effective controls, including stress testing and compliance reviews
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implementing policies and procedures to ensure compliance with disclosure and advertising requirements to clearly differentiate the investments in advised funds from obligations of the bank or insured deposits
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ensuring proper management, regulatory and financial reporting of contingent liabilities arising out of its investment advisory activities.
The Company and the Bank have taken appropriate action to implement and audit compliance with these requirements.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
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 key risk factors affecting our business are addressed in Item 1A, Risk Factors starting on page 13 of this 10-K. Changes in interest rates can potentially have a significant impact on earnings as well as the Net Interest Income and Economic Value of Equity discussion and graph below.
Net Interest Income (“NII”) and Economic Value of Equity (“EVE”) Simulations
The results of the asset liability model indicate how much of the Company’s net interest income and net economic value are “at risk” (deviation from the base case) from +/- 2% shocks. This exercise is valuable in identifying risk exposures and in comparing the Company’s interest rate risk profile relative to other financial intermediaries.
The EVE and NII results as of December 31, 2008 are displayed in the table below. These figures indicate that the Company’s net interest income at risk over a one-year period and net economic value at risk are well within the adopted ALCO policy ranges.
RATE SENSITIVITY
EVE Summary
Assuming the entire yield curve was to instantaneously increase 200 basis points, our projected EVE at December 31, 2008 would increase by approximately 12.0% from the base. At December 31, 2007 in the up 200 basis point scenario, our EVE was projected to decrease by approximately 9.0% from the base projection. The rates down 200 basis point scenario assumes the yield curve instantaneously decreases 200 basis points where appropriate. When the yield curve is less than 2 percent, the yield curve is assigned a floor of zero. Using this methodology and assuming the entire yield curve shifts down 200 basis points, the projected EVE at December 31, 2008 is forecast to increase by approximately 8.8% from the base. At December 31, 2007, in the down 200 basis point scenario, our EVE was projected to increase by approximately 5.3% from the base projection.
NII Summary
Assuming the entire yield curve was to instantaneously increase 200 basis points, the projected net interest income for the next twelve periods beginning January 1, 2009 would increase by approximately 13.5% from the base projection. At December 31, 2007 in the up 200 basis point scenario, our projected net interest income for the twelve month period beginning January 1, 2008 would have decreased by approximately 3.7% from the base projection. The rates down 200 basis points scenario assumes the yield curve instantaneously decreases 200 basis points where appropriate. When the
yield curve is less than 2 percent, the yield curve is assigned a floor of zero. Using this methodology and assuming the entire yield curve shifts down 200 basis points, our projected net interest income for the twelve month period beginning January 1, 2009 would decrease by approximately 9.3%. At December 31, 2007, in the down 200 basis point scenario, our projected net interest income for the twelve month period beginning January 1, 2008 was projected to decrease by approximately 0.8% from the base projection.
The following have contributed to the improved figures:
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Continuous improvements in the asset liability-modeling tool provides greater granularity and improved cash flow computations.
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The Bank used broker CDs and wholesale funding to pre-fund the 2009 RAL season, as discussed in the Liquidity section above. This strategy provided the Bank the opportunity to secure liquidity during a time of uncertainty and volatile credit markets, but it also had a positive impact on EVE in all scenarios and NII in the plus 200 basis point scenario. By carrying more cash on the balance sheet, the EVE risk was reduced and net interest income increased in the plus 200 scenario.
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The Bank extended the maturities of wholesale borrowings and retail CDs during the fourth quarter of 2008. This had a positive impact on the profile of the EVE and the NII in the plus 200 scenario.
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The Bank sold $81.7 million of fixed rate mortgage loans in the fourth quarter of 2008.
Among the assumptions that have been included in the model are those that address optionality. Management has updated and implemented a more robust process surrounding the following examples of optionality:
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The option customers have to prepay their loans or the decay rate of non maturing deposits;
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The option issuers of some of the securities held by the Company to prepay or call their debt;
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The option of the Company to prepay or call certain types of its debt;
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The option of the Company to reprice its administered deposits.
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Improved incorporation of loan features, including imbedded caps and floors, reset features and other aspects of loan terms and conditions.
Simulation estimates depend on, and will change with the size and mix of the actual and projected balance sheet at the time of each simulation. Management is unaware of any material limitations such that results would not reflect the net interest risk exposures of the Company. Various shortcomings are inherent in both the EVE and NII sensitivity analyses. Certain assumptions may not reflect the manner in which actual yields and costs respond to market changes. Similarly, prepayment estimates and similar assumptions are subjective in nature, involve uncertainties and, therefore, cannot be determined with precision. Changes in interest rates may also affect our operating environment and operating strategies as well as those of our competitors. In addition, certain adjustable rate assets have limitations on the magnitude of rate changes over specified periods of time. Accordingly, although our NII sensitivity analyses may provide an indication of our IRR exposure, such analyses are not intended to and do not provide a precise forecast of the effect of changes in market interest rates on our net interest income and our actual results will differ. There are no material positions, instruments or transactions that are not included in the modeling or included instruments that have special features that are not included.
ITEM 8.
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Audited consolidated financial statements and related documents required by this item are included in this Annual Report on Form 10-K on the pages indicated:
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders of Pacific Capital Bancorp
We have audited the accompanying consolidated balance sheets of Pacific Capital Bancorp and subsidiaries (the “Company”) as of December 31, 2008 and 2007, and the related consolidated statements of operations, comprehensive income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statement. 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pacific Capital Bancorp and subsidiaries at December 31, 2008 and 2007, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Pacific Capital Bancorp’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 26, 2009 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Los Angeles, California
February 26,
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders of Pacific Capital Bancorp
We have audited Pacific Capital Bancorp’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Pacific Capital Bancorp’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 included in the accompanying Management’s Report of Internal Controls Over Financial Reporting. Our responsibility is to express an opinion on 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, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, 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, Pacific Capital Bancorp maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Pacific Capital Bancorp as of December 31, 2008 and 2007 and the related consolidated statements of operations, comprehensive income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008 of Pacific Capital Bancorp and our report dated February 26, 2009 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Los Angeles, CA
February 26, 2009
Pacific Capital Bancorp and Subsidiaries
CONSOLIDATED BALANCE SHEETS
See the accompanying notes.
Pacific Capital Bancorp and Subsidiaries
CONSOLIDATED STATEMENTS OF OPERATIONS
See the accompanying notes.
Pacific Capital Bancorp and Subsidiaries
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Amount of losses reclassified out of accumulated other comprehensive income into earnings for the period was $5.9 million in 2008, $1.1 million in 2007 and $8.6 million in 2006. The income tax benefit related to these losses were $2.5 million, $451,000 and $3.6 million in 2008, 2007, and 2006, respectively.
See the accompanying notes.
Pacific Capital Bancorp and Subsidiaries
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
** The amount recognized as compensation expense related to restricted stock awards was $2.9 million, $4.1 million and $3.7 million in 2008, 2007 and 2006, respectively.
See the accompanying notes.
Pacific Capital Bancorp and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
Pacific Capital Bancorp and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
(continued)
See the accompanying notes.
Pacific Capital Bancorp and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations
PCB is a bank holding company organized under the laws of the state of California. PCB provides a full range of commercial and consumer banking services to households, professionals, and businesses through its wholly-owned subsidiary PCBNA. These banking services include depository, lending and wealth management services. PCBNA’s lending products include commercial, consumer, commercial and residential real estate loans and SBA loans. PCBNA is also one of the largest nationwide providers of financial services related to the electronic filing of income tax returns including the RAL and RT business products. Depository services include checking, interest-bearing checking (“NOW”), money market (“MMDA”), savings, and CD accounts, as well as safe deposit boxes, travelers’ checks, money orders, foreign exchange services, and cashiers checks. PCBNA offers a wide range of wealth management services through the Wealth Management segment which includes two wholly-owned subsidiaries, MCM and REWA and a 20% interest in Veritas. The Wealth Management segment offers a wide range of trust and investment advisory services as well as the same loan and deposit products offered to the Community and Commercial Banking customers.
PCBNA conducts its banking services under five brand names: Santa Barbara Bank & Trust (“SBB&T”), First National Bank of Central California (“FNB”), South Valley National Bank (“SVNB”), San Benito Bank (“SBB”), and First Bank of San Luis Obispo (“FBSLO”). The SBB&T offices are located in Santa Barbara, Ventura and Los Angeles counties. Banking offices are located in eight counties in the central coast of California from Los Angeles to Santa Clara.
Basis of Presentation
The accounting and reporting policies of the Company are in accordance with accounting principles generally accepted in the United States (“GAAP”) and conform to practices within the financial services industry. The accounts of the Company and its consolidated subsidiaries are included in these Consolidated Financial Statements. All significant intercompany balances and transactions have been eliminated.
The accompanying unaudited Consolidated Financial Statements have been prepared in accordance with GAAP. The preparation of financial statements in conformity to GAAP requires management to make estimates and assumptions that affect the amount of assets and liabilities as well as disclosures of contingent assets and liabilities at the date of the financial statements. Although Management believes these estimates to be reasonably accurate, actual amounts may differ. In the opinion of Management, all adjustments considered necessary have been reflected in the financial statements during their preparation.
Certain amounts in the 2007 and 2006 financial statements have been reclassified to be comparable with classifications used in the 2008 financial statements.
Consolidation of Subsidiaries and Variable Interest Entities
PCB has five wholly-owned subsidiaries. PCBNA, a banking subsidiary and four unconsolidated subsidiaries used as business trusts in connection with issuance of trust-preferred securities as described in Note 14, “Long-term Debt and Other Borrowings” of these Consolidated Financials Statements.
PCBNA has four wholly-owned consolidated subsidiaries:
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MCM and REWA, two registered investment advisors that provide investment advisory services to individuals, foundations, retirement plans and select institutional clients.
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SBBT RAL Funding Corp. which is utilized as part of the financing of the RAL program as described in Note 7, “RAL and RT Programs”.
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PCB Service Corporation, utilized as a trustee of deeds of trust in which PCBNA is the beneficiary.
PCBNA also retains ownership in several low-income housing partnerships that generate tax credits. These partnerships are considered variable interest entities and are not consolidated into these Consolidated Financial Statements. The Company has invested $55.9 million in limited partnerships that construct low-income housing. The partnerships generate tax credits for the Company. Generally, the Company’s partnership interests are less than 50% of the total interests. Low-Income Tax Housing Partnerships are not required to be consolidated into the Company’s Consolidated Financial Statements.
In late 2007, Veritas was organized. PCBNA made an initial investment of $250,000 in Veritas. An additional investment of $750,000 was made in late January 2008. Veritas commenced operations in the second quarter of 2008. PCBNA’s variable interest in Veritas includes $1.0 million of equity at risk and an $80,000 loss which accounts for a 20% investment share of Veritas’ for 2008. PCBNA’s share of Veritas’ loss is included in the Company’s Consolidated Financial Statements using the equity method. PCBNA is not the primary beneficiary and therefore the Company has not included 100% of Veritas’ financial results into the Company’s Consolidated Financial Statements.
The Company does not have any other entities that should be considered for consolidation.
Cash Reserve Requirement
All depository institutions are required by law to maintain reserves against their transaction deposits. The reserves must be held in cash or with the FRB for their area. The amount of the reserve may vary each day as banks are permitted to meet this requirement by maintaining the specified amount as an average balance over a two-week period. The average daily cash reserve balances required to be maintained by PCBNA totaled approximately $7.9 million in 2008 and $4.3 million in 2007. In addition, PCBNA must maintain sufficient balances to cover the checks written by bank customers that are clearing through the FRB because they have been deposited at other banks.
Investment Securities
All investments reported by the Company as securities are debt securities. Securities may be classified as held-to-maturity, available-for-sale or trading. The appropriate classification is initially decided at the time of purchase. All securities currently held by the Company are classified as AFS or trading. At December 31, 2008 and 2007, the Company did not hold any of its securities in a held-to-maturity portfolio.
Securities classified as AFS and trading are reported as an asset on the Consolidated Balance Sheets at their estimated fair value. When the fair value of the security portfolio increases, the security balance increases and when the fair value declines, the security balance decreases. As the fair value of AFS securities changes, the changes are reported net of income tax as an element of OCI, except for impaired securities. When AFS securities are sold, the unrealized gain or loss is reclassified from OCI to non-interest income. The changes in the fair value of the trading securities are reported in non-interest income.
When the estimated fair value of a security is lower than the book value, a security is considered to be impaired. In Note 4, “Securities” of these Consolidated Financial Statements, the Company is required to disclose whether the impairment is temporary or other than temporary for all securities held in the AFS portfolio. Quarterly, the Company reviews impaired securities to determine whether the impairment is other than temporary. Factors that would be considered in deciding whether the impairment is other than temporary include:
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the nature of the investment;
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the cause(s) of the impairment;
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the severity and duration of the impairment;
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the strength of the market for the security;
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the length of time the Company intends and is able to hold the security; and
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credit ratings for the security and its sector.
If the impairment is determined to be other than temporary, the Company recognizes the impairment by accounting for the loss in the statement of operations within non-interest income in the period in which the impairment occurs. As explained in Note 4, “Securities” of these Consolidated Financial Statements, in December 2007, Management changed their intent to no longer hold certain MBS held in the AFS portfolio until recovery or maturity. Due to the change of intent by Management, the Company recognized unrealized losses for the AFS MBS portfolio through the statement of operations and unrealized gains through OCI.
Interest income is recognized based on the coupon rate and increased by the accretion of discounts earned or decreased by the amortization of premiums paid over the contractual life of the security using the interest method.
PCBNA is a member of both the FRB and the FHLB and, as a condition of membership in both organizations; it is required to purchase stock. In the case of the FRB, the amount of stock that is required to be held is based on PCBNA’s capital. As PCBNA’s capital increased additional stock in the FRB was required to be purchased. The required ownership of FHLB stock is based on the borrowing capacity used by PCBNA. These investments are considered equity securities with no actively traded market. Therefore, the shares are considered restricted investment securities and reported in other assets in the Consolidated Balance Sheets. Such investments are carried at cost, which is equal to the value at which they may be redeemed. The dividend income received from the stock is reported in other income.
Loans, Interest and Fees from Loans
Interest income on loans is accrued daily. Loan fees collected for the origination of loans less direct loan origination costs (net deferred loan fees) are amortized over the contractual life of the loan through interest income. If a loan has scheduled payments, the amortization of the net deferred loan fee is calculated using the interest method over the contractual life of the loan. If the loan does not have scheduled payments, such as a line of credit, the net deferred loan fee is recognized as interest income on a straight-line basis over the contractual life of the loan commitment. Loan fees received for loan commitments are recognized as interest income over the term of the commitment. When loans are repaid any remaining unamortized balances of unearned fees, deferred fees and costs and premiums and discounts paid on purchased loans are accounted for through interest income.
The Company generally holds loans for investment and has the intent and ability to hold loans until their maturity and therefore, they are reported at book value. Periodically, the Company identifies loans
it expects to sell prior to maturity. When loans are identified to be sold, they are reclassified as held for sale and reported at the lower of cost or fair value in the Consolidated Balance Sheets. Included in a loan’s cost are unearned deferred fees and costs and credit discounts specifically relating to the loans held for sale. At December 31, 2008 and 2007, the Company had $11.1 million and $68.3 million, respectively of loans classified as held for sale. Additional information regarding loans classified as held for sale is disclosed in Note 5, “Loans” of these Consolidated Financial Statements.
In September 2008, the Bank started originating mortgage loans for sale. When a mortgage loan is originated for sale, the loan is segregated from the mortgage loans originated for investment. The loans are segregated due to the short period of time they are held and therefore no allowance for loan loss, deferred fees or expenses are reported for loans held for sale. The loans are generally held for less than thirty days. If a loan has been reported as held for sale for more than 60 days, the loan is reclassified as a loan held for investment. Some of the loan commitments which the Bank plans to sell also have interest rate lock commitments for approximately 30 days with potential borrowers. The mortgage rate lock agreements with borrowers qualify as derivatives under Statement of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended (“SFAS 133”). The value of these derivatives is nominal as rate lock commitments are entered into at current market rates. The Bank does not collect a fee for these interest rate locks. These mortgage rate lock commitments are not material the Company’s Consolidated Financial Statements and, therefore are not recorded. At December 31, 2008 the Company had $18.7 million in notional outstanding mortgage loan rate lock commitments.
Nonaccrual Loans: When a borrower discontinues making payments as contractually required by the note, the Company must determine whether it is appropriate to continue to accrue interest. Generally, the Company places loans in a nonaccrual status and ceases recognizing interest income when the loan has become delinquent by more than 90 days and/or when Management determines that the repayment of principal and collection of interest is unlikely. The Company may decide that it is appropriate to continue to accrue interest on certain loans more than 90 days delinquent if they are well secured by collateral and collection is in process.
When a loan is placed in a nonaccrual status, any accrued but uncollected interest for the loan is reversed out of interest income in the period in which the status is changed. Subsequent payments received from the customer are applied to principal and no further interest income is recognized until the principal has been paid in full or until circumstances have changed such that payments are again consistently received as contractually required. In the case of commercial customers, the pattern of payment must also be accompanied by a positive change in the financial condition of the borrower.
Impaired Loans: A loan is identified as impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. Most impaired loans are classified as nonaccrual. However, there are some loans that are termed impaired because of doubt regarding collectibility of interest and principal according to the contractual terms, but are both fully secured by collateral and are current in their interest and principal payments. These impaired loans are not classified as nonaccrual. A valuation allowance is established for an impaired loan when the fair value of the loan is less than the recorded investment. The Bank determines a loan is impaired in accordance with SFAS 114 utilizing the fair value of the collateral for collateral dependent loans or an analysis of the discounted cash flows.
Troubled Debt Restructured Loans: A loan is restructured when the Bank determines that a borrower’s financial condition has deteriorated but, still has the ability to repay the loan. A loan is considered restructured when the original terms have been modified in favor of the borrower or either principal or interest has been forgiven.
Prepayments: Borrowers may prepay their loans before their contractual maturity. When interest rates are declining, the Company expects the rate of prepayments to increase. Changes in the rate of prepayments impact the amortization of deferred origination fees and costs. The Company recognizes the remaining unamortized amounts into interest income when a loan prepays before the contractual maturity.
RAL and RT Programs
RALs
RALs are short-term consumer loans offered to taxpayers, secured by their anticipated tax refund and subject to an underwriting process prior to approval. At the request of the taxpayer, the refund claim is paid by the IRS to the Bank once the tax return has been processed. This constitutes the source of repayment of the RAL. Funds received from the IRS above the sum of the RAL less associated contractual fees are remitted to the taxpayer by the Bank.
The RAL funds advanced by the Bank are generally repaid by the IRS within several weeks. Therefore, the processing costs and provision for loan loss represent the major costs of these loans. This cost structure is different than for other loans since usually the cost of funds is the major cost for the Company in making a loan. Because of RALs short duration, the Bank cannot recover the processing costs through interest calculated over the term of the loan. Consequently, the Bank has structured the fees to have a fixed component to cover processing costs and a variable component to cover loan losses and the cost of funds. The customer signs a promissory note which requires the Company to report fees received for RALs as interest income.
RAL interest income varies based on the amount of the loan and not the term of the loan. The larger the loan, the greater the amount at risk from nonpayment. Therefore, the fee varies to correspond to the increased credit risk rather than the length of time the loan is outstanding.
RTs
An RT is an electronic transfer of an income tax refund directly to the taxpayer. The Company acts as a conduit from the IRS and State tax authorities to the taxpayer enabling an expedited delivery of the taxpayer’s income tax refund. There is no credit risk or borrowing cost for the Company because RTs are only delivered to the taxpayer upon receipt of the refund directly from the IRS. Payment of an RT is made in one of two ways. The Company either authorizes the tax preparer to provide a check directly to the taxpayer or the Company deposits the refund into a taxpayer’s account.
Fees Earned on RALs and RTs
Income from the RAL/RT Programs consists of the fees earned on these products. Fees earned on RALs are reported in interest income while fees earned on RTs are reported in non-interest income. The Company originates these products through three channels: Jackson Hewitt, other professional tax preparers and self filers. Regardless of the program a basic fee per product is charged. The fees charged for the products differ by source due to varying contractual terms. A description of the different fee structures is provided as follows:
JH: Fees charged on RALs offered through JH include an account handling fee and a finance charge equaling a percentage of the loan amount subject to a maximum and minimum. The RT fee is a fixed amount. The amount of fees is not impacted by the amount of charge-offs related to RALs that were originated by JH.
Other Professional Tax Preparers (“PRO”): Fees charged on RALs offered through other professional tax preparers include an account handling fee and a flat fee based on certain tiered loan amounts. The RT fee is a fixed amount.
Self Filers (“PER”): Fees charged on RALs offered through websites used by self filers include a flat fee for certain tiered loan amounts. The RT fee is a fixed amount. The fees charged for RALs varied as each website used by self filers had a different fee structure.
In 2006, the Company and JH entered into two new contracts, a program contract with Jackson Hewitt, Inc. and a technology services contract with Jackson Hewitt Technology Services, Inc. These contracts provided for JH to reduce the proportion of its transactions directed to the Company from approximately the 80% proportion for 2005 to approximately 75% in the 2008 tax season, and changed the method by which JH was compensated for the services it provides to the Company. The fee-splitting arrangement provided for in the earlier contract was eliminated, and, under the new contracts with JH, JH is compensated for services through fixed fees for program and technology services.
The first change in the 2006 JH contracts did not have a significant impact on the number of transactions directed to the Company. The initial reduction was accomplished not on an individual transaction basis, but instead by directing the transactions from specific JH offices to the other bank with whom JH contracts. This reduction in the proportion of transactions directed to the Company did not have an impact on the number of transactions as the growth in the number of transactions done by the offices still directed to the Company were slightly more than the number of transactions originated.
The second change in the 2006 JH contracts had a substantial impact on the amount of revenue, but little impact on pre-tax income as the amount of the fixed fees is approximately equal to what would have been shared with JH under the previous contract. While the “economics” are virtually the same under the new contracts as under the old, the presentation is different. Under the previous contract, the fees were recognized net of the amount of the fee split with JH. Under the new contracts, the whole amount of the revenue from the RALs and RTs is recognized by the Company and the program and technology service fees are shown as expenses.
Refund Anticipation Loan Securitization
The Company generally sells some of its RALs through a securitization each year during the months of January and February. To qualify as a sale, a transfer of assets must meet the criteria of SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishing of Liabilities” (“SFAS 140”). To be accounted for as a sale, SFAS 140 requires that (1) assets transferred be isolated from the transferor-put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership; (2) each transferee has the right to pledge or exchange the assets it received; and (3) the transferor does not maintain control over the transferred assets through either (i) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or (ii) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call.
The first requirement of SFAS 140 is satisfied through the sale of the RALs from the Company to a wholly-owned subsidiary of the Bank, SBBT RAL Funding Corp. This special purpose entity then sells the loans to other banks. By the structure of the purchase agreements between the Bank and this special purpose entity, the ability of the Company or its creditors to reach the assets is judged to be remote. This conclusion is supported by a legal opinion obtained each year by the Company.
The second requirement of SFAS 140 is satisfied because the purchase agreements with RAL Funding and the other banks give such other banks the right to pledge or exchange the RALs.
The third requirement of SFAS 140 is satisfied because there is no requirement that the RAL Funding repurchase RALs other than those that did not meet the underwriting criteria in the purchase agreement
and were therefore inadvertently included among the sold loans. RAL Funding is permitted to repurchase loans in a “clean-up call” when the remaining unpaid loans have reached a minimal amount.
The purchase agreement specifically states that it is the intention of all of the parties that the transaction between SBBT RAL Funding Corp. and the participating banks and their conduits be treated as a sale for all purposes, other than for federal and state income tax purposes, and the Company has obtained a legal opinion each year supporting the true sale and legal isolation of the transferred assets from the Company.
The Company has concluded that the securitization of the RALs satisfy the criteria for sale treatment under SFAS 140.
The securitization is active only during the first quarter and terminated prior to the end of the first quarter of each year, there are no balances, retained interests, or servicing assets to be accounted for or disclosed at March 31 of each year. Any RALs outstanding at the end of each quarter are considered as loans held for investment. In February of each year, the Company closes the securitization facility and, once the facility is closed the Company does not re-open the securitization facility until the following year. There are no balances related to RALs, securitized or otherwise, recorded on the balance sheet at December 31 of each year.
Allowance for loan losses
Credit risk is inherent in the business of extending loans and leases to borrowers. The Company establishes an estimated reserve for these inherent loan losses and records the change in this estimate through charges to current period earnings. These charges are recorded as provision for loan losses. All specifically identifiable and quantifiable losses are charged off against the allowance when realized. The allowance for loan losses is Management’s estimate of loan losses inherent within the loan portfolio at each balance sheet date.
The Company formally determines the adequacy of the allowance on a quarterly basis. This determination is based on the periodic assessment of the credit quality or “grading” of loans. Loans are initially graded when originated. Loans are re-graded at renewal, when identified facts demonstrate change in risk of nonpayment, or if the loan becomes delinquent. Re-grading of larger problem loans will occur at least quarterly.
After reviewing the grades in the loan portfolio, the second step is to assign or allocate a portion of the allowance to groups of loans and to individual loans to cover Management’s estimate of the loss that may be present in these loans. The estimation of probable losses takes into consideration the loan grade and other factors such as:
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loan balances
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loan pool segmentation
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historical loss analysis
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identification, review, and valuation of impaired loans
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change in the economy upon the lending activities
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change in the concentrations of the lending activities
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change in the growth of the lending activities
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change in the delinquencies and classified loan trends of the lending activities
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change in the control environments upon the lending activities
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change in the management and staffing effectiveness upon the lending activities
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change in the loan review effectiveness upon the lending activities
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change in the underlying collateral values upon the lending activities
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change in the competition/regulatory/legal issues upon the lending activities
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change related to unanticipated events upon the lending activities
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change and additional valuation for structured financing and syndicated national credits
GAAP, banking regulations, and sound banking practices require that the Company record this estimate of inherent losses in the form of an allowance for loan losses. When loans are determined to be uncollectible, losses are recognized and accounted for as charge-offs against this allowance. A secured consumer loan which includes residential real estate loans that are 120 days past due will be charged-off down to the fair value of the collateral. If a consumer loan is unsecured, after the loan is 120 days past due, the loan will be charged-off. For commercial Loans, these would include commercial and industrial loans and loans secured by commercial real estate, as soon as deterioration of the borrower’s credit quality is identified, the loan is put on nonaccrual. If the commercial loan is secured, the loan is charged-off down to the collateral’s fair value. When the Company recovers an amount on a loan previously charged-off, the recovery increases the amount of allowance for loan losses.
Allowance for loan loss from RALs: RALs are originated in the first and second quarters of the year. The allowance for loan losses related to RALs is applied on an aggregate level. Specifically, the Company uses loss rates from prior years to estimate the inherent losses. However, because of the uncertainty of repayment after more than three months from origination, all RALs unpaid at year-end are charged-off. Therefore, the Company does not have an allowance for loan loss for unpaid RALs at the end of any year.
Reserve for Off-Balance Sheet Commitments
In addition to the exposure to credit loss from outstanding loans, the Company is also exposed to credit loss from certain off-balance sheet commitments such as unused loan commitments and letters of credit. Losses are experienced when the Company is contractually obligated to make a payment under these instruments and must seek repayment from a borrower which may not be as financially sound in the current period as they were when the commitment was originally made.
As with its outstanding loans, the Company applies the same historical loss rates and qualitative factors to its off-balance sheet obligations in determining an estimate of losses inherent in these contractual obligations. The estimate for loan losses on off-balance sheet instruments is included within other liabilities and the charge to income that establishes this liability. Additional disclosure regarding Company’s reserve for off-balance sheet commitments is located in Note 5, “Loans” on page 111 of these Consolidated Financial Statements.
Income Taxes
The Company uses the accrual method of accounting for financial reporting purposes as well as for tax return purposes. Due to tax regulations, several items of income and expense are recognized in different periods for tax return purposes than for financial reporting purposes. These items represent “temporary differences.” The Company is required to provide in its financial statements for the eventual liability or deduction in its tax return for these temporary differences until the item of income or expense has been recognized for both financial reporting and for taxes. The provision is recorded in the form of deferred tax expense or benefit as the temporary differences arise, with the accumulated amount
recognized as a deferred tax liability or asset. Deferred tax assets represent future deductions in the Company’s income tax return, while deferred tax liabilities represent future payments to tax authorities.
Premises and Equipment
Premises and equipment are reported at cost less accumulated depreciation. Depreciation is expensed over the estimated useful lives of the assets. For most assets accelerated methods of depreciation are used. Certain assets with shorter useful lives are depreciated utilizing the straight-line method of depreciation. The estimated average useful lives of premises and equipment are as follows:
Leasehold improvements are amortized over the terms of the leases or the estimated useful lives of the improvements, whichever is shorter.
Management annually reviews Premises and Equipment in order to determine if facts and circumstances suggest that the value of an asset is not recoverable.
Leases
The Company leases a majority of its branches and support offices. Leases are accounted for as capital leases or operating leases based on the requirements of GAAP. When the terms of the lease indicate that the Company is leasing the building for most of its useful economic life or the present value of the sum of lease payments represents most of the fair value of the building, the transaction is accounted for as a capital lease. In a capital lease, the building is recognized as an asset of the Company and the net present value of the contracted lease payments is recognized as a long-term liability. The amortization charge relating to assets recorded under capital leases is included with depreciable expense.
A majority of the Company’s leases have cost-of-living adjustments based on the consumer price index. Some of the leases have fixed increases provided for in the terms or increases based on the index but have a minimum increase irrespective of the change in index. In these cases, the total fixed or minimum lease expense is recognized on a straight-line basis over the term of the lease.
Loan Servicing Rights
Included in other assets are loan servicing rights associated with the sale of loans in which the servicing of the loan is retained. The Company receives a fee for servicing loans sold. The right to receive this fee for performing servicing is of value to the Company and could be sold should the Company choose to do so. Companies engaged in selling loans and retaining servicing rights for a fee are required to recognize servicing rights as an asset. The rights are recorded at the net present value of the fees that will be collected, less estimated servicing costs, which approximates the fair value.
Loan servicing rights are amortized in proportion to, and over the period of, estimated future net servicing income. In addition, Management periodically evaluates these servicing rights for impairment. Loan servicing rights are evaluated for impairment based upon the fair value of the rights as compared to amortized cost on a loan-by-loan basis. The servicing rights are amortized to non-interest income over the expected lives of the loans. Estimates of the lives of the loans are based on several industry standard sources.
Because the rate at which consumers prepay their loans are impacted by changes in interest rates-prepayments increase as interest rates fall, and decrease as interest rates rise-the value of the servicing right changes with changes in interest rates. When prepayments increase, the Company will collect less servicing fees so the value of the servicing rights decline. A valuation of the servicing assets are performed at each reporting period and reductions to the servicing assets’ carrying value are made when the carrying balance is higher than the fair value of the servicing asset utilizing the lower of cost or market valuation methodology.
Repurchase Agreements
The Company occasionally enters into repurchase agreements whereby it purchases securities or loans from another institution and agrees to resell them at a later date for an amount in excess of the purchase price. While in form these are agreements to purchase and resell, in substance they are short-term secured investments in which the excess of the sale proceeds over the purchase price represents interest income. This income is accrued over the term of the investment. For security or collateral, the Company receives assets with a higher fair value than the amount invested.
Trust Assets and Investment and Advisory Fees
The Company has a trust department, two subsidiaries, MCM and REWA and, a 20% interest in Veritas that have fiduciary responsibility for the assets that they manage on behalf of customers. These assets are not owned by the Company and are not reflected in the accompanying Consolidated Balance Sheets. Fees for most trust services are based on the market value of customer assets, and the fees are accrued monthly.
Earnings Per Share
The computation of basic earnings per share for all periods presented in the Consolidated Statements of Income is based on the weighted average number of shares outstanding during each year retroactively restated for stock dividends and stock splits.
Diluted earnings per share include the effect of common stock equivalents for the Company, which consist of shares issuable on the exercise of outstanding options and restricted stock awards and common stock warrants. The number of options assumed to be exercised is computed using the “treasury stock method.” This method assumes that all options with an exercise price lower than the average stock price for the period have been exercised at the average market price for the period and that the proceeds from the assumed exercise have been used for market repurchases of shares at the average market price. The Company receives a tax benefit for the difference between the market price and the exercise price of non-qualified options when options are exercised. The treasury stock method also assumes that the tax benefit from the assumed exercise of options is used to retire shares. When the Company’s net income available to common stockholders is in a loss position, the diluted earnings per share calculation utilizes average shares outstanding.
Once stock options or restricted stock vest, the shares are included in the weighted average shares outstanding.
Statement of Cash Flows
For purposes of reporting cash flows, “cash” includes cash and due from banks, Federal funds sold, and securities purchased under agreements to resell. Federal funds sold and securities purchased under agreements to resell are one-day transactions, with the Company’s funds being returned to it the next business day.
Postretirement Health Benefits
The Company provides eligible retirees with postretirement health care and dental benefit coverage. These benefits are also provided to the spouses and dependents of retirees on a shared cost basis. Benefits for retirees and spouses are subject to deductibles, co-payment provisions, and other limitations. The expected cost of such benefits is charged to expense during the years that the employees render service to the Company and thereby earn their eligibility for benefits.
Each year the Company recognizes a portion of the change in the accumulated postretirement benefit obligation (“APBO”) as an expense. This portion is called the net periodic postretirement benefit cost (the “NPPBC”). The NPPBC, is made up of several components:
The Accumulated Postretirement Benefit Obligation
The commitment the Company has made to provide these benefits results in an obligation that must be recognized in the financial statements. This obligation, termed the APBO, is the actuarial net present value of the obligation for: (1) already retired employees’ expected postretirement benefits; and (2) the portion of the expected postretirement benefit obligation earned to date by current employees. The net present value is that amount which if compounded at an assumed interest rate would equal the amount expected to be paid in the future.
This obligation must be re-measured each year due to changes in each of the following factors: (1) the number of employees working for the Company; (2) the average age of the employees working for the Company as this impacts how soon it would be expected that the Company will begin making payments; (3) increases in expected health care costs; and (4) prevailing interest rates. In addition, because the obligation is measured on a net present value basis, the passage of each year brings the eventual payment of benefits closer, and therefore, like the compounding of interest, increases the obligation.
Further information regarding the Company’s Postretirement Health Benefits is disclosed in Note 15, “Postretirement Benefits” of these Consolidated Financial Statements.
Other Real Estate Owned and Other Foreclosed Property
Real estate acquired through foreclosure on a loan or by surrender of the real estate in lieu of foreclosure is called OREO. OREO is originally recorded in the Company’s financial records at the fair value of the OREO, less estimated costs to sell. If the outstanding balance of the loan is greater than the fair value of the OREO at the time of the acquisition, the difference is charged-off against the allowance for loan losses.
During the time the property is held, all related operating or maintenance costs are expensed as incurred. Later decreases in the fair value of the property are charged to non-interest expense by establishing a valuation allowance in the period in which they become known. Increases in the fair value may be recognized as reductions of non-interest expense but only to the extent that they represent recoveries of amounts previously written-down. Expenditures related to improvements of the property are capitalized to the extent that they are realizable through increases in the fair value of the properties. Increases in market value in excess of the fair value at the time of foreclosure are recognized only when the property is sold.
At December 31, 2008 and 2007, the Company held OREO that had a recorded value, less estimated costs, of $7.1 million and $3.4 million, respectively, which is less than the Company’s estimate of the fair value of the property.
Derivative Financial Instruments
GAAP requires that all derivatives be recorded at their current fair value on the balance sheet. Certain derivative transactions that meet specified criteria, qualify for hedge accounting under GAAP. The Company does not hold any derivatives that meet the criteria for hedge accounting. If a derivative does not meet the specific criteria, gains or losses associated with changes in its fair value are immediately recognized in non-interest income.
Goodwill and Intangible Assets
In connection with the acquisitions, the Company has recorded the excess of the purchase price over the estimated fair value of the assets received and liabilities assumed as goodwill. Management reviews goodwill for impairment in the third quarter of each year or if there is a triggering event which may indicate a need to review goodwill for impairment. Given this current economic downturn and the ongoing events within the banking industry, Management has deemed it prudent to assess Goodwill for impairment on a quarterly basis for the foreseeable future. The year-end goodwill analysis did not result in any additional goodwill impairment. All goodwill impairment testing is performed by an independent third party in conjunction with Management.
Based on the Company’s annual assessment for goodwill, an impairment charge of $22.1 million was recorded in non-interest expense in the third quarter of 2008. Management does not believe that any further impairment of goodwill has occurred based on its year-end assessment.
Intangible assets are generally acquired in an acquisition. If the benefit of the intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed, rented, or exchanged, regardless of the acquirer’s intent to do so, the acquired intangible asset will be a separately recognized asset. Such intangible assets are subject to amortization over their useful lives. Among these intangible assets are core deposit intangibles and customer relationship intangibles. The Company amortizes core deposit intangibles over their estimated useful life. The customer relationship intangible is amortized in proportion to and over the life of the anticipated service fee revenue.
With the July 2006 acquisition of MCM and January 2008 acquisition of REWA, the goodwill and core relationship intangible asset are included in the Wealth Management segment.
In Note 10, “Goodwill and Other Intangible Assets” of these Consolidated Financial Statements for additional information and disclosure.
Segments
GAAP requires that the Company disclose certain information related to the performance of various segments of its business. Segments are defined based on how the Chief Executive Officer of the Company views the Company’s operations. Management has determined that the Company has four reportable operating segments: Community Banking, Commercial Banking, RAL and RT Programs and Wealth Management. The All Other segment consists of the administrative support units and PCB. The factors used in determining these reportable segments are explained in Note 24, “Segments” of these Consolidated Financial Statements beginning on page 142.
Stock-Based Compensation
The Company grants non-qualified stock options and restricted stock. All stock-based compensation is accounted for in accordance with Statement of Financial Accounting Standards No. 123R, Share Based Payment (“SFAS 123R”). The accounting for stock-based compensation expense is disclosed in Note 19 “Shareholders’ Equity” of these Consolidated Financial Statements.
SFAS 123R requires issuers to record compensation expense over the vesting period of the share-based award. The amount of compensation expense to be recognized over this term is the “fair value” of the options at the time of the grant utilizing a binomial option-pricing model. The option-pricing model computes fair value for the options based on the length of their term, the volatility of the stock price in past periods, and other factors.
The Company also grants restricted stock as a form of employee and director compensation. Restricted stock is expensed over the vesting period. A valuation model is not used for pricing restricted stock since the value is based on the closing price of the Company’s stock on the grant date. The amount of expense is based on the shares granted multiplied by the stock price on the date of the grant. When the restricted stock vests, the employee receives the stock.
Other Recent Accounting Pronouncements
In September 2006, the FASB issued Statement of Financial Accounting Standard (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP. SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. The Company adopted SFAS 157 on January 1, 2008. There was no financial impact to the Consolidated Financial Statements upon adoption. For additional information on the fair value of certain financial assets and liabilities, see Note 23, “Fair Value of Financial Instruments” of these Consolidated Financial Statements on page 138.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 allows the Company an irrevocable election to measure certain financial assets and liabilities at fair value, with unrealized gains and losses on the elected items recognized in earnings at each reporting period. The fair value option (“FVO”) may only be elected at the time of initial recognition of a financial asset or financial liability or upon the occurrence of certain specified events. The election is applied on an instrument by instrument basis, with a few exceptions, and is applied only to entire instruments and not to portions of instruments. SFAS 159 also provides expanded disclosure requirements regarding the effects of electing the fair value option on the financial statements. The Company did not elect the adoption of SFAS 159 for any of its existing financial assets or liabilities as of January 1, 2008. In the subsequent event footnote of the first quarter
Form 10-Q, the Company disclosed its intent to elect the FVO for certain FHLB advances. However, the Company has since determined that it is unable to obtain the necessary inputs for the selected liabilities on a consistent and repeatable basis since they are unique and not from active markets. As such, the Company has not fair valued any of its FHLB advances.
In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS 141(R)”) and SFAS No. 160, “Accounting and Reporting of Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51” (“SFAS 160”). SFAS 141(R) is required to be adopted concurrently with SFAS 160 and is effective for business combination transactions for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. This will be effective for the Company for the calendar year beginning January 1, 2009. SFAS 141(R) and SFAS 160 are effective prospectively; however, the reporting provisions of SFAS 160 are effective retroactively. Management does not anticipate that there will be a material impact on the Company’s financial condition or results of operations from adoption of these accounting pronouncements.
In February 2008, the FASB issued FSP FAS 140-3, “Accounting for Transfers of Financial Assets and Repurchase Financing Transactions” (“FSP FAS No. 140-3”). The objective of FSP FAS No. 140-3 is to provide implementation guidance on accounting for a transfer of a financial asset and repurchase financing. Under the guidance in FSP FAS No. 140-3, there is a presumption that an initial transfer of a financial asset and a repurchase financing are considered part of the same arrangement for purposes of evaluation under SFAS No. 140. If certain criteria are met, however, the initial transfer and repurchase financing shall not be evaluated as a linked transaction and shall be evaluated separately under SFAS No. 140. FSP FAS No. 140-3 is effective for fiscal years and interim periods beginning after November 15, 2008, and interim periods within those fiscal years. The Company does not expect the adoption of FSP FAS 140-3 to have a material impact on the Company’s Consolidated Financial Statements.
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133” (“SFAS No. 161”). SFAS No. 161 amends and expands the disclosure requirements of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, and requires entities to provide enhanced qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair values and amounts of gains and losses on derivative contracts, and disclosures about credit-risk-related contingent features in derivative agreements. SFAS No. 161 is effective for fiscal years and interim periods beginning after November 15, 2008. Management has increased the disclosures for the derivative instruments held in these Consolidated Financial Statements to comply with SFAS 161. For additional information on the derivative instruments held by the Company, see Note 22, “Derivative Instruments” of these Consolidated Financial Statements on page 137.
In April 2008, the FASB issued FSP FAS 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 removes the requirement of SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”) for an entity to consider, when determining the useful life of an acquired intangible asset, whether the intangible asset can be renewed without substantial cost or material modifications to the existing terms and conditions associated with the intangible asset. FSP FAS 142-3 replaces the previous useful-life assessment criteria with a requirement that an entity shall consider its own experience in renewing similar arrangements. If the entity has no relevant experience, it would consider market participant assumptions regarding renewal. FSP FAS 142-3 is effective for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. The Company does not expect the adoption of FSP FAS 142-3 to have a material impact on the Company’s Consolidated Financial Statements.
In June 2008, the FASB issued FSP EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities” (“FSP EITF 03-6-1”). FSP EITF 03-6-1 addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing earnings per share under the two-class method as described in SFAS No. 128, “Earnings per Share.” Under the guidance in FSP EITF 03-6-1, unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents are participating securities and shall be included in the computation of earnings per share pursuant to the two-class method. FSP EITF 03-6-1 is effective for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. All prior-period earnings per share data presented shall be adjusted retrospectively. The Company does not expect the adoption of FSP EITF 03-6-1 to have a material impact on the Company’s Consolidated Financial Statements.
2. ACQUISITIONS AND DISPOSITIONS
On January 4, 2008, PCBNA acquired the assets of REWA, a San Luis Obispo, California-based registered investment advisor which provides personal and financial investment advisory services to individuals, families and fiduciaries. On the date of purchase, REWA managed assets of $464.1 million. PCBNA initially paid approximately $7.0 million for substantially all of the assets and liabilities of REWA (with an additional contingent payment due five years after the purchase date) and formed a new wholly-owned subsidiary of PCBNA by the same name. As a result of the acquisition of REWA, the Company recorded $4.2 million of goodwill and $2.8 million of other intangible assets. The goodwill associated with the purchase of REWA will be reviewed annually for impairment. The other intangible assets will be amortized over their individual expected lives and analyzed quarterly for impairment. The clients of REWA will continue to be served by the same principal and support staff.
On May 16, 2006, PCBNA entered into an Asset Purchase Agreement with MCM, a California-based registered investment advisor which at July 1, 2006 managed assets in excess of $850 million and provided planning and investment solutions to individuals, foundations, retirement plans and select institutional clients. The MCM acquisition gave the Company the opportunity to provide an expanded array of products to our existing wealth management clients and provide PCBNA’s products to MCM’s clientele. On July 1, 2006, PCBNA acquired MCM for an initial cash payment of approximately $7.0 million with additional contingent payments due in succeeding years. In exchange, PCBNA acquired substantially all of the assets and liabilities of MCM and formed a new wholly-owned subsidiary of PCBNA by the same name, MCM. In connection with the acquisition of MCM, the Company has recorded $4.7 million of goodwill and $2.3 million for the customer relationship intangible. The customer relationship intangible began amortization at the date of purchase and will be amortized based on an estimated life of 15 years with adjustments based on forecasted cash flows.
The Company has not disclosed pro forma financial information about combined operations, as the acquisitions were not material to the Company as a whole.
In October 2008, the Company sold $54.4 million of deposits and associated buildings and equipment from the Santa Paula and Harvard branches and, $30.4 million of various types of real estate secured, small business loans and lines of credit and consumer loans to Ojai Community Bank. For a more detailed discussion on the loans sold, refer to Note 6, “Loan Sales and Transactions” of these Consolidated Financial Statements. The Company recorded a $3.1 million gain on sale related to this transaction.
3. EARNINGS PER SHARE
The following table presents a reconciliation of basic earnings per share and diluted earnings per share. The denominator of the diluted earnings per share ratio includes the effect of dilutive securities. The securities outstanding that are potentially dilutive are employee stock options, restricted stock and common stock warrants.
(1) (Loss)/income per diluted common share for the year ended December 31, 2008 is calculated using basic weighted average shares outstanding.
For the years ended December 31, 2008, 2007 and 2006, the average outstanding unexercised stock options of 1,265,000, 980,000 and 142,000 shares, respectively were not included in the computation of earnings per share because they were anti-dilutive. For the year ended December 31, 2008, 1,509,000 of common stock warrants which were not included in the computation of earnings per share because they were anti-dilutive. The common stock warrants were issued in conjunction with the preferred stock issued to the U.S. Treasury in November 2008. For more information related to the common stock warrants, refer to Note 19, “Shareholders’ Equity” of these Consolidated Financial Statements. For the years ended December 31, 2007 and 2006, the Company did not have any common stock warrants.
4. SECURITIES
A summary of securities held by the Company at December 31, 2008 and 2007 is as follows:
(1) U.S. Treasury obligations are securities that are backed by the full faith and credit of the United States Government.
(2) U.S. Agency obligations are general obligations that are not backed by the full faith and credit of the United States Government and consist of Government Sponsored Enterprises issued by the Federal Farm Credit, Federal Home Loan Bank and Tennessee Valley Authority.
(3) Mortgage-backed securities are securitized mortgage loans that are not backed by the full faith and credit of the United States Government and consist of Government Sponsored Enterprises which guarantee the collection of principal and interest payments. The securities primarily consist of securities issued by Federal Home Loan Mortgage Corporation and Federal National Mortgage Association.
Trading Securities
At December 31, 2008 and 2007, the Company held $213.9 million and $146.9 million, respectively of securities classified as trading. In January 2008 and October 2008, the Company recharacterized certain residential real estate loans into a guaranteed mortgage securitization, increasing the balance in this portfolio.
Available-for-Sale Securities
At December 31, 2008 and 2007, the Company held $1.18 billion of securities in an AFS portfolio. Generally, AFS securities’ unrealized gains or losses are accounted for by adjusting the carrying amount of the securities, and losses with a corresponding amount in OCI, which is then adjusted by a deferred tax asset or liability at our statutory tax rate of 42.05%. In December 2007, Management changed its intent with regard to holding its AFS MBS to maturity or ultimate recovery. As a result, the Company recognized a $5.8 million and $3.0 million of impairment loss at December 31, 2008 and 2007, respectively, because without the intent to hold until recovery, the securities could no longer be regarded as temporarily impaired. This decision was made during the fourth quarter of 2007, for strategic balance sheet and interest rate risk management purposes, as well as to provide additional liquidity for the Company.
In December 2006, the Company decided to sell securities purchased in 2003 and 2004 as part of a “leveraging strategy”. While not sold until early 2007, the Company recognized an $8.8 million impairment loss due to a change in intent to hold these securities. When the sale was executed in the first quarter of 2007, the securities had recovered a portion of their value due to changes in interest rates. The Company recognized a $1.6 million gain, for a total recognized net loss of $7.2 million on these securities. The proceeds from the sale were used to reduce wholesale borrowings and to reinvest in higher yielding securities.
Fair values on securities at each reporting period are either the fair value for the same security or a security with similar characteristics. Fair values are obtained from independent sources. If a security is in an unrealized loss position for more than twelve months, Management is required to determine whether or not each security is temporarily or permanently impaired.
The following table shows all AFS securities that are in an unrealized loss position and temporarily impaired as of December 31, 2008 and 2007.
In Management’s opinion, the unrealized losses of AFS securities of $10.0 million at December 31, 2008 are a result of market interest rate fluctuations and the current economic environment. The issuers of these securities have not, to our knowledge, established any cause for default on these securities and the various rating agencies have reaffirmed these securities’ long-term investment grade status at December 31, 2008. The Company has the ability and the intention to hold these securities until their fair values recover. As such, Management does not believe that there are any securities, other than the AFS MBS identified as impaired as disclosed above that are other-than-temporarily impaired, and therefore, no additional impairment charges are warranted. Management is aware of one asset backed security held in the investment portfolio that has some sub-prime loans as the underlying collateral but, this security is rated AAA and, all principal and interest payments are current.
Contractual Maturities for Securities Portfolio
The amortized cost and estimated fair value of debt securities at December 31, 2008 and 2007, by contractual maturity, are shown in the table below.
Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. With interest rates on a number of the Company’s securities with coupon rates higher than the current market rates, Management expects that issuers that have the right to call the securities will exercise these rights and pay the bonds off earlier than the contractual term.
Sales and Calls of Securities
The following table summarizes the securities sold and called for the last three years.
Securities Pledged
Securities with a carrying value of approximately $1.01 billion and $1.03 billion at December 31, 2008 and 2007, respectively, were pledged to secure public funds, trust deposits, repurchase agreements and other borrowings as required or permitted by law.
5. LOANS
Loans held for sale
At December 31, 2008 and 2007, the Company held $11.1 million and $68.3 million, respectively as loans held for sale. Loans held for sale are reported at the lower of cost or market. Loans held for sale at December 31, 2008 consisted of $1.1 million of residential real estate and $10.0 million of SBA loans which were originated for sale. On December 21, 2007, the Company entered an agreement to sell $68.2 million of adjustable rate residential real estate loans with a book value of $68.0 million. In exchange for the loans sold, MBS securities were received with the same underlying loans and placed in the trading portfolio. All of the residential real estate loans classified as held for sale at December 31, 2008 were sold by the end of January 2009. All loans in held for sale at December 31, 2007 were sold in January 2008.
Loans held for investment
The composition of the Company’s loans held for investment portfolio is as follows:
The loan balances above are net of net deferred loan origination fees, commitment, extension fees and origination costs of $7.7 million for 2008 and $6.9 million for 2007.
Impaired Loans
The table below summarizes the impaired loan information reported within the loans held for investment.
The table below summarizes interest income received and recognized for impaired loans.
A valuation allowance is established for an impaired loan when the fair value of the loan is less than the recorded investment. The Bank determines a loan is impaired in accordance with SFAS 114 utilizing the fair value of the collateral for collateral dependent loans or an analysis of the discounted cash flows. The valuation allowance amounts disclosed above are included in the allowance for loan losses reported in the balance sheets for December 31, 2008 and 2007. The increase in net impaired loans is mostly attributed to the current economic conditions which primarily impacted the Bank’s
construction loan portfolio. At December 31, 2008, the construction loan portfolio had net impaired loans of $117.1 million or 74.4% of the total net impaired loans. A majority of these loans are in a nonaccrual status at December 31, 2008, also increasing the nonaccrual loans disclosed in the table below.
Nonaccrual and Past Due Loans Still Accruing
The table below summarizes loans classified as nonaccrual:
Total nonaccrual loans increased by $114.4 million. Nonaccrual loans in the construction loan portfolio increased by $101.2 million at December 31, 2008. The Company had troubled debt restructured loans (“TDRs”) of $33.7 million compared to no TDRs at December 31, 2007. Several of the TDRs were also from the construction loan portfolio and account for $28.2 million of the restructured loans. Prior to the loans becoming TDRs, the Company charged-off $8.7 million of the loan’s outstanding balance. The Company had foreclosed collateral of $7.1 million and $3.4 million as of December 31, 2008 and 2007, respectively. The increase in foreclosed collateral is mostly land and commercial buildings which consist of $6.1 million of the $7.1 million balance at December 31, 2008.
Refund Anticipation Loans
For the discussion of the RALs and the securitization of RALs see Note 7, “RAL and RT Programs” on page 113 of these Consolidated Financial Statements.
Pledged Loans
At December 31, 2008, loans secured by residential and commercial real estate with principal balances totaling $2.98 billion were pledged to FHLB and $1.29 billion were pledged as collateral to the FRB as collateral for borrowings.
These amounts pledged do not represent the amount of outstanding borrowings that are required to be supported by collateral. The Company borrows extensively during the first quarter of each year to fund its RAL Program.
Loan Sales and Transactions
The total gain on sale of loans for the years ended December 31, 2008, 2007 and 2006 was $46.9 million, $68.0 million and $45.2 million, respectively. The largest component of the gain on sale of
loans was the gain on sale of RALs which was $44.6 million, $41.8 million and $43.2 million for the years ended December 31, 2008, 2007 and 2006, respectively. A more detailed explanation of the gain on sale of RALs is included in Note 7, “RAL and RT Programs” of these Consolidated Financial Statements.
During 2008, the Company sold SBA loans for a gain on sale of $1.2 million, residential real estate loans for a gain on sale of $756,000 and various other types of loans in conjunction with the sale of two branches in October 2008. During 2007, the Company sold or converted to securities RAL, Lease, Indirect Auto, Residential Real Estate and SBA loans. A more detailed discussion regarding these sales are in Note 6, “Loan Sales and Transactions” of these Consolidated Financial Statements.
Unfunded Loan Commitments and Letters of Credit
As of December 31, 2008, the contractual commitments for unfunded commitments and letters of credit are as follows:
Included in unfunded loan commitments are secured and unsecured lines of credit and loans.
Letters and lines of credit are commitments to extend credit and standby letters of credit for the Bank’s customers. These commitments meet the financing needs of the Bank’s customers in the normal course of business and are commitments with “off-balance sheet” risk since the Bank has committed to issuing funds for customers but, there is no current loan outstanding.
Lines of credit are obligations to lend money to a borrower. Credit risk arises when the borrowers’ current financial condition may indicate less ability to pay than when the commitment was originally made. In the case of standby letters of credit, the risk arises from the possibility of the failure of the customer to perform according to the terms of a contract. In such a situation, the third party might draw on the standby letter of credit to pay for completion of the contract and the Company would have to look to its customer to repay these funds to the Company with interest. To minimize the risk, the Company uses the same credit policies in making commitments and conditional obligations as it would for a loan to that customer.
Standby letters of credit and financial guarantees are conditional commitments issued by the Company to guarantee the performance of a customer to a third party in borrowing arrangements. At December 31, 2008, the maximum undiscounted future payments that the Company could be required to make were $134.7 million. Approximately 43.1% of these arrangements mature within one year. The Company generally has recourse to recover from the customer any amounts paid under these guarantees. Most of the guarantees are fully collateralized by the same types of assets used as loan collateral, however several are unsecured. The Company has recorded a $452.7 million liability associated with the unearned portion of the letter of credit fees for these guarantees as of December 31, 2008.
The Company anticipates that a majority of the above commitments will not be fully drawn on by customers. Consumers do not tend to borrow the maximum amounts available under their home equity
lines and businesses typically arrange for credit lines in excess of their expected needs to handle contingencies. A majority of the lines of credit are adjustable rate commitments that are tied to prime or a base-lending rate. If a rate is fixed on a line of credit, the commitments are not usually for more than three months.
The maximum non-discounted exposure to credit risk is represented by the contractual amount of those instruments. The majority of these commitments are for one year or less. Lines of credit and letters of credit may be withdrawn by the Company subject to applicable legal requirements.
The Company has exposure to loan losses from unfunded loan commitments and letters of credit. As funds have not been disbursed on these commitments, they are not reported as loans outstanding. Loan losses related to these commitments are not included in the allowance for loan losses reported in Note 7, “Allowance for Loan Losses” of these Consolidated Financial Statements and are accounted for as a separate loss contingency as a liability. This loss contingency for the unfunded loan commitments and letters of credit was $8.0 million at December 31, 2008, an increase of $6.9 million since December 31, 2007. The increase in the reserve for off balance sheet commitments is discussed on pages 41 and 50 of this Form 10-K. Changes to this liability are adjusted through other non-interest expense.
The table below summarizes the loss contingency related to loan commitments.
Concentration of Lending Activities
The Company’s lending activities are primarily driven by the customers served in the market areas where the Company has branch offices in the State of California with exception of the RAL Program.
The Company monitors concentrations within five broad categories: industry, geography, product, call code, and collateral. The Company’s loan portfolio has concentration of loans collateralized by California real estate. The nature of the collateral for real estate secured loans are 1-4 units of single family residential, multifamily residential, and commercial buildings of various types. At December 31, 2008, commercial real estate, commercial and industrial and agricultural loans comprised 55.4% of the Company’s loan portfolio but, consisted of diverse borrowers. The Company has considered this concentration in evaluating the adequacy of the allowance for loan loss in the allocated component.
The Community Banking, Commercial Banking and RAL and RT Programs segments account for the majority of the loan activity for the Bank. The Community Banking segment serves consumers and small businesses by offering lines of credit, equity lines and loans, automobile loans, residential mortgage loans and debit card processing. The Commercial Banking segment serves larger business customers with traditional commercial lending products such as lines of credit, letters of credit, asset-based lending, foreign exchange services and treasury management. The RAL and RT Program segment offers RALs to consumers throughout the United States.
Related Parties
In the ordinary course of business, the Company has extended credit to directors and executive officers of the Company. These related party loans totaled $35.9 million and $37.5 million at December 31, 2008 and 2007, respectively. At December 31, 2008, the maturities of the related party
loans ranged from approximately 6 months to 28 years. Such loans are subject to ratification by the Board of Directors, exclusive of the borrowing director. Federal banking regulations require that any such extensions of credit not be offered on terms more favorable than would be offered to non-related party borrowers of similar credit worthiness.
6. LOAN SALES AND TRANSACTIONS
During 2008, 2007, and 2006, the Company sold or converted Residential Real Estate loans, RAL, SBA loans and various other types of loans.
Residential Real Estate Loans
In January and October 2008, the Company recharacterized $68.2 million and $13.9 million, respectively of residential real estate loans into a guaranteed mortage securitization which were from the loans held for investment portfolio. The Company retained the servicing on the loans and, recognized a servicing asset of $402,000 and $113,000 in January and October of 2008, respectively. The MBS were placed into the Company’s trading portfolio.
In September 2008, the Company began originating residential real estate loans for sale and recognized $134,000 gain on sale. These loans are generally sold within 30 days of origination. During 2008, $31.8 million residential real estate loans were originated for sale. Of the $31.8 million of loans originated for sale, $13.9 million were sold with servicing rights retained and $111,000 servicing right was recognized.
In October 2008, the Company sold $81.7 million of residential real estate loans from the loans held for investment portfolio and recognized a $640,000 gain on sale. The Company retained servicing on the loans sold and, recognized a servicing asset of $855,000. Since these loans were sold from the loans held for investment loan portfolio, there was $475,000 of allowance for loan losses and net deferred origination fees and expenses of negative $353,000 which were reclassified as part of the gain on sale calculation.
On December 28, 2007, the Company recharacterized $285.1 million of fixed rate residential real estate loans from the Community Banking segment to MBS with the same par amount. The Company retained the servicing on the loans sold and recognized a servicing asset of $2.7 million. The recharacterized residential real estate loans were placed into the Company’s trading portfolio.
RALs
The Company sold $2.21 billion, $1.69 billion and $1.56 billion of RALs into a securitization facility through SBBT RAL Funding Corp during the first quarter of 2008, 2007, and 2006, respectively. The net gain on sale of RALs for the years ended December 31, 2008, 2007 and 2006 were $44.6 million, $41.8 million and $43.2 million, respectively. A detailed discussion of RALs sold through the securitization is included in Note 7, “RAL and RT Programs” of these Consolidated Financial Statements.
SBA Loans
During 2008, the Company sold $38.5 million of SBA loans. The Company occasionally sells the guaranteed portion of selected SBA 7(a) loans into the secondary market, on a servicing retained basis. The Company retained the unguaranteed portion of these loans and serviced the loans as required under the SBA programs to specified yield amounts. The SBA program stipulates that the Company retain a minimum of 5% of the unguaranteed loan balance. The percentage of each
unguaranteed loan in excess of 5% may be periodically sold into the secondary market, typically for a cash premium. During 2007, the Company sold $4.6 million of the unguaranteed portion of selected SBA 7 (a) loans with servicing retained and recorded an immaterial servicing liability. The SBA lending activities are included in the Commercial Banking segment.
The Company also periodically sells certain SBA 504 loans into the secondary market, on a servicing released basis, typically for a cash premium.
For the year ended December 31, 2008, 2007 and 2006, the Company recognized a gain on sale of SBA loans of $1.2 million, $2.4 million and $2.0 million, respectively. For information associated with the servicing rights see Note 11, “Loan Servicing Rights” of these Consolidated Financial Statements.
Loans sold as part of Branch Sale
In October 2008, the Company sold two retail banking branches located in Santa Paula, California as disclosed in Note 2, “Acquisitions and Dispositions” of these Consolidated Financial Statements. In conjunction with the sale of these branches, the Company also sold $30.4 million of loans. A summary of the types of loans sold were; residential real estate loans of $17.6 million, commercial real estate loans of $ 7.9 million, home equity loans and lines of credit of $3.4 million, lines of credit of $ 1.3 million and small business term loans of $183,000.
Of the $30.4 million of loans sold, $29.1 million were sold with servicing retained and, an immaterial servicing right was recognized as part of the gain on sale of the two branches.
Leases
In the second quarter of 2007, the Bank sold its leasing loan portfolio of $254.7 million of loans for a net gain on sale of $24.3 million. No servicing assets were retained by the Company in relation to the sale. This loan portfolio was reported in the Community Banking segment prior to sale.
Indirect Auto Loans
In the second quarter of 2007, the Bank sold $221.8 million of the indirect auto loan portfolio and realized a net loss on the loan portfolio sale of $850,000. The indirect auto portfolio was reported in the Community Banking segment.
7. RAL AND RT PROGRAMS
RAL and RT Programs
The Company sells two products related to the electronic filing of tax returns. The products are designed to provide taxpayers with faster access to funds claimed by them as a refund on their tax returns. This access may be in the form of a loan-a RAL-from the Company secured by the refund claim or in the form of a facilitated electronic transfer or check prepared by their tax preparer-an RT. The RAL and RT Programs are highly seasonal. Approximately 90% of the activity occurs in the first quarter of each year.
Refund Anticipation Loans
RALs are short-term consumer loans offered to taxpayers, secured by their anticipated tax refund and subject to an underwriting process prior to approval. At the request of the taxpayer, the refund claim is paid by the IRS to the Bank once the tax return has been processed. This constitutes the source of repayment of the RAL. Funds received from the IRS above the sum of the RAL less associated contractual fees are remitted to the taxpayer by the Bank.
The RAL funds advanced by the Bank are generally repaid by the IRS within several weeks. Therefore, the processing costs and provision for loan loss represent the major costs of these loans. This cost structure is different than for other loans since usually the cost of funds is the major cost for the Company in making a loan. Because of RALs short duration, the Bank cannot recover the processing costs through interest calculated over the term of the loan. Consequently, the Bank has structured the fees to have a fixed component to cover processing costs and a variable component to cover loan losses and the cost of funds. The customer signs a promissory note which requires the Company to report fees received for RALs as interest income.
Net interest income for RALs was $100.0 million, $105.5 million and $109.8 million, respectively for the years ended December 31, 2008, 2007 and 2006.
The following table represents RAL originations and net charge-offs for the years indicated:
Unpaid RALs outstanding at the end of the year were charged off. Therefore, no RALs are reported as of December 31 of each year. As shown in the tables in Notes 5, “Loans” and Note 8, “Allowance for Loan Losses,” there are no RALs or allowance for RALs at December 31 of each year.
Fees Earned on RALs and RTs
The following table summarizes RAL and RT fees for the years indicated:
Total RT transactions increased by 1.5 million or 30.8% from 4.8 million for the year ended December 31, 2007 to 6.3 million for the year ended December 31, 2008. Implementation of new credit risk management controls resulted in an increased number of RAL customer applications that were declined which then converted to an RT, resulting in the $22.8 million increase in RT fees for the year ending December 31, 2008 compared to December 31, 2007.
The following table represents changes in RAL fee income for the three years presented:
Refund Anticipation Loan Securitizations
Securitization Facility: One source of external funds the Company uses to extend RALs to customers is a securitization facility. If the securitization facility was not in place, during the peak period the amount of the RALs outstanding may result in unacceptable capital ratios for PCBNA. The securitization facility provides funds for lending and restores PCBNA’s capital to an acceptable level since the facility removes some of the RALs from the balance sheet. By the end of February, the balance of RALs is low enough so that RAL sales, through the securitization are not necessary. Individual RALs are each of a relatively small amount (approximately $3,300 per RAL for the 2008 season), so a securitization is the most efficient method to accomplish the sale of RALs. The RAL securitization occurs during the first quarter of each year and does not remain at the end of any subsequent reporting period. The 2008, 2007, and 2006 securitization facility was terminated on February 22, February 23, and February 24, respectively.
The Company has used a securitization for the last seven years, including 2008. The maximum amount of the securitization was set at $1.60 billion for the 2008 RAL season compared to $1.50 billion in 2007 and $1.10 billion for the 2006 RAL season. The capacity has increased over the last few years to accommodate the increase in RAL balances each year.
Securitization Operations: The securitization is managed by a primary bank, termed the “agent bank”, and several other participating banks. Each of the banks, agent and participating, are allocated a certain proportion of the RALs sold by the Bank. The agent and participating banks may purchase their allocated loans directly for their own portfolio or they may have their allocation purchased by subsidiary entities called conduits. These conduits purchase assets from a number of financial institutions, RALs purchased from the Bank being just one class of assets. The conduits fund their asset purchases through the issuance of commercial paper and are referred to as multi-seller commercial paper funding conduits.
With each sale of RALs from the Company to SBBT RAL Funding Corp., an investment request is submitted to the agent bank. If approved, undivided ownership interests in the RALs will be purchased by agent and participating banks or their multi-seller commercial paper funding conduits, without recourse.
Each purchase is made at 95% of the amount of the RALs net of the deferred fees so that a 5% over-collateralization exists for the benefit of the investors. The Bank is required to remit to the investors in the securitization cash received from the IRS up to the 95% amount. Payments received in excess of the 95% figure are retained by the Bank.
As of December 31, 2008, 2007 and 2006 there were no borrowings outstanding under the securitization facility.
Fees paid associated with the securitization facility include an administrative agent fee payable to the lead bank, an upfront fee, a commitment fee and a usage fee applied against the average balance of advances. There are no retained interests or servicing assets at March 31 of any year, or during any subsequent reporting period.
Repurchase of Securitized Loans: While there is no requirement that SBBT RAL Funding Corp. repurchase RALs other than those that did not meet the underwriting criteria in the purchase agreement, under SFAS 140, the seller may repurchase a minimal amount of loans as part of a “clean-up call” to close the transaction. In practice, all loans sold into the securitization are either fully repaid or repurchased by SBBT RAL Funding Corp. at the termination of the securitization in mid-February of each calendar year consistent with the terms of the Securitization Agreement. At the close of the securitization, the Company repurchased $20.9 million and $31.8 million of RALs in February 2008 and 2007, respectively, at fair value.
A majority of the RALs repurchased from the securitization are collected or charged-off before the end of the first quarter. In 2008, all repurchased RALs that remained uncollected at March 31, 2008 were deemed uncollectible and charged-off in the amount of $14.9 million as a reduction to the gain on sale of RALs.
In prior years, repurchased RALs outstanding at the end of the first quarter that were evaluated as collectible were reported on the balance sheet as RALs. Recoveries on repurchased RALs above the estimate at March 31, 2007 were accounted for as recoveries through the allowance for loan losses. Charge-offs of these RALs over the amount estimated, taken in subsequent quarters, were accounted for as losses taken against the allowance for loan losses.
Calculation of the Gain on Sale of Tax Refund Loans: The gain on sale from the RAL securitization is calculated by reference to the securitization-related cash flows received and paid. Because the securitization is active only within the first quarter of each year, there is no present value discounting of the cash flows. The cash flows involved in the securitization are as follows:
(1) Cash is received from the investors for the principal amount of the loans less the discount for the credit enhancement;
(2) Cash is received from the IRS for the amount of the refund and paid to the investors;
(3) Cash is paid to the investors for the commitment and funding fees;
(4) Cash is paid to the investors to repurchase outstanding loans at the termination of the securitization as a “cleanup call;” and
(5) Cash received from the IRS subsequent to the termination of the securitization representing collections on the repurchased loans
During the term of the securitization, more cash is received from the IRS for customer refunds than is paid to the investors by the amount of the discount for the credit enhancement that includes the finance charge or fee paid by the RAL customer for the loan which is not sold into the securitization. In the table below, this excess is reported as RAL fees received on securitized loans. In the calculation of the net gain on sale of RALs, the RAL fees received on securitized loans are reduced by the direct costs of the securitization (fees paid to investor, commitment fees paid and other fees paid) and loan losses as summarized in the table below.
RAL Allowance and Provision for Loan Losses
The Company follows the same policies for charging-off RALs regardless of whether the RAL had been securitized or not. Some of the repurchased and some of the non-securitized loans are charged-off at the end of each quarter, with all remaining outstanding RALs charged-off at December 31 of each year. Due to the high volume of RALs made each year, the determination of collectibility is statistically based on historical payment patterns adjusted for information received from the IRS on current year payment processing.
RAL provision for loan losses was $21.8 million, $92.0 million and $36.7 million for the years ended December 31, 2008, 2007 and 2006, respectively. The increased provision for loan losses on RALs at December 31, 2007 was due to high loss rates in the RAL pre-file product and increased incidences of tax preparer and customer fraud that affected the traditional RAL product. The RAL pre-file product is a RAL that was offered in advance of the taxpayer’s filing of their tax return, primarily in the month of January, for a portion of the anticipated refund amount. A RAL pre-file loan is repaid once a RAL or RT is funded by the IRS. In 2007, the Company decided to no longer offer this product.
Losses associated with RALs result from the IRS not remitting funds associated with a particular tax return. This occurs for a number of reasons, including errors in the tax return and tax return fraud.
8. ALLOWANCE FOR LOAN LOSSES
The following table summarizes the allowance for loan losses:
9. PREMISES AND EQUIPMENT
Software purchased by the Company is included above in furniture, fixtures and equipment. Developed software represents the accumulated balance of developed or modified software and primarily relates to the Company’s core accounting and retail delivery systems. Included in the development costs is capitalized interest. The Company’s capitalized interest costs were approximately $40,000 and $47,000 for the years ended December 31, 2007 and 2006, respectively. There was no capitalized interest expense for the year ended December 31, 2008.
Lease Obligations
The following table shows the contractual lease obligations of the Company at December 31, 2008:
The Company leases most of its office locations and substantially all of these office leases contain multiple five-year renewal options and provisions for increased rents, principally for property taxes and maintenance. As of December 31, 2008, the minimum commitment under non-cancelable leases for the next five years and thereafter are shown in the above table. The amounts in the table for minimum rentals are not reported net of the contractual obligations of sub-tenants. Sub-tenants leasing space from the Company under these operating leases are contractually obligated to the Company for approximately $4.2 million. Approximately 74% of these payments are due to the Company over the next three years. Total rental expense, net of sublease income, for premises included in non-interest expenses are $13.1 million in 2008, $10.8 million in 2007, and $10.0 million in 2006.
10. GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill was $128.7 million and $145.7 million at December 31, 2008 and 2007, respectively. Goodwill is recorded as an asset in the Company’s balance sheets.
In January 2008, the Company purchased REWA, as disclosed in Note 2, “Mergers and Acquisitions” of these Consolidated Financial Statements. The Company recorded $4.6 million of goodwill, a $2.6 million customer relationship intangible asset and a $220,000 intangible asset for the non-compete agreements for the purchase of REWA.
Goodwill is tested for impairment during the third quarter of each year or if management determines there is a triggering event which may indicate a need to review goodwill for impairment. Given this current economic downturn and the ongoing events within the banking industry, Management has deemed it prudent to assess Goodwill for impairment on a quarterly basis for the foreseeable future. The year-end goodwill analysis did not result in any additional goodwill impairment. All goodwill impairment testing is performed by an independent third party in conjunction with Management.
In order to determine the fair value of each reporting unit in the third quarter of 2008, the Company reviewed the capitalized earnings of each reporting unit, the outlook of the current economic environment and took into consideration the transaction multiples of publicly traded financial institutions adjusted for a change in control. When the fair value of a reporting unit is less than its carrying value, the Company is required to utilize a Step 2 valuation approach in accordance with SFAS 142. All of the Company’s reporting units passed Step 1 of the annual SFAS 142 impairment analysis in the third quarter of 2008 except the Commercial Banking segment. The Step 2 goodwill impairment analysis of the Commercial Banking segment required the Step 1 fair value of the reporting unit to be allocated to all of the fair values of the underlying tangible and intangible assets and liabilities for purposes of calculating the fair value of goodwill. This allocation resulted in a $22.1 million goodwill impairment recorded in the third quarter of 2008. The goodwill impairment calculation is an estimate subject to ongoing review as certain circumstances may cause additional impairment to be assessed in the future.
The tables below summarize the change in the core deposit intangible by acquisition.
A separate intangible asset was recorded for the customer relationship intangibles acquired with the acquisitions of REWA and MCM. The table below summarizes the activity in the customer relationship intangible.
The customer relationship intangibles are amortized based on estimated undiscounted cash flows over fifteen years.
With the purchase of REWA in January 2008, there was also a separate intangible for the non-compete agreements of $220,000 with amortization of $31,000 for the year ended December 31, 2008.
Amortization expense for the core deposit and customer relationship intangibles was $2.6 million, $1.2 million and, $3.4 million for the years ended December 31, 2008, 2007 and 2006, respectively. The intangibles have an estimated weighted average life of 9.8 years.
Below is a summary of estimated amortization expense over the next five years and thereafter:
11. LOAN SERVICING RIGHTS
The table below summarizes the activity of the Company’s servicing rights.
During 2008 and in December 2007, the Company sold $177.7 million and, $285.1 million of residential real estate loans and retained the servicing rights. Upon the sale of these loans, servicing rights of $1.5 million and $2.7 million were recognized during 2008 and in December 2007, respectively. Throughout 2008, 2007, and 2006 the Company sold SBA loans as described in Note 6, “Loan Sales and Transactions” of these Consolidated Financial Statements and retained servicing rights. The servicing rights obtained through the sale of SBA loans were $584,000, $557,000 and $581,000 for the years ending December 31, 2008, 2007 and 2006, respectively.
During the third quarter of 2007, the Company sold $4.6 million of the unguaranteed portion of SBA 7(a) loans. The Company established a nominal servicing liability. The servicing liability will be amortized over the estimated life of the loans sold.
As of December 31, 2008, the Company serviced for others $500.5 million of mortgage loans, $112.8 million of SBA loans and approximately $29.1 million of loans secured by residential real estate second trust deeds, multi-family and commercial real estate loans in conjunction with the sale of two branches in October 2008.
Additional information regarding the sale of these loans is described in Note 6, “Loan Sales and Transactions” of these Consolidated Financial Statements.
12. DEPOSITS
The table below summarizes deposits by type.
Certificates of deposit are the only deposits, which have a specified maturity. The balances of other deposit accounts are primarily assigned to the less than one-year time range. Of the total deposits at December 31, 2008, $5.98 billion may be either immediately withdrawn or matures within 1 year; $555.4 million matures within 1 to 3 years, $58.6 million matures within 3 to 5 years, and $958,000 matures in more than 5 years.
As of December 31, 2008, the Company had $329.3 million of securities pledged as collateral for our Local Agency deposits.
13. SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE AND FEDERAL FUNDS PURCHASED
Securities sold under agreements to repurchase (“repos”) are borrowings by the Company collateralized by pledged investment securities. The Company enters into repos for various terms: overnight, several weeks and multi-year periods. Federal funds purchased consist of unsecured overnight borrowings from other financial institutions.
Throughout the year, repos with terms of several weeks to several months are offered to customers that wish to place funds with the Company in excess of the $250,000 FDIC limit on deposit insurance.
The following table summarizes repurchase agreements and federal funds purchased.
14. LONG-TERM DEBT AND OTHER BORROWINGS
The following table summarizes long-term debt and other borrowings:
Other Short-Term Borrowings
Other short-term borrowings include treasury tax and loans (“TT&Ls”) with the FRB and short term advances with FHLB. TT&Ls are obtained through the Federal Reserve Bank’s Term Investment Option (“TIO”) program. At December 31, 2008, the Company did not have any TT&Ls from the TIO program. At December 31, 2007, the Company had $100.0 million of TT&Ls from the TIO program.
The TIO is an investment opportunity offered to participants that have treasury tax and loans with the Federal Reserve Bank. Included within the Treasury tax and loan amounts are payroll deposits made by employers to PCBNA for eventual payment to the IRS. PCBNA may hold these deposits and pay interest on them until called by the Treasury Department.
At December 31, 2008 and 2007, the weighted average interest rate paid for short-term borrowings were 2.37% and 4.00%, respectively. For the years ending December 31, 2008 and 2007, total interest expense for short-term borrowings were $2.8 million and $8.6 million, respectively. Total interest expense on short-term borrowings for December 31, 2006 is not readily available and is included in interest expense on long-term debt and other borrowings.
Federal Home Loan Bank Advances
As a member of FHLB the Company has established a credit line under which the borrowing capacity is determined subject to underlying collateral. As of December 31, 2008, total advances with the FHLB were $1.54 billion and $1.10 billion, at December 31, 2007. There were $732.4 million in advances with scheduled maturities of 1 year or less, $374.3 million maturing in 1 to 3 years, and $430.3 million maturing in more than 3 years with a total weighted average rate of 3.94% and maturity dates ranging from 2008 to 2031.
Subordinated Debt
Subordinated debt issued by the Bank qualifies as Tier 2 capital for PCBNA and the Company in the computation of capital ratios discussed in Note 20, “Regulatory Capital Requirements” of these Consolidated Financial Statements.
The table below summarizes the subordinated debt issued by the Bank.
(1) The $35.0 million of subordinated debt above has a variable rate which reprices every three months based on the 90-day LIBOR rate plus 2.60%.
The subordinated debt issued by the Company is summarized in the table below:
Capital Lease
The obligation under capital lease of $9.9 million at December 31, 2008 was incurred at the beginning of 2004 when the Company assumed the master lease on a shopping center in which one of its branch offices is located. The net present value of the portion of the payments related to the buildings is recorded as a capital lease. The lease calls for monthly payments through 2038. The implied interest rate is 5.89%. The amortization of the leased buildings is included with depreciation expense. The lease provides for specific increases during its term. The total lease payments for 2008 were $344,000. As of December 31, 2008, the total minimum sublease rent to be received under non-cancelable subleases is $2.1 million. The Company also leases the land under an operating lease. The above debt instruments contain no significant restrictive covenants or triggering events as to the issuance of other debt or require payment in full prior to the scheduled maturity.
Issuance of Preferred Securities and Common Stock Warrants
In November 2008, the U.S. Treasury purchased $180.6 million of the Company’s preferred stock through the TARP CPP and also received common stock warrants. The SEC’s Deputy Chief Accountant and the FASB’s Technical Director determined that all preferred stock issuance and associated common stock warrants related to this program were to be accounted for as equity and, therefore the disclosure of this transaction is discussed in Note 19, “Shareholders’ Equity” of these Consolidated Financial Statements.
15. POSTRETIREMENT BENEFITS
All eligible retirees may obtain health insurance coverage through the Company’s Retiree Health Plan (“the Plan”). The coverage is provided through the basic coverage plan provided for current employees. Based on a formula involving date of retirement, age at retirement, and years of service prior to retirement, the Plan provides that the Company will pay a portion of the health insurance premium for the retiree. The portion varies from 60% to 100% of the premium amount paid for current
employees. Though the premiums for a retiree’s health coverage are not paid until after the employee retires, the Company is required to recognize the cost of those benefits as they are earned rather than when paid.
The following tables disclose the reconciliation of the beginning and ending balances of the APBO; the reconciliation of beginning and ending balances of the fair value of the plan assets; and the funding status of the Plan:
A summary of the activity in Accumulated Other Comprehensive Income in accordance with FAS 158 is as follows:
At December 31, 2008, the Company increased the accrued post retirement benefits liability by $8.8 million. This increase was mostly due to lower than projected returns on the VEBA assets and benefit costs increased at a higher rate than projected for 2008. The increase of $8.8 million of the accrued post retirement liability had a corresponding entry to decrease OCI by $5.1 million and increased the deferred tax assets for post retirement benefits by $3.7 million.
The Plan provides for graduated levels of benefits based on length of service. During 2005, the Company amended the Plan to require employees retiring after 2010 to have additional years of service time to achieve a specified level of benefits.
The Components of the Net Periodic Postretirement Benefit Cost
Each year the Company recognizes a portion of the change in the APBO as an expense. This portion is called the net periodic postretirement benefit cost (the “NPPBC”). The NPPBC is made up of several components: The following table includes the amounts for each of the components of the NPPBC.
The net actuarial loss and prior service credit for the defined benefit pension plans that will be amortized from accumulated OCI into NPPBC over the next fiscal year are $1.2 million and $645,000, respectively.
The Use of Estimates and the Amortization of Experience Gains and Losses
The following table discloses the assumed rates that have been used for the factors impacting the APBO.
The discount rate is used to compute the present value of the APBO. It is selected each year by reference to the current rates of investment grade corporate bonds. Higher discount rates result in a lower APBO at the end of the year and the NPPBC to be recognized for the following year, while lower rates raise both.
The Company used 6.50% as its estimate of the long-term rate of return on plan assets. The APBO is a long-term liability of 30 years or more. The 6.50% rate is the assumed average earning rate over an equally long investment horizon. If the rate of return in any year is greater than this estimate, the Company will have an experience gain and an experience loss if the rate of return is less. (Loss)/earnings on the plan’s assets were (37.40%), 18.30% and 2.06% for the years ended December 31, 2008, 2007, and 2006, respectively.
The Medicare Prescription Drug, Improvement and Modernization Act was enacted in 2003. Beginning with 2005, the APBO disclosed in the above tables reflect the expected federal subsidy provided by the act because the Company has been able to conclude that the benefits provided by the Plan are equivalent to those provided by the act.
Increases in health insurance costs impact the portion of the APBO because such increases result in higher health insurance premiums paid by the Company. If costs rise at a higher rate than assumed by the Company, there will be an experience loss. If they rise at a lesser rate, there will be an experience gain.
The Company has used various rates year to year for the health care inflation rate for current employees. For 2009, 2010, 2011 and thereafter, the Company has assumed the following rates 8.0%, 7.0%, 6.0% and 5.0%, respectively.
Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects:
Rather than recognizing the whole amount of the experience gains or losses in the year after they arise, under GAAP they are recognized through amortization over the average remaining service lives of the employees. Amortization over time is used because many of these changes may be partially or fully reversed in subsequent years as further changes in experience and/or assumptions occur. The unamortized experience gains or losses make up a substantial portion of the unfunded liability recognized with the adoption of SFAS 158. The experience gains or losses are amortized into expense through the NPPBC, the amount recorded is an adjustment to OCI.
The table below summarizes the total recognized in NPPBC and OCI:
Plan Assets
The Company established a VEBA to hold the assets that will be used to pay the benefits for participants of the plan other than key executive officers. As a separate benefit trust, the VEBA assets are not reported in the assets of the Company. The majority of the plan assets have been invested in insurance policies on the lives of current and former employees of the Company. In turn, the premiums paid on these policies in excess of the mortality costs of the insurance and the administrative costs are invested in mutual funds. This investment practice is followed in order to accumulate assets that earn a nontaxable return because the mutual funds are “wrapped” in the insurance policies.
The following table shows the weighted-average allocation of VEBA plan assets by asset category:
Funded Status
If the assets of the VEBA are more than the APBO related to employees of the Company not defined as key employees, the VEBA is overfunded. If the assets of the VEBA are less than the APBO related to employees of the Company not defined as key employees, the VEBA is underfunded. The funded status of the plan is shown in the first table in this note as the amount by which the plan assets are more or less than the APBO. As of December 31, 2008 the total underfunded liability was $14.3 million.
Employers are allowed discretion as to whether and how they set aside funds to meet the funding obligation. GAAP requires assumed increases in the rate of future health care costs to be used in computing the amount of APBO and the funded status of such plans. Internal Revenue Code (“IRC”) however, does not permit the Company to deduct the portion of the NPPBC for non-key employees that relates to assumed increases in the rate of future health care costs. As long as future health care costs are projected to increase, the Company could not deduct a contribution of the whole amount necessary to fully fund the non-key employee obligation. In addition, the IRC prohibits funding of the obligation related to key employees.
Cash Flows
Contributions: The intended funding policy of the Company with respect to the non-key employee plan is to contribute assets to the VEBA at least sufficient to pay the costs of current medical premiums of retirees. In some years the Company also contributes assets to pay the costs of the life insurance premiums and to provide additional earning assets for the VEBA to reduce any underfunded condition. Generally, these additional contributions will not exceed the amount that can be deducted in the Company’s current income tax return. In those years that the Company does not contribute assets for the payment of the life insurance premiums, assets in the VEBA are used to pay the premiums. Proceeds from the life insurance policy payoffs will fund benefits and premiums in the future. Such proceeds are included in the assumed 6.50% rate of return on the assets of the plan. If the Company’s Employee Benefits Advisory Committee has made a formal decision on the contribution to be made for the year prior to year-end, the contribution will be recognized as a receivable in the plan assets of the VEBA. During 2008, 2007 and 2006 contributions of $2.0 million, $411,000 and $1.5 million, respectively were made. Management estimates that it will make approximately the same contribution in 2009 as in 2008.
The estimated future health benefits are as follows:
16. INCOME TAXES
The components of income tax expense for the years ended December 2008, 2007 and 2006 were as follows:
The reconciliation of the federal statutory income tax rate to the Company’s effective income tax rate for the years ended December 31, 2008, 2007 and 2006 was as follows:
Significant components of the Company’s net deferred tax asset at December 31, 2008 and 2007 are presented in the following table.
The Company evaluates its deferred tax assets on a quarterly basis to determine whether a valuation allowance is required. In accordance with SFAS 109, the Company assesses whether a valuation allowance should be established based on its determination of whether it is more likely than not that some portion or all of the deferred tax assets will not be realized.
The Company believes that the realization of the recognized net deferred tax asset of $70.6 million is more likely than not based on existing carryback ability and expectations as to future taxable income. The Company has reported pretax financial statement income from continuing operations of approximately $154 million, on average, over the last three years.
The Company adopted the provisions of FASB Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes, on January 1, 2007. This Interpretation provides guidance for accounting and disclosure for uncertainty in tax provisions and for the recognition and measurement related to the accounting for income taxes. The adoption of FIN 48 did not have a material effect to our financial statements. Management concluded that there were no significant uncertain tax positions requiring recognition in our financial statements. The Company did not, as a result of FIN 48, recognize any adjustment in the liability for unrecognized tax benefits that impacted the beginning retained earnings.
The Company files income tax returns in the U.S. Federal jurisdiction and various state jurisdictions. In February 2009, IRS completed an audit of the Company’s 2006 Federal tax return. The audit resulted in no change to the Company’s 2006 Federal tax liability. In 2008, the California Franchise Tax Board (FTB) commenced a limited audit of amended returns filed by the Company for the 2003 and 2004 tax years. The amended returns were filed to claim a deduction for enterprise zone loan interest not claimed on the original returns and the audit pertains only to the enterprise zone loan interest deductions. In addition, the FTB is auditing the enterprise zone loan interest deductions claimed on the Company’s original 2005 and 2006 California tax returns.
The Company does not believe that the FTB audit will result in changes to its California tax liability for the years under audit nor that there will be any material changes in its unrecognized tax positions over the next 12 months. The Company remains open to audit by the IRS for the 2005 and 2007 tax years and by various state taxing authorities for 2004 - 2007 tax years.
The Company may from time to time be assessed interest or penalties by major tax jurisdictions, although any such assessments historically have been minimal and immaterial to financial results. In the event the Company has an assessment from a taxing authority, any resulting interest and penalties are recognized as a component of income tax expense.
The Company allocates tax expense between the parent company and its subsidiaries based on Federal banking law and regulation. The parent only statement of operations is presented in Note 25, “Pacific Capital Bancorp (Parent Company Only Financials).”
17. EMPLOYEE BENEFIT PLANS
The Company’s Employee Stock Ownership Plan (“ESOP”) was initiated in January 1985. The ESOP is a plan whereby the Company may make annual, discretionary contributions for the benefit of eligible employees. Substantially all of the contributions are invested in the Company’s common stock. Total contributions by the Company to the ESOP plan were $197,000, $0, and $0 for the years ended December 31, 2008, 2007 and 2006, respectively. As of December 31, 2008, the ESOP held 1,375,000 shares.
The Company’s profit-sharing plan has two components. The Salary Savings Plan component is authorized under Section 401(k) of the Internal Revenue Code. An employee may defer up to 80% of pre-tax salary in the plan up to a maximum dollar amount set each year by the Internal Revenue Service. The Company matches 100% of the first 3% of the employee’s compensation that the employee elects to defer and 50% of the next 3%, but not more than 4.5% of the employee’s total compensation. In 2008, 2007, and 2006, the employer’s matching contributions were $2.7 million, $2.5 million and $2.9 million, respectively. The other component is the Incentive & Investment Plan (“I&I Plan”), which permits contributions by the Company to be invested in various mutual funds chosen by the employees. The Company made no contributions to this plan during 2008, 2007 and 2006.
Total contributions made by the Company to the Retiree Health Plan as discussed in Note 15, “Postretirement Benefits” of these Consolidated Financial Statements were $2.0 million, $411,000, and $1.5 million for 2008, 2007, and 2006, respectively.
The administrative expenses of these plans are paid by the Company.
18. COMMITMENTS AND CONTINGENCIES
Contractual Lease Obligations
The contractual obligations for leases are disclosed in Note 9, “Premises and Equipment” of these Consolidated Financial Statements.
Contractual Commitments for Unfunded Loans and Letter of Credits
For a summary and more information of the contractual commitments for unfunded loan commitments and letters of credit as of December 31, 2008 refer to Note 5, “Loans” of these financial statements.
Legal
The Company has been a defendant in a class action lawsuit brought on behalf of persons who entered into a refund anticipation loan application and agreement (the “RAL Agreement”) with the Company from whose tax refund the Company deducted a debt owed by the applicant to another RAL lender. The lawsuit was filed on March 18, 2003 in the Superior Court in San Francisco, California as Canieva Hood and Congress of California Seniors v. Santa Barbara Bank & Trust, Pacific Capital Bank, N.A., and Jackson-Hewitt, Inc. The Company is a party to a separate cross-collection agreement with each of the other RAL lenders by which it agrees to collect sums due to those other lenders on delinquent RALs by deducting those sums from tax refunds due to its RAL customers and remitting those funds to the RAL lender to whom the debt is owed. This cross-collection procedure is disclosed in the RAL Agreement with the RAL customer and is specifically authorized and agreed to by the customer. The plaintiff does not contest the validity of the debt, but contends that the cross-collection is illegal and requests damages on behalf of the class, injunctive relief against the Company, restitution of sums collected, punitive damages and attorneys’ fees. Venue for this suit was changed to Santa Barbara. The Company filed an answer to the complaint and a cross complaint for indemnification against the other RAL lenders. On May 4, 2005, a superior court judge in Santa Barbara granted a motion filed by the Company and the other RAL lenders, which resulted in the entry of a judgment in favor of the Company dismissing the suit.
The plaintiffs filed an appeal. On September 29, 2006, the Court of Appeal, in a 2-1 decision, issued an opinion which held that the claims in the Complaint that the Company had violated certain California consumer protection laws were not preempted by Federal law and regulations. The Company and the Cross-Defendants filed a petition for writ of certiorari with the United States Supreme Court seeking to reverse the Court of Appeal’s opinion. The petition was denied.
The plaintiff filed an amended complaint in the superior court. The Company filed a demurrer to the cause of action in the amended complaint based on the California Consumers Legal Remedies Act. The superior court granted the demurrer without leave to amend. The plaintiff’s petition for writ of mandate seeking to reverse the superior court’s decision was denied by the Court of Appeal. The plaintiff filed an appeal to the California Supreme Court which was denied.
A Sixth Amended Complaint was filed which added an additional plaintiff, Tyree Bowman. The Company filed an answer to the complaint.
The plaintiff, the Company, the other defendant and the cross-defendants have entered into an agreement to settle the case. The Court has preliminarily approved the settlement and set a hearing for April 26, 2009, to hear any objections from class members. If a final judgment is ultimately entered which is consistent with the settlement agreement, it will not have a material effect on the Company’s financial position, results of operation or cash flow.
The Company is a defendant in two class actions which were both filed on January 14, 2008. Big Sky Ventures I, LCC, et al v. Pacific Capital Bancorp, et al was filed in the United States District Court, Central District of California. Joseph D. Irlanda v. Pacific Capital Bancorp, et al was filed in the Superior Court of California, County of Los Angeles.
In Big Sky Ventures, the plaintiffs purport to represent a class consisting of all tax preparation franchisees of Jackson Hewitt, Inc located outside of California. In Irlanda, the plaintiff purports to represent a class consisting of all tax preparation franchisees of Jackson Hewitt, Inc located in California.
The plaintiffs in both actions entered into annual Bank Product Agreements (the “Agreement”) with the Company which gave them the right, but not the obligation, to provide to their customers certain Company financial products such as refund anticipation loans. The plaintiffs in both actions allege that prior to the Agreement with the Company applicable to the 2006 tax year, they could charge their customers fees in connection with the Company’s financial products which they provided. The plaintiffs allege that in the 2006 tax year Agreement, their fees were limited to $40 per product and that in the Agreements for the 2007 and 2008 tax years, they were prohibited from charging their customers any fee for providing them with such products. Further, they allege that in their franchise agreements with Jackson Hewitt, Inc, they are required to provide the Company’s financial products to their customers.
In each action, the plaintiffs make the following claims for relief:
1. A judicial declaration that the agreements applicable to the 2007 and 2008 tax years are unconscionable, void and unenforceable for economic duress, lack of consent, undue influence, and lack of consideration.
2. Injunctive relief prohibiting the Company from enforcing the terms of the 2008 Bank Product Agreement.
3. For restitution from the Company for the uncompensated services provided by the plaintiffs during the 2006, 2007 and 2008 tax years.
4. For rescission of the 2008 Bank Product Agreement.
5. For damages from the Company pursuant to California’s Unfair Competition Law under Business and Professions Code Sections 172000, et seq.
In Big Sky Ventures, the Company filed a motion to dismiss the complaint. Following a hearing on May 15, 2008, the motion was granted in part and denied in part. The judge’s order granted the motion to dismiss as to the cause of action for restitution and unjust enrichment and denied it as to the other causes of action. In addition, the order struck the plaintiffs’ requests for punitive damages and attorneys fees. The plaintiffs filed an amended complaint which added causes of action for 1) intentional interference with prospective economic advantage, 2) negligent interference with prospective advantage, and 3) quantum meruit. The Company has filed answer to the amended complaint.
In the Irlanda case, an amended complaint was filed. The Company filed a demurrer and motion to strike the amended complaint. Following a hearing on December 5, 2008, the court sustained the Company’s demurrer without leave to amend and ordered the entry of judgment in favor of the Company.
The Company believes that there is no merit to the claims made in these actions and intends to vigorously defend itself.
The Company is involved in various lawsuits of a routine nature that are being handled and defended in the ordinary course of the Company’s business. Expenses are being incurred in connection with defending the Company, but in the opinion of Management, based in part on consultation with legal counsel, the resolution of these lawsuits will not have a material impact on the Company’s financial position, results of operations, or cash flows.
19. SHAREHOLDERS’ EQUITY
Stock Issuance
In November 2008, the Company issued 180,634 shares of Series B Preferred Stock with no par value and per share stated value of $1,000 for total gross proceeds of $180.6 million. The Series B Preferred
Stock was issued in conjunction with the TARP CPP. The Series B Preferred Stock has a cumulative dividend of 5% for the first five years and a 9% cumulative dividend, thereafter. The dividends are paid out of retained earnings and reduce the income available to common stockholders. The Series B Preferred Stock is callable after February 15, 2012, qualifies as Tier 1 Capital and has no voting rights. The Series B Preferred Stock may not be redeemed by the Company prior to February 15, 2012 except with proceeds from the sale and issuance for cash of perpetual preferred stock, Common Stock or any combination of such securities that in each case, qualify as and may be included as Tier 1 Capital of the Company. On or after February 15, 2012, the Company may, at its option, redeem, in whole or in part from time to time. Any redemption of the Series B Preferred Stock will be at a redemption price equal to the liquidation preference per share plus any accrued dividends.
The Company also issued 1,512,003 of common stock warrants with an exercise price of $17.92 a share. The common stock warrants entitle the U.S. Treasury to convert the preferred shares to common stock at any time over a ten year period. The common stock warrants were recorded at their fair value of $4.7 million which is equal to 15.0% of the senior preferred shares value and recorded in shareholders’ equity as surplus. The fair value was determined using the binomial option pricing model by a third party.
In 2005, the Company established a Dividend Reinvestment and Direct Stock Purchase Plan. The dividend reinvestment provision allows shareholders to have the Company’s transfer agent purchase new shares of stock with their dividends from the open market. The direct stock purchase plan allows the Company to sell shares directly to shareholders and others, as it deems advisable. Dividend reinvestment was minimal in 2008, 2007, and 2006. In October 2008, the Company issued 407,313 shares of common stock and received gross proceeds of $7.2 million. The shares issued in October 2008 were issued from the Direct Stock Purchase Plan to raise additional capital. There were no shares issued in 2007 or 2006 under the Direct Stock Purchase Plan.
Stock Repurchases
During 2007, the Company commenced and completed the share repurchase program of $25.0 million authorized by the Company’s Board of Directors. There were 1,090,966 shares repurchased at an average share price of $22.86 per share. No shares were repurchased in 2008 or 2006.
The Company occasionally repurchases shares of its common stock to offset the increased number of shares issued as a result of the exercise of employee stock options and as part of its dividend reinvestment program. Share repurchases are generally conducted as open-market transactions.
Non-Qualified Stock Options
During 2008, the Company’s shareholders adopted the 2008 Equity Incentive Plan, which authorized 2,500,000 shares to be issued for stock compensation. The purpose of the plan is to attract, motivate, and retain employees, consultants, and directors of the Company, and to encourage stock ownership. This plan permits the granting of non-qualified stock options, incentive stock options; stock appreciation rights (“SARs”), restricted stock, and performance units. As of December 31, 2008, only non-qualified stock options, and restricted stock have been granted. Under this plan, non-qualified option grants vest and are exercisable in cumulative 20% installments on each annual anniversary date. Generally, the employee’s interest in the restricted stock shall vest in equal installments over three years. No further grants will be made under the 2002 Stock Plan or the 2005 Directors Stock Plan, but shares may continue to be issued under such plans pursuant to grants previously made. Upon adoption of this 2008 Equity Incentive Plan, 605,000 shares from the 2002 Stock Plan and 122,000 shares from the 2005 Directors Stock Plan were rolled into the 2008 Equity Incentive Plan. Of the original authorized shares of 2,450,870 remain for future awards.
The Company’s 2002 Stock Plan was authorized 2,666,667 shares (adjusted for 2002 and 2004 stock splits) for granting of non-qualified options and restricted stock. Effective October 22, 2007, non-qualified option grants vest and are exercisable in cumulative 20% installments on each annual anniversary date. Generally non-qualified stock option grants prior to October 22, 2007 vested in cumulative 20% installments with the first 20% vested six months after the grant date and then 20% on each anniversary thereafter. Non-qualified stock option grants expire ten years from the date of grant. Of the original authorized shares, 127,287 shares remain for future issuance of non-qualified stock options and restricted stock awards.
In May 2005, our shareholders adopted the 2005 Directors Stock Plan, which authorized 150,000 shares to be issued for stock compensation. The 2005 Directors Stock Plan allowed for awards of non-qualified stock options and restricted stock. To date, restricted stock has been granted to non-employee directors, which is 100% vested one year from date of grant. All of the awards granted under this plan have vested and no further shares will be granted under this plan.
All awards granted under these plans were granted with an exercise price set at 100% of the market value of the Company’s common stock on the date of the grant.
The table below summarizes the assumptions used in calculating the fair value of the non-qualified stock options granted over the last three years.
The fair values of the Company’s employee stock options are estimated at the date of grant using a binomial option-pricing model. This model requires the input of highly subjective assumptions, changes to which can materially affect the fair value estimate. Additionally, there may be other factors, which would otherwise have a significant effect on the fair value of employee stock options granted, but may not be considered by the model. Accordingly, while Management believes that this option-pricing model provides a reasonable estimate of fair value, this model may not necessarily provide the best single measure of fair value for the Company’s employee stock options. Expected volatilities are based on historical volatility of the Company’s stock and other factors. The Company uses historical data to estimate option exercise and employee termination within the valuation model. The expected term of options granted is derived from the output of the option valuation model and represents the period of time that options granted are expected to be outstanding.
A summary of non-qualified stock option activity for the year ended December 31, 2008 is presented below:
Non-qualified stock option compensation expense recognized in accordance with Statement of Financial Accounting Standards No. 123R, Share Based Payment (“SFAS 123R”) for the year ending December 31, 2008, 2007 and 2006 was $1.3 million, $1.9 million and $1.7 million, respectively.
The weighted-average grant-date fair value of options granted during the years 2008, 2007, and 2006 was $5.88, $7.48 and $10.33, respectively. The total intrinsic value of options exercised during the years ended December 31, 2008, 2007 and 2006 was $123,000, $4.4 million and $4.5 million, respectively.
Cash received from option exercises under all plans for the years ended December 31, 2008, 2007 and 2006 was $283,000, $4.4 million and $4.3 million, respectively. The tax benefit realized from option exercises totaled $52,000, $1.8 million and $1.1 million, respectively, for the years ended December 31, 2008, 2007 and 2006, respectively.
Total tax benefit recognized from stock option expense was $559,000, $789,000 and $728,000 for the years ending December 31, 2008, 2007 and 2006, respectively. At December 31, 2008, there was $2.6 million of total unrecognized compensation cost related to non-vested stock options. That cost is expected to be recognized over a weighted-average period of 1.4 years.
Restricted Stock Awards
In April 2005, the Company began issuing restricted stock under the stock option plans noted above. For the period of April 2005 to October 21, 2007, restricted stock granted to employees generally vests in annual increments of 5%, 10%, 15%, 30% and 40%. Beginning October 22, 2007, restricted stock grants to employees generally vest in equal annual increments over three years. The restricted stock granted to outside directors vests at the end of one year. Compensation expense for restricted stock is measured based on the closing price of the stock on the day of the grant. The compensation expense is recognized over the vesting period. The weighted-average grant-date fair value of restricted stock granted during the years of 2008, 2007, and 2006 was $21.25, $31.54 and $31.40, respectively. The total value of shares vested during the year ended December 31, 2008, 2007 and 2006 was $2.0 million, $1.7 million and $1.3 million, respectively.
A summary of the activity of restricted stock for the year ended December 31, 2008 is presented below:
The compensation expense recognized for restricted stock awards was $2.9 million, $4.2 million and $3.7 million for the years ending December 2008, 2007, and 2006, respectively. The total tax benefit recognized for restricted stock awards was $1.2 million, $1.7 million and $1.6 million for the years ending December 31, 2008, 2007 and 2006, respectively. At December 31, 2008, there was $5.6 million of unrecognized compensation expense for unvested restricted stock with an expected weighted-average period of 1.2 years to be recognized.
20. REGULATORY CAPITAL REQUIREMENTS
The Company and PCBNA are subject to various regulatory capital requirements administered by the Federal banking agencies. Failure to meet minimum capital requirements as specified by the regulatory framework for prompt corrective action could cause the regulators to initiate certain mandatory or discretionary actions that, if undertaken, could have a direct material effect on the Company’s financial statements.
Risk-weighted assets are computed by applying a weighting factor from 0% to 100% to the carrying amount of the assets as reported in the balance sheet and to a portion of off-balance sheet items such as loan commitments and letters of credit. The definitions and weighting factors are all contained in the regulations. However, the capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
The minimum ratios that must be maintained under the regulatory requirements to meet the standard of “adequately capitalized” and the minimum ratios required to meet the regulatory standards of “well capitalized” are presented below.
The Company’s and PCBNA capital ratios as of December 31, 2008 and 2007 were as follows:
PCBNA must meet the same capital adequacy standards as the Company. As of December 31, 2008, both PCBNA and the Company met the requirements as well-capitalized under the regulatory framework for prompt corrective action. Based on discussions with the OCC following the conclusion of the Bank’s most recent examination, Management expects the OCC to establish for the Bank a minimum Tier 1 risk based capital ratio of 8.5% and a minimum total risk based capital ratio of 11%. Management expects that the Bank will continue to be deemed well-capitalized notwithstanding the establishment of these expected minimum capital ratios.
Management also plans to maintain a very robust and dynamic capital plan in conjunction with discussions it has held with the OCC. This capital plan will be based on a rolling twelve month forecast, stressed accordingly for market conditions and the Company’s balance sheet conditions. If any capital shortfalls become apparent, Management will immediately activate contingency plans to address any such shortfalls through additional capital raising, asset sales or other means necessary. At this time, the Company exceeds its minimum capital ratios, though conditions could change at any time given industry conditions.
Pacific Capital Bancorp is the parent company and sole owner of PCBNA. However, there are legal limitations on the amount of dividends, which may be paid by PCBNA to Bancorp. The amounts, which may be paid as dividends by a bank are determined based on the bank’s capital accounts and earnings in prior years. As of December 31, 2008, PCBNA would have been permitted to pay up to $276.9 million to Pacific Capital Bancorp.
21. NON-INTEREST EXPENSE
Other expense
The table below discloses the largest items included in other non-interest expense.
22. DERIVATIVE INSTRUMENTS
The Company has entered into interest rate swap agreements with customers to mitigate their interest rate risk exposure associated with the loans they have with the Company. At the same time, the Company entered into offsetting interest rate swap agreements with other financial institutions to mitigate the Company’s interest rate risk exposure associated with the swap agreements with its customers. At December 31, 2008, the Company had swaps with matched terms with an aggregate notional amount of $173.3 million and a fair value of $17.9 million. The fair values of these swaps are
recorded as other assets and other liabilities in the Company’s balance sheet. Changes in the fair value of these swaps are recorded in the Company’s statement of operations. At December 31, 2008, the Company recorded a credit valuation adjustment of $92,000 in non-interest expense in its statement of operations. Swap agreements with customers are secured by the collateral arrangements for the underlying loans these customers have with the Company. During the second quarter of 2008, a customer defaulted on their monthly swap payments to the Company and caused a swap agreement with a notional amount of $6.9 million to no longer be matched with a corresponding swap with another financial institution.
During the third quarter of 2008, the Company entered into $50.0 million of U.S. Treasury futures contracts in order to economically hedge the exposure to changes in value of the MBS held in the AFS portfolio as discussed in Note 4, “Securities” of these Consolidated Financial Statements. These futures contracts require daily settlement based on their fair value. The Company accounts for these futures as trading assets or liabilities with all changes in fair value recorded in net gains (losses) on securities in the statement of operations. For the year ended December 31, 2008, the Company recognized $4.9 million in losses associated with these futures contracts. As these futures contracts mature, Management intends to roll these futures contracts into new contracts depending on market conditions at the time of maturity. The contracts held at December 31, 2008 mature on March 20, 2009.
23. FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities. AFS and trading securities are recorded at fair value on a recurring basis. Additionally, the Company may be required to record other assets and liabilities at fair value on a non-recurring basis. These non-recurring fair value adjustments involve the lower of cost or market accounting and write downs resulting from impairment of assets.
The Company has adopted SFAS 157 effective January 1, 2008. SFAS 157 defines fair value, establishes a framework for measuring fair value, establishes a three-level valuation hierarchy for disclosure of fair value measurement and enhances disclosure requirements for fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:
Level 1:
Observable quoted prices in active markets for identical assets and liabilities.
Level 2:
Observable quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
Level 3:
Model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.
The following methods and assumptions were used to estimate the fair value of each class of financial instruments and servicing rights that are recognized at fair value on a recurring and non-recurring basis:
Securities
AFS and trading securities are recorded at fair value on a recurring basis. The U.S. Treasuries in the AFS portfolio are classified as level 1 of the valuation hierarchy as there are quoted prices available in an active market for identical assets. The remaining securities held in the trading and AFS portfolios
are valued using observable market information for similar assets and accordingly, classified as level 2 of the valuation hierarchy. If observable market information is not available and there is limited activity or less transparency around inputs, securities would be classified within level 3 of the valuation hierarchy.
Loans Held for Sale
Loans held for sale are carried at the lower of cost or market. The fair value of loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics or based on the agreed upon sale price. As such, the Company classifies loans held for sale as a non-recurring valuation within level 2 of the fair value hierarchy. At December 31, 2008, the Company had loans held for sale with an aggregate carrying value of $11.1 million and an estimated fair value of $11.3 million.
Impaired Loans
The Company records certain loans at fair value on a non-recurring basis. When a loan is considered impaired, an allowance for loan losses is established. SFAS 157 applies to loans measured for impairment using the practical expedients method permitted by SFAS 114, Accounting by Creditors for Impairment of a Loan. Impaired loans are measured at an observable market price, if available or at the fair value of the loans collateral, if the loan is collateral dependent. The fair value of the loan’s collateral is determined by appraisals or independent valuation which is then adjusted for the cost related to liquidation of the collateral. When the fair value of the loan’s collateral is based on an observable market price or current appraised value, given the current real estate markets, the appraisals may contain a wide range of values and depend on unobservable significant valuation inputs, and accordingly, the Company classifies the impaired loans as a non-recurring level 3 of the valuation hierarchy. When the Company measures impairment using anything but an observable market price or a current appraised value, the fair value measurement is not in the scope of SFAS 157 and is not included in the tables below.
Servicing Rights
Servicing rights are carried at the lower of aggregate cost or estimated fair value. Servicing rights are subject to quarterly impairment testing. When the fair value of the servicing rights is lower than their carrying value an impairment is recorded by reducing the right to the current fair value. The Company uses independent third parties to value the servicing rights. The valuation model used takes into consideration discounted cash flows using current interest rates, and prepayment speeds for each type of the underlying asset being serviced. The Company classifies these servicing rights as non-recurring level 3 in the valuation hierarchy. For the year ended December 31, 2008, the Company reduced the carrying value of the servicing rights by $1.2 million due to amortization and $1.5 million due changes in the fair value.
Derivatives
The Company’s swap derivatives are not listed on an exchange and are instead executed over the counter (“OTC”). As no quoted market prices exist for such instruments, the Company values these OTC derivatives primarily based on the broker pricing indications and in consideration of the risk of counterparty nonperformance. OTC interest rate swap key valuation inputs are observable interest rate and/or yield curves and do not require significant judgment, and accordingly, the swap values are classified within Level 2 of the fair value hierarchy.
Assets and liabilities measured at fair value on a recurring basis at December 31, 2008 are summarized in the following table:
The Company may be required to measure certain assets and liabilities at fair value on a non-recurring basis in accordance with GAAP. These include assets and liabilities that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period.
Assets and liabilities measured at fair value on a non-recurring basis at December 31, 2008 are summarized in the table below:
There were no liabilities measured at fair value on a non-recurring basis at December 31, 2008.
In accordance with SFAS 107, Disclosures about Fair Value of Financial Instruments, the financial instruments in the following table represent financial assets and liabilities which are not carried at fair value on the Company’s balance sheet and/or otherwise disclosed in the recurring and non-recurring fair value measurements in this note.
The financial instruments disclosed in this foot note include such items as securities, loans, deposits, debt, derivatives, and other instruments. Disclosure of fair values is not required for certain items such as obligations for pension and other postretirement benefits, premises and equipment, other real estate owned, goodwill, prepaid expenses, core deposit intangibles and other customer relationships, other intangible assets and income tax assets and liabilities. Accordingly, the aggregate fair value of amounts presented in this note does not purport to represent, and should not be considered representative of, the underlying “market” or franchise value of the Company. Further, due to a variety of alternative valuation techniques and approaches permitted by the fair value measurement accounting standards as well as significant assumptions that are required to be made in the process of valuation and could and do differ between various market participants, a direct comparison of our fair value information with that of other financial institutions may not be appropriate.
The following methods and assumptions were used to estimate the fair value of each class of financial instruments determined practicable to estimate the fair value:
Cash and Due from Banks
The carrying values of cash and interest-bearing demand deposits in other financial institutions are the fair value.
Net Loans Held for Investment, net
The current pricing of the held for investment loans reflects a significant discount to their carrying value. The loans held for investment was adversely affected by a significant reduction in or lack of the liquidity as well as unprecedented disruptions in the financial markets, especially during the second half of 2008. As a result, the fair values for these loans as disclosed are substantially less than what the Company believes is indicated by their performance and Management’s view of the expected cash flows.
Deposits
The fair value of demand deposits, money market accounts, and savings accounts is the amount payable on demand as of December 31 of each year. The fair value of fixed-maturity certificates of deposit is estimated by discounting the interest and principal payments using the rates currently offered for deposits of similar remaining maturities.
Long-term Debt and Other Borrowings
For FHLB advances, the fair value is estimated using rates currently quoted by the FHLB for advances of similar remaining maturities. For subordinated debt issued, the fair value is estimated by discounting the interest and principal payments using approximately the same interest rate spread to treasury securities of comparable term as the notes had when issued. For treasury tax and loan obligations, the carrying amount is a reasonable estimate of fair value.
Repurchase Agreements and Federal Funds Purchased
For Federal funds purchased the carrying amount is a reasonable estimate of their fair value. The fair value of repurchase agreements is determined by reference to rates in the wholesale repurchase market. The rates paid to the Company’s customers are slightly lower than rates in the wholesale market and, consequently, the fair value will generally be less than the carrying amount. The fair value of the long-term repurchase agreements is determined in the same manner as for the subordinated debt described above.
24. SEGMENTS
The Company has four operating lines of business for Management reporting purposes including Community Banking, Commercial Banking, RAL and RT Programs and Wealth Management. The reported financial results for each respective business are based on Management assumptions, which allocate balance sheet and income statement items to each segment based on the type of customer and the types of products and services offered. If the Management structure and or allocation process changes, allocations, transfers and assignments may change.
The following tables present information for each specific operating segment regarding assets, profit or loss, and specific items of revenue and expense that are included in that measure of segment profit or loss as reviewed by the Chief Executive Officer. Included in the table is the All Other information which includes the unallocated portions of administrative support units and PCB.
Community Banking
This segment offers a complete line of banking and diversified financial products and services to consumers and small businesses. Loan products include lines of credit, equity lines and loans, automobile loans, residential mortgage origination, small business lending and debit card processing. In the third quarter of 2008, residential loans began to be originated for sale on a flow basis. In the second quarter of 2007, the Company sold the leasing loan portfolio and a majority of the indirect auto loans were sold as described in Note 6, “Loan Sales and Transactions” of these Consolidated Financial Statements. These portfolios were part of the Community Banking segment and the sale of these loan portfolios has impacted the Community Banking segments interest income. Deposit products include checking, savings, money market accounts, Individual Retirement Accounts (IRAs), time deposits and debit cards. Community Banking serves customers through traditional banking branches, loan service centers, ATMs, through the customer contact call center and online.
Commercial Banking
This segment offers a complete line of commercial and industrial and commercial real estate secured loan products and services. These include traditional commercial loans and lines of credit, letters of credit, asset-based lending, foreign exchange services and treasury management. Commercial Banking also serves the commercial real estate market with products and services such as construction loans for commercial and residential development, land acquisition and development loans, secured and unsecured lines of credit and financing arrangements for completed structures.
Wealth Management
This segment offers trust and investment advisory services and private banking lending, deposit services and securities brokerages services to high net worth individuals and businesses.
RAL and RT Programs
The products provided in this segment are described in Note 7, “RAL and RT Programs” of these Consolidated Financial Statements on page 113. This business segment relates to the filing of income tax returns and consequently is highly seasonal. Approximately 90% of the activity occurs in the first quarter of each year.
All Other
This segment consists of administrative support areas of the Company including PCB. Management does not consider it an operating segment of the Company. The All Other segment is presented in the segment tables above to reflect unallocated operating segments to the consolidated totals of the Company’s Consolidated Financial Statements. The administrative support units include the Company’s executive administration, risk management, information technology operations, marketing, credit administration, human resources, corporate real estate, legal, treasury, finance and accounting areas of the Company. The income generated by the All Other segment is from PCBNA’s securities portfolio which is managed by the treasury department.
Change to the Reportable Segments and Indirect Credit (Charge) for Funds
On March 29, 2007, the Company announced the appointment of a new Chief Executive Officer (CEO). With the appointment of a new CEO, the segment reporting structure has changed. Reportable segments are defined as to how the chief operating decision maker views the operating results of a Company as per SFAS 131, Disclosures about Segments of an Enterprise and Related Information.
The changes made to the reportable segments are as follows:
n
Eleven retail branches with a high concentration of high net worth customers were moved from the Community Banking segment to the Wealth Management segment.
n
The SBA lending, Income Property lending and Commercial lending from FBSLO was moved from the Community Banking segment to the Commercial Banking segment.
n
The Premier and Private Banking divisions were moved from the Community Banking segment to the Commercial Banking segment.
n
The Enterprise Sales division was moved from the All Other segment to the Community Banking segment.
Due to these changes made to the reportable segments, Management was required to re-allocate goodwill to each segment based on the pro-rata fair value of each segment in accordance with SFAS 142. The re-allocation of goodwill occurred when the Company reviewed goodwill for the annual goodwill impairment test in the third quarter of 2008 as described on page 98 in Note 1, “Significant Accounting Policies” of these financial statements.
During the process of re-allocating goodwill, several of the assets and liabilities which had been reported in the All Other segment were allocated to the appropriate operating segment based on usage by the operating segments. In addition, all of the assets and liabilities in all of the operating segments were reviewed and, re-allocated to the appropriate segments to create balanced balance sheets. The process of allocating the assets and liabilities to create balanced balance sheets creates the “indirect credit (charge) for funds” within the tables above. The “indirect credit (charge) for funds is the interest income, interest expense, non-interest income and non-interest expense associated with the transfers of the assets and liabilities to the operating segments.
Included in indirect credit (charge) for funds is an allocation of non-interest expense from the All Other segment for the services provided by the administrative support units include the Company’s executive administration, risk management, information technology operations, marketing, credit administration, human resources, corporate real estate, legal, treasury, finance and accounting areas to the operating segments based on the estimated use of each department services utilized.
The segment tables above are presented as if the changes listed above were in effect as of January 1, 2006 to present comparable information.
The Company has no operations in foreign countries to require disclosure by geographical area. The Company has no single customer generating 10% or more of total revenues.
25. PACIFIC CAPITAL BANCORP (PARENT COMPANY ONLY FINANCIALS)
The condensed financial statements of the Bancorp are presented on the following pages.
PACIFIC CAPITAL BANCORP
Balance Sheets
PACIFIC CAPITAL BANCORP
Statement of Operations
PACIFIC CAPITAL BANCORP
Statements of Cash Flows
26. QUARTERLY FINANCIAL DATA (UNAUDITED)
* Non-interest income is net of securities gains (losses).
** Earnings per share summation difference is due to rounding.
*** Loss per diluted common share for the quarter ended December 31, September 30, and June 30, 2008 is calculated using basic weighted average shares outstanding.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Under the supervision and with the participation of our Management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of December 31, 2008.
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management is responsible for establishing and maintaining adequate internal control over financial reporting at the Company. Our internal control over financial reporting is a process designed under the supervision of the Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external reporting purposes in accordance with accounting principles generally accepted in the United States of America. A company’s internal control over financial reporting includes policies and procedures that (1) pertain to the maintenance of records that accurately and fairly reflect, in reasonable detail, transactions and dispositions of the company’s assets, (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 are being made only in accordance with authorizations of Management and the 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 company’s 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.
As of December 31, 2008, the Company carried out an evaluation, under the supervision and with the participation of the Company’s Management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s internal control over financial reporting pursuant to Rule 13a-15(c), as adopted by the SEC under the Exchange Act. In evaluating the effectiveness of the Company’s internal control over financial reporting, Management used the framework established in “Internal Control-Integrated Framework,” issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”).
Based on this evaluation, Management concluded that as of December 31, 2008, the Company’s internal control over financial reporting was effective.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
Pursuant to the terms of Securities Purchase Agreement, the Company agreed that, until such time as the U.S. Treasury ceases to own any securities of the Company acquired under the Securities Purchase Agreement, and during the period in which any obligation arising from financial assistance provided under the TARP CPP remains outstanding, the Company will take all necessary action to
ensure that its benefit plans with respect to its senior executive officers and other highly compensated employees comply with Section 111(b) of EESA and will not adopt any benefit plans with respect to, or which cover, its senior executive officers that do not comply with EESA. On November 19, 2008, the Compensation Committee of the BOD took action to amend the Company’s benefit plans to comply with Section 111(b) of EESA, as in effect on that date, and the BOD ratified such action on November 20, 2008.
On February 17, 2009, ARRA was signed into law. Section 7001 of ARRA amended Section 111 of EESA in its entirety. While the U.S. Treasury must promulgate regulations to implement the restrictions and standards set forth in Section 7001, ARRA, among other things, significantly expands the executive compensation restrictions previously imposed by EESA. On February 26, 2009, the BOD took action to amend the Company’s benefit plans to comply with Section 111 of EESA, as amended by ARRA. Each of Company’s named executive officers, together with certain of the Company’s other employees, have entered into a Consent in the form attached hereto as Exhibit 10.29, pursuant to which they consented to the amendment of such benefit plans.
GLOSSARY
Accretion: Accretion is the recognition as interest income of the excess of the par value of a security over its cost at the time of purchase.
AFS: Available for sale.
Asset and Liability Committee (ALCO): Oversees the decisions made by the Company’s Management to manage the risk associated with the assets and liabilities held by the Company.
Accumulated Postretirement Benefit Obligation (APBO): is the actuarial net present value of the obligation for: (1) already retired employees’ expected postretirement benefits; and (2) the portion of the expected postretirement benefit obligation earned to date by current employees.
ALL: Allowance for loan loss
ARB: Accounting Research Bulletin
ARRA: American Recovery and Reinvestment Act of 2009
ATM: Automated Teller Machine
Average balances: Average balances are daily averages, i.e., the average is computed using the balances for each day of the year, rather than computing the average of the first and last day of the year.
Bps (Basis Points): Basis points are a percentage expressed by multiplying a percentage by 100. For example, 1.0% is 100 basis points.
Basis risk: When financial instruments have interest rates that differ in how often they change, the extent to which they change, and whether they change sooner or later than other interest rates.
BHCA: Bank Holding Company Act of 1965
BOD: Board of Directors
Call Code: Regulatory code assigned to each individual loan account in order to classify on appropriate FDIC Call Report line item.
CD: Certificate of Deposit
CDARs: Certificate of Deposit Account Registry Services
Core Bank: Includes the Community Banking, Commercial Banking, Wealth Management and All Other segments of the Bank.
Core Deposit Intangibles (CDI): Premium paid on deposits during the time of acquisition.
CEO: Chief Executive Officer
CFO: Chief Financial Officer
CMO: Collateralized Mortgage Obligations
Coupon rate: The stated rate of the loan or security.
COSO: Committee of Sponsoring Organizations
CRA: Community Reinvestment Act
Credit risk: Credit risk relates to the possibility that a debtor will not repay according to the terms of the debt contract.
DIF: Deposit Insurance Fund
ECOA: Equal Credit Opportunity Act
Effective tax rate: The effective tax rate is the amount of the combined current and deferred tax expense divided by the Company’s income before taxes as reported in the Consolidated Statements of Income.
ESOP: Employee Stock Ownership Plan
EESA: Emergency Economic Stabilization Act of 2008
Economic Value of Equity (EVE): A cash flow calculation that takes the present value of all asset cash flows and subtracts the present value of all liability cash flows.
FACT: Fair and Accurate Credit Transactions Act
FASB: Financial Accounting Standards Board
FBSLO: First Bank of San Luis Obispo
FDI Act: Federal Deposit Insurance Act
FDIC: Federal Deposit Insurance Corporation
FDICIA: Federal Deposit Insurance Corporation Improvement Act
FDIRA: Federal Deposit Insurance Reform Act of 2006
FH Act: Fair Housing Act
FHLB: Federal Home Loan Bank
FHLMC: Federal Home Loan Mortgage Corporation
FICO: Financing Corporation, an agency of the federal government established to recapitalize the predecessor to the DIF
FIN 48: FASB Interpretation No. 48
FNB: First National Bank of Central California
FNMA: Federal National Mortgage Association
FOMC: Federal Open Market Committee
FRB: Board of Governors of the Federal Reserve System
FTE: Fully Taxable Equivalent
Fully tax equivalent yield (FTE): A basis of presentation of net interest income and net interest margin adjusted to consistently reflect income from taxable and tax-exempt loans and securities based on the California franchise tax rate of 10.84% and a Federal tax rate of 35%. While the income from these securities and loans is taxable for California, the Company does receive a Federal income tax benefit of 35% of the California tax paid. Since, state taxes are deductible for Federal taxes, and to the extent that the Company pays California franchise tax on this income from these loans and securities, the deduction for state taxes on the Company’s Federal return is larger. The tax equivalent yield is also impacted by the
disallowance of a portion of the underlying cost of funds used to support tax-exempt securities and loans. To compute the tax equivalent yield for these securities one must first add to the actual interest earned an amount such that if the resulting total were fully taxed, and if there were no disallowance of interest expense, the after-tax income would be equivalent to the actual tax-exempt income. This tax equivalent income is then divided by the average balance to obtain the tax equivalent yield.
FTE Net Interest Margin: FTE net interest margin is net interest income plus the FTE 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.
GAAP: General Accepted Accounting Principles, which are approved principles of accounting as generally accepted in the United States of America.
GLBA: Gramm-Leach-Bliley Act
HMDA: Home Mortgage Disclosure Act
HOEPA: Home Ownership and Equal Protection Act of 1994
Holiday Loans: Holiday loans are products offered by professional tax preparers to their clients.
I&I Plan: Incentive and Investment Plan, which permits contributions by the Company to be invested in various mutual funds chosen by the Employees.
Interest rate risk: Interest rate risk relates to the adverse impacts of changes in interest rates on financial instruments.
IRA: Individual Retirement Accounts
IRC: Internal Revenue Code
IRS: Internal Revenue Service
IT: Information Technology
JH: Refers to both Jackson Hewitt, Inc. and Jackson Hewitt Technology Service. The
Company has a contract with each company. These contracts outline the payments as it relates to the program and marketing fees. . Throughout this document a combination of these contracts is referred to as “JH”.
LIBOR: London Inter-Bank Offered Rate
Market risk: Market risk results from the fact that the market values of assets or liabilities on which the interest rate is fixed will increase or decrease with changes in market interest rates.
Mismatch risk: Mismatch risk arises from the fact that when interest rates change, the changes do not occur equally in the rates of interest earned on assets and paid on liabilities. This occurs because of differences in the contractual maturity terms of the assets and liabilities held.
MCM: Morton Capital Management
MD&A: Management Discussion and Analysis
MBS: Mortgage Backed Securities
MSR: Mortgage Servicing Rights
NASDAQ: National Association of Securities Dealers Automated Quotations
Net Interest Income (NII): Net interest income is the difference between the interest earned on the loans and securities portfolios and the interest paid on deposits and wholesale borrowings.
Net interest margin: 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.
NFIA: National Flood Insurance Act
Net Periodic Postretirement Benefit Cost (NPPBC): The portion of the change in APBO that the Company recognizes as an expense.
NOW: Negotiable Order of Withdrawal
OCC: Office of the Comptroller of the Currency
OCI: Other Comprehensive Income
OREO: Other Real Estate Owned
PATRIOT Act: Under the PATRIOT Act, financial institutions are required to establish and maintain anti-money laundering programs.
PCB: Pacific Capital Bancorp
PCBNA: Pacific Capital Bank, National Association
PCCI: Pacific Crest Capital Inc.
PER: Self Filers
PRO: Other professional tax preparers
RAL: Refund anticipation loan
RAL and RT Programs: There are two products related to income tax returns filed electronically, RAL and RT. The Company provides these products to taxpayers who file their returns electronically nationwide.
Repos: Federal funds purchased and securities sold under agreement to repurchase.
RESPA: Real Estate Settlement Procedures Act
REWA: R.E. Wacker Associates
RT: Refund transfer
Sarbanes-Oxley Act: In 2002, the Sarbanes-Oxley Act (“SOX”) was enacted as Federal legislation. This legislation imposes a number of new requirements on financial reporting and corporate governance on all corporations.
SBA: Small Business Administration
SBB: San Benito Bank
SBB&T: Santa Barbara Bank & Trust
SBNB: Santa Barbara National Bank
SEC: Securities and Exchange Commission
SFAS: Statement of Financial Accounting Standards issued by the FASB.
SOX: See Sarbanes-Oxley Act
SVNB: South Valley National Bank
The Company: The Company is Pacific Capital Bancorp, which is a bank holding company.
TLGP: FDIC’s Temporary Liquidity Guarantee Program
TARP: Troubled Asset Relief Program
TARP CPP: TARP Capital Purchase Program
TDR: Troubled debt restructure, restructured loans
TILA: Truth in Lending Act
TIO: FRB’s Term investment option
TT&L: Treasury tax and loan
Veritas: Veritas Wealth Advisors, a limited liability company.
VEBA: Voluntary Employees’ Beneficiary Association
Weighted average rate: The weighted average rate is calculated by dividing the total interest by the computed average balance.
Wholesale funding: Wholesale funding is comprised of borrowings from other financial institutions and deposits received from sources other than through customer relationships.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required by this item is incorporated by reference from the Company’s Definitive Proxy Statement for the 2009 Annual Meeting of Shareholders to be held on April 30, 2009.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference from the Company’s Definitive Proxy Statement for the 2009 Annual Meeting of Shareholders to be held on April 30, 2009.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this item is incorporated by reference from the Company’s Definitive Proxy Statement for the 2009 Annual Meeting of Shareholders to be held on April 30, 2009.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by this item is incorporated by reference from the Company’s Definitive Proxy Statement for the 2009 Annual Meeting of Shareholders to be held on April 30, 2009.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item is incorporated by reference from the Company’s Definitive Proxy Statement for the 2009 Annual Meeting of Shareholders to be held on April 30, 2009.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a)1. FINANCIAL STATEMENTS
The listing of financial statements required by this item is set forth in the index under Item 8 of this Annual Report on Form 10-K.
2. FINANCIAL STATEMENT SCHEDULES
The listing of supplementary financial statement schedules required by this item is set forth in the index under Item 8 of this Annual Report on Form 10-K.
3. EXHIBITS
The listing of exhibits required by this item is set forth in the Exhibit Index beginning on page 159 of this Annual Report on Form 10-K, which Exhibit Index indicates each exhibit that is a management contract or compensatory plan or arrangement.
(b) EXHIBITS
See exhibits listed in “Exhibit Index” on page 159 of this report.
(c) FINANCIAL STATEMENT SCHEDULES
There are no financial statement schedules required by Regulation S-X that have been excluded from the annual report to shareholders.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed by the undersigned, thereunto duly authorized.
Pacific Capital Bancorp
EXHIBIT INDEX TO PACIFIC CAPITAL BANCORP FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 2008
Shareholders may obtain a copy of any exhibit by writing to:
Carol Zepke, Corporate Secretary
Pacific Capital Bancorp
P.O. Box 60839
Santa Barbara, CA 93160
* Effective December 30, 1998, Santa Barbara Bancorp and Pacific Capital Bancorp merged and, contemporaneously with effectiveness of the merger, Santa Barbara Bancorp, the surviving entity, changed its corporate name to Pacific Capital Bancorp. Documents identified as filed by Santa Barbara Bancorp prior to December 30, 1998 were filed by Santa Barbara Bancorp (File 0-11113). Documents identified as filed by Pacific Capital Bancorp prior to December 30, 1998 were filed by Pacific Capital Bancorp as it existed prior to the merger (File No. 0-13528).
** Filed herewith.
x Indicates management contract or compensatory plan or arrangement
The Exhibits listed below are incorporated by reference from the specified filing.
(1) Filed as Exhibit 3(i)(b) to the Current Report on Form 8-K of Pacific Capital Bancorp (File No. 0-11113) filed June 17, 2005.
(2) Filed as Exhibit 3(i)(b) to the Quarterly Report on Form 10-Q of Pacific Capital Bancorp (File No. 0-11113) for the fiscal quarter ended September 30, 2005.
(3) Filed as Exhibit 3.1 to the Current Report on Form 8-K of Pacific Capital Bancorp (File No. 0-11113) filed on November 26, 2008.
(4) Filed as Exhibit 3.2 to the Current Report on Form 8-K of Pacific Capital Bancorp (File No. 0-11113) filed on November 26, 2008.
(5) Filed as Exhibit 4.1 to the Quarterly Report on Form 10-Q of Pacific Capital Bancorp (File No. 0-11113) for the fiscal quarter ended March 31, 2003.
(6) Filed as Exhibit 4.2 to the Current Report on Form 8-K of Pacific Capital Bancorp (File No. 0-11113) filed on November 26, 2008.
(7) Filed as Exhibit 10.1.1 to the Annual Report on Form 10-K of Pacific Capital Bancorp (File No. 0-01113) for the fiscal year ended December 31, 2004.
(8) Filed as Exhibit 10.2 to the Quarterly Report on Form 10-Q of Pacific Capital Bancorp (File No. 0-01113) for the fiscal quarter ended June 30, 2008.
(9) Filed as Exhibit 10.3 to the Quarterly Report on Form 10-Q of Pacific Capital Bancorp (File No. 0-01113) for the fiscal quarter ended June 30, 2008.
(10) Filed as Exhibit 4.2 to the Registration Statement on Form S-8 of Santa Barbara Bancorp (Registration No. 33-48724) filed on June 22, 1992.
(11) Filed as Exhibits 10.1.3 through 10.1.3.4 to the Annual Report on Form 10-K of Pacific Capital Bancorp (File No. 0-01113) for the fiscal year ended December 31, 2004.
(12) Filed as Exhibits 10.1.4 through 10.1.4.2 to the Annual Report on Form 10-K of Pacific Capital Bancorp (File No. 0-01113) for the fiscal year ended December 31, 2004.
(13) Filed as Exhibit 10.1.5 to the Annual Report on Form 10-K of Pacific Capital Bancorp (File No. 0-01113) for the fiscal year ended December 31, 2004.
(14) Filed as Exhibit 10.1.6 to the Annual Report on Form 10-K of Pacific Capital Bancorp (File No. 0-01113) for the fiscal year ended December 31, 2004.
(15) Filed as Exhibit 10.6.1 to Annual Report on Form 10-K of Pacific Capital Bancorp (File No. 0-11113) for the fiscal year ended December 31, 2006.
(16) Filed as Exhibit 10.1.8 to Annual Report on Form 10-K of Santa Barbara Bancorp (File No. 0-11113) for the fiscal year ended December 31, 1997.
(17) Filed as Exhibit 10.1.13 to Annual Report on Form 10-K of Santa Barbara Bancorp (File No. 0-11113) for fiscal year ended December 31, 1995.
(18) Filed as Exhibits 10.1.8 through 10.1.8.2 to the Annual Report on Form 10-K of Pacific Capital Bancorp (File No. 0-01113) for the fiscal year ended December 31, 2004.
(19) Filed as Exhibit 10.1 to Current Report on Form 8-K of Pacific Capital Bancorp (File No. 0-11113) filed February 20, 2008.
(20) Filed as Exhibits 10.1.13 through 10.1.13.1 to the Annual Report on Form 10-K of Pacific Capital Bancorp (File No. 0-01113) for the fiscal year ended December 31, 2004.
(21) Filed as Exhibit 99.1 to the Current Report on Form 8-K of Pacific Capital Bancorp (File No. 0-11113) filed September 25, 2007.
(22) Filed as Exhibit 10.1.15 to Annual Report on Form 10-K of Pacific Capital Bancorp (File No. 0-11113) for the fiscal year ended December 31, 2005.
(23) Filed as Exhibits 10.1.23, 10.1.25 and 10.1.26 to the Quarterly Report on Form 10-Q of Pacific Capital Bancorp (File No. 0-11113) for the fiscal quarter ended September 30, 2006.
(24) Filed as Exhibit 10.14 to Annual Report on Form 10-K of Pacific Capital Bancorp (File No. 0-11113) for the fiscal year ended December 31, 2006.
(25) Filed as Exhibits 10.1.18 and 10.1.19 to Annual Report on Form 10-K of Pacific Capital Bancorp (File No. 0-11113) for the fiscal year ended December 31, 2005.
(26) Filed as Addendum B to the Definitive Proxy Statement on Schedule 14A of Pacific Capital Bancorp (File No. 0-11113) filed April 21, 2005.
(27) Filed as Exhibits 4.2 and 4.3 to the Registration Statement on Form S-8 of Pacific Capital Bancorp (Registration No. 333-127982) filed on August 31, 2005.
(28) Filed as Exhibit 10.1 to the Current Report on Form 8-K of Pacific Capital Bancorp (File No. 0-11113) filed March 30, 2007.
(29) Filed as Exhibit 10.2 to Current Report on Form 8-K (File No. 0-11113) filed February 20, 2008.
(30) Filed as Exhibit 10.23 and 10.24 to the Quarterly Report on Form 10-Q of Pacific Capital Bancorp (File No. 0-11113) for the fiscal quarter ended June 30, 2007.
(31) Filed as Exhibit A to the Definitive Proxy Statement on Schedule 14A of Pacific Capital Bancorp (File No. 0-11113) filed March 19, 2008.
(32) Filed as Exhibit 10.1 to the Quarterly Report on Form 10-Q of Pacific Capital Bancorp (File No. 0-01113) for the fiscal quarter ended June 30, 2008.
(33) Filed as Exhibit 10.1 to the Current Report on Form 8-K of Pacific Capital Bancorp (File No. 0-11113) filed November 26, 2008.
(34) Filed as Exhibit 10.2 to the Current Report on Form 8-K of Pacific Capital Bancorp (File No. 0-11113) filed November 26, 2008.
(35) Filed as Exhibit 10.3 to the Current Report on Form 8-K of Pacific Capital Bancorp (File No. 0-11113) filed November 26, 2008.
(36) Filed as Exhibit 10.4 to the Current Report on Form 8-K of Pacific Capital Bancorp (File No. 0-11113) filed November 26, 2008.