Item 1. Business
General
The Company
Sierra Bancorp (the “Company”) is a California corporation headquartered in Porterville, California, and is a registered bank holding company under federal banking laws. The Company was formed to serve as the holding company for Bank of the Sierra (the “Bank”), and has been the Bank’s sole shareholder since August 2001. The Company exists primarily for the purpose of holding the stock of the Bank and of such other subsidiaries it may acquire or establish. As of December 31, 2017, the Company’s only other subsidiaries were Sierra Statutory Trust II, Sierra Capital Trust III, and Coast Bancorp Statutory Trust II, which were formed solely to facilitate the issuance of capital trust pass-through securities (“TRUPS”). Pursuant to the Financial Accounting Standards Board (“FASB”) standard on the consolidation of variable interest entities, these trusts are not reflected on a consolidated basis in the financial statements of the Company. References herein to the “Company” include Sierra Bancorp and its consolidated subsidiary, the Bank, unless the context indicates otherwise. At December 31, 2017, the Company had consolidated assets of $2.340 billion (including gross loans of $1.558 billion), liabilities totaling $2.084 billion (including deposits of $1.988 billion), and shareholders’ equity of $256 million. The Company’s liabilities include $35 million in debt obligations due to its trust subsidiaries, related to TRUPS issued by those entities.
The Bank
Bank of the Sierra, a California state-chartered bank headquartered in Porterville, California, offers a full range of retail and commercial banking services via branch offices located throughout California’s South San Joaquin Valley, the Central Coast, Ventura County, and neighboring communities. The Bank was incorporated in September 1977, and opened for business in January 1978 as a one-branch bank with $1.5 million in capital. Our growth in the ensuing years has largely been organic in nature, but includes four whole-bank acquisitions: Sierra National Bank in 2000, Santa Clara Valley Bank in 2014, Coast National Bank in 2016, and Ojai Community Bank in October 2017. See Note 21 to the consolidated financial statements, Business Combinations, for details on our most recent acquisitions.
The Ojai Community Bank acquisition included branches in Ojai, Ventura, Santa Paula, and Santa Barbara, California, and we consolidated our Oxnard loan production office into the Ventura branch shortly after the acquisition. Furthermore, we acquired a branch in Woodlake, California in November 2017, opened de novo branches in Bakersfield and Pismo Beach earlier in the year, and relocated our Paso Robles branch in the first quarter of 2017. We also closed our Fresno Herndon branch in October 2017, but intend to open another Fresno branch on Palm Avenue in the first half of 2018 within close proximity of the discontinued office. With our latest acquisitions and branching activity, as of December 31, 2017 the Bank operated 39 full-service branches in the following California locations:
Porterville:
Administrative Headquarters
86 North Main Street
Main Office
90 North Main Street
West Olive Branch
1498 West Olive Avenue
Arroyo Grande:
Arroyo Grande Office
1360 East Grand Avenue
Atascadero:
Atascadero Office
7315 El Camino Real
Bakersfield:
Bakersfield California Office
4456 California Ave
Bakersfield Riverlakes Office
4060 Coffee Road
Bakersfield East Hills Office
2501 Mt. Vernon Avenue
Bakersfield Ming Office
8500 Ming Avenue
California City:
California City Office
8031 California City Blvd.
Clovis:
Clovis Office
1835 East Shaw Avenue
Delano:
Delano Office
1126 Main Street
Dinuba:
Dinuba Office
401 East Tulare Street
Exeter:
Exeter Office
1103 West Visalia Road
Farmersville:
Farmersville Office
400 West Visalia Road
Fillmore:
Fillmore Office
527 Sespe Avenue
Fresno:
Fresno Shaw Office
636 East Shaw Avenue
Fresno Sunnyside Office
5775 E. Kings Canyon Rd.
Hanford:
Hanford Office
427 West Lacey Boulevard
Lindsay:
Lindsay Office
142 South Mirage Avenue
Ojai:
Ojai Office
402 W. Ojai Avenue
Paso Robles:
Paso Robles Office
1207 Spring Street
Pismo Beach:
Pismo Beach Office
1401 Dolliver Street
Reedley:
Reedley Office
1095 W. Manning Street
San Luis Obispo:
San Luis Obispo Office
500 Marsh Street
Sanger:
Sanger Office
1500 7th Street
Santa Barbara:
Santa Barbara Office
21 E. Carrillo Street
Santa Clarita:
Santa Clarita Office
26328 Citrus Street
Santa Paula:
Santa Paula Office
901 E. Main Street
Santa Paula Harvard Office
537 West Harvard Boulevard
Selma:
Selma Office
2446 McCall Avenue
Tehachapi:
Tehachapi Downtown Office
224 West “F” Street
Tehachapi Old Town Office
21000 Mission Street
Three Rivers:
Three Rivers Office
40884 Sierra Drive
Tulare:
Tulare Office
246 East Tulare Avenue
Tulare Prosperity Office
1430 E Prosperity Avenue
Ventura:
Ventura Office
89 S. California Street
Visalia:
Visalia Mooney Office
2515 South Mooney Blvd.
Visalia Downtown Office
128 East Main Street
Woodlake:
Woodlake Office
232 N. Valencia Boulevard
Additional branching activity has occurred in or is planned for the first part of 2018, including the consolidation of Ojai Community Bank’s former Santa Paula branch (the Santa Paula Harvard Office) into our Santa Paula Main Street office in early January, the opening of a branch on Palm Avenue in Fresno in the second quarter, and the acquisition of Community Bank of Santa Maria’s Lompoc branch in the second quarter (see “Recent Developments” below). Complementing the Bank’s stand-alone offices are specialized lending units which include our real estate industries center, an agricultural credit center, and an SBA lending unit. We also have ATMs at all branch locations and six different non-branch locations. Furthermore, the Bank is a member of the Allpoint network, which provides our deposit customers with surcharge-free access to over 43,000 ATMs across the nation and another 12,000 ATMs in foreign countries, and customers have access to electronic point-of-sale payment alternatives nationwide via the Pulse network. To ensure that account access preferences are addressed for all customers, we provide the following options: an internet branch which provides the ability to open deposit accounts online; an online banking option with bill-pay and mobile banking capabilities, including mobile check deposit; a customer service center that is accessible by toll-free telephone during business hours; and an automated telephone banking system that is usually accessible 24 hours a day, seven days a week. We offer a variety of other banking products and services to complement and support our lending and deposit products, including remote deposit capture and payroll services for business customers.
Our chief products and services relate to extending loans and accepting deposits. Our lending activities include real estate, commercial (including small business), mortgage warehouse, agricultural, and consumer loans. The bulk of our real estate loans are secured by commercial, professional office and agricultural properties, but we also offer a complete line of construction loans for residential and commercial development, permanent mortgage loans, land acquisition and development loans, and multifamily credit facilities. Secondary market services for residential mortgage loans are provided through the Bank’s affiliations with Freddie Mac, Fannie Mae and certain non-governmental institutions. As noted above, gross loans totaled $1.558 billion at December 31, 2017, and the percentage of our total loan and lease portfolio for each of the principal types of credit we extend was as follows: (i) loans secured by real estate (78.7%); (ii) agricultural production loans (3.0%); (iii) commercial and industrial loans and leases (including SBA loans and direct finance leases) (8.7%); (iv) mortgage warehouse loans (8.9%); and (v) consumer loans (0.7%). Interest, fees, and other income on real-estate secured loans, which is by far the largest segment of our portfolio, totaled $53.3 million, or 55% of net interest plus other income in 2017, and $42.1 million, or 50% of net interest plus other income in 2016.
In addition to loans, we offer a wide range of deposit products and services for individuals and businesses including checking accounts, savings accounts, money market demand accounts, time deposits, retirement accounts, and sweep accounts. The Bank’s deposit accounts are insured by the Federal Deposit Insurance Corporation (the “FDIC”) up to maximum insurable amounts. We attract deposits throughout our market area via referrals from other customers, direct-mail campaigns, a customer-oriented product mix, competitive pricing, convenient locations,
drive-through banking, and by offering various other delivery channels. We strive to retain our deposit customers by providing a consistently high level of service. At December 31, 2017, the consolidated Company had 118,700 deposit accounts totaling $1.988 billion, compared to 107,500 deposit accounts totaling $1.695 billion at December 31, 2016.
We have not engaged in any material research activities related to the development of new products or services during the last two fiscal years. However, our officers and employees are continually searching for ways to increase public convenience, enhance customer access to payment systems, and enable us to improve our competitive position. The cost to the Bank for these development, operations, and marketing activities cannot be calculated with any degree of certainty. We hold no patents or licenses (other than licenses required by bank regulatory agencies), franchises, or concessions. Our business has a modest seasonal component due to the heavy agricultural orientation of the Central Valley, but as our branches in more metropolitan areas have expanded we have become less reliant on the agriculture-related base. We are not dependent on a single customer or group of related customers for a material portion of our core deposits, but our time deposit balances at December 31, 2017 include $120 million in deposits from the State of California, comprising 6% of total deposits. Furthermore, for loans we have what could be considered to be industry concentrations in loans to the dairy industry (8% of total loans), and credit extended to mortgage companies in the form of mortgage warehouse loans (9% of total loans). Our efforts to comply with government and regulatory mandates on consumer protection and privacy, anti-terrorism, and other initiatives have resulted in significant ongoing expense to the Bank, including compliance staffing costs and other expenses associated with compliance-related software. However, as far as can be determined there has been no material effect upon our capital expenditures, earnings, or competitive position as a result of environmental regulation at the Federal, state, or local level. The Company is not involved with chemicals or toxins that might have an adverse effect on the environment, thus its primary exposure to environmental legislation is through lending activities. The Company’s lending procedures include steps to identify and monitor this exposure in an effort to avoid any related loss or liability.
Recent Developments
On October 1, 2017, the Company completed its acquisition of OCB Bancorp, parent company to Ojai Community Bank (collectively referred to herein as “Ojai”), and the conversion of Ojai’s core banking system to Bank of the Sierra’s core system took place on November 3, 2017. Furthermore, on November 3, 2017 the Company acquired the Woodlake branch of Citizen’s Business Bank. See Note 21 to the consolidated financial statements, Business Combinations, for more detailed information on these acquisitions.
On January 23, 2018, the Bank announced that it has entered into an agreement with Community Bank of Santa Maria to acquire its branch located in Lompoc, California (Santa Barbara County). The transaction is expected to close in the second quarter of 2018, subject to the receipt of all required regulatory approvals. Subsequent to the acquisition, the Lompoc branch will operate as a full-service branch of Bank of the Sierra. Lompoc branch deposits totaled $39 million at December 31, 2017, consisting largely of non-maturity deposits. However, some of those deposits are excluded pursuant to the terms of the acquisition agreement and it is expected that the amount ultimately acquired could be closer to $35 million. The acquisition agreement also contemplates that Bank of the Sierra will purchase the Lompoc branch building, the real property on which the building is located, and certain other equipment and fixed assets at their aggregate fair value of $1.7 million.
Recent Accounting Pronouncements
Information on recent accounting pronouncements is contained in Note 2 to the consolidated financial statements.
Competition
The banking business in California is generally highly competitive, including in our market areas. Continued consolidation within the banking industry has heightened competition in recent periods, following on the heels of a relatively large number of FDIC-assisted takeovers of failed banks and other acquisitions of troubled financial institutions in the aftermath of the Great Recession. There are also a number of unregulated companies competing for business in our markets, with financial products targeted at profitable customer segments. Many of those companies are able to compete across geographic boundaries and provide meaningful alternatives to banking products and services. These competitive trends are likely to continue.
With respect to commercial bank competitors, our business is dominated by a relatively small number of major banks that operate a large number of offices within our geographic footprint. Based on June 30, 2017 FDIC combined market share data for the 30 cities within which the Company currently maintains branches, the largest portion of deposits belongs to Wells Fargo Bank with 21.7% of total combined deposits, followed by Bank of America (17.3%), JPMorgan Chase (10.4%), Union Bank (8.7%), and Rabobank (5.5%). Bank of the Sierra ranks sixth on the 2017 market share list with 4.7% of total deposits (including Ojai Community Bank deposits). In Tulare County, however, where the Bank was originally formed, we rank first for deposit market share with 20.0% of total deposits at June 30, 2017, and had the largest number of branch locations (12, including our online branch). With the addition of the Woodlake branch, which is not included in the numbers above, Bank of the Sierra now operates 13 branches in Tulare County and enjoys an even higher market share percentage. The larger banks noted above have, among other advantages, the ability to finance wide-ranging advertising campaigns and to allocate their resources to regions of highest yield and demand. They can also offer certain services that we do not provide directly but may offer indirectly through correspondent institutions, and by virtue of their greater capitalization those banks have legal lending limits that are substantially higher than ours. For loan customers whose needs exceed our legal lending limits, we typically arrange for the sale, or participation, of some of the balances to financial institutions that are not within our geographic footprint.
In addition to other banks our competitors include savings institutions, credit unions, and numerous non-banking institutions such as finance companies, leasing companies, insurance companies, brokerage firms, asset management groups, mortgage banking firms and internet companies. Innovative technologies have lowered traditional barriers of entry and enabled many of these companies to offer services that were previously considered traditional banking products, and we have witnessed increased competition from companies that circumvent the banking system by facilitating payments via the internet, mobile devices, prepaid cards, and other means.
Strong competition for deposits and loans among financial institutions and non-banks alike affects interest rates and terms on which financial products are offered to customers. Mergers between financial institutions have created additional pressures within the financial services industry to streamline operations, reduce expenses, and increase revenues in order to remain competitive. Competition is also impacted by federal and state interstate banking laws which permit banking organizations to expand into other states. The relatively large California market has been particularly attractive to out-of-state institutions.
For years we have countered rising competition by offering a broad array of products with flexibility in structure and terms that cannot always be matched by our competitors. We also offer our customers community-oriented, personalized service, and rely on local promotional activity and personal contact by our employees. As noted above, layered onto our traditional personal-contact banking philosophy are technology-driven initiatives that improve customer access and convenience.
Employees
As of December 31, 2017 the Company had 490 full-time and 86 part-time employees. On a full-time equivalent basis staffing stood at 560 at December 31, 2017, up from 479 at December 31, 2016.
Regulation and Supervision
Banks and bank holding companies are heavily regulated by federal and state laws and regulations. Most banking regulations are intended primarily for the protection of depositors and the deposit insurance fund and not for the benefit of shareholders. The following is a summary of certain statutes, regulations and regulatory guidance affecting the Company and the Bank. This summary is not intended to be a complete explanation of such statutes, regulations and guidance, all of which are subject to change in the future, nor does it fully address their effects and potential effects on the Company and the Bank.
Regulation of the Company Generally
The Company is a legal entity separate and distinct from the Bank and its other subsidiaries. As a bank holding company, the Company is regulated under the Bank Holding Company Act of 1956 (the “BHC Act”), and is subject
to supervision, regulation and inspection by the Federal Reserve Board. The Company is also subject to certain provisions of the California Financial Code which are applicable to bank holding companies. In addition, the Company is under the jurisdiction of the SEC and is subject to the disclosure and regulatory requirements of the Securities Act of 1933 and the Securities Exchange Act of 1934, each administered by the SEC. The Company’s common stock is listed on the NASDAQ Global Select market (“NASDAQ”) with “BSRR” as its trading symbol, and the Company is subject to the rules of NASDAQ for listed companies.
The Company is a bank holding company within the meaning of the BHC Act and is registered as such with the Federal Reserve Board. A bank holding company is required to file annual reports and other information with the Federal Reserve regarding its business operations and those of its subsidiaries. In general, the BHC Act limits the business of bank holding companies to banking, managing or controlling banks and other activities that the Federal Reserve has determined to be so closely related to banking as to be a proper incident thereto, including securities brokerage services, investment advisory services, fiduciary services, and management advisory and data processing services, among others. A bank holding company that also qualifies as and elects to become a “financial holding company” may engage in a broader range of activities that are financial in nature or complementary to a financial activity (as determined by the Federal Reserve or Treasury regulations), such as securities underwriting and dealing, insurance underwriting and agency, and making merchant banking investments. The Company has not elected to become a financial holding company but may do so at some point in the future if deemed appropriate in view of opportunities or circumstances at the time.
The BHC Act requires the prior approval of the FRB for the direct or indirect acquisition of more than five percent of the voting shares of a commercial bank or its parent holding company. Acquisitions by the Bank are subject instead to the Bank Merger Act, which requires the prior approval of an acquiring bank’s primary federal regulator for any merger with or acquisition of another bank. Acquisitions by both the Company and the Bank also require the prior approval of the California Department of Business Oversight (the “DBO”) pursuant to the California Financial Code.
The Company and the Bank are deemed to be “affiliates” of each other and thus are subject to Sections 23A and 23B of the Federal Reserve Act as well as related Federal Reserve Regulation W which impose both quantitative and qualitative restrictions and limitations on transactions between affiliates. The Bank is also subject to laws and regulations requiring that all extensions of credit to our executive officers, directors, principal shareholders and related parties must, among other things, be made on substantially the same terms and follow credit underwriting procedures no less stringent than those prevailing at the time for comparable transactions with persons not related to the Bank.
Under certain conditions, the Federal Reserve has the authority to restrict the payment of cash dividends by a bank holding company as an unsafe and unsound banking practice, and may require a bank holding company to obtain the approval of the Federal Reserve prior to purchasing or redeeming its own equity securities. The Federal Reserve also has the authority to regulate the debt of bank holding companies.
A bank holding company is required to act as a source of financial and managerial strength for its subsidiary banks and must commit resources as necessary to support such subsidiaries. The Federal Reserve may require a bank holding company to contribute additional capital to an undercapitalized subsidiary bank and may disapprove of the holding company’s payment of dividends to the shareholders in such circumstances.
Regulation of the Bank Generally
As a state chartered bank, the Bank is subject to broad federal regulation and oversight extending to all its operations by the FDIC and to state regulation by the DBO. The Bank is also subject to certain regulations of the Federal Reserve Board.
Capital Adequacy Requirements
The Company and the Bank are subject to the regulations of the Federal Reserve Board and the FDIC, respectively, governing capital adequacy. These agencies have adopted risk-based capital guidelines to provide a systematic ana
lytical framework that imposes regulatory capital requirements based on differences in risk profiles among banking organizations, considers off-balance sheet exposures in evaluating capital adequacy, and minimizes disincentives to holding liquid, low-risk assets. Capital levels, as measured by these standards, are also used to categorize financial institutions for purposes of certain prompt corrective action regulatory provisions.
Pursuant to the adoption of final rules implementing the Basel Committee on Banking Supervision’s capital guidelines for all U.S. banks and bank holding companies with more than $500 million in assets, minimum regulatory requirements for both the quantity and quality of capital held by the Company and the Bank increased effective January 1, 2015. Furthermore, a capital class known as Common Equity Tier 1 capital was established in addition to Tier 1 capital and Tier 2 capital, and most financial institutions were given the option of a one-time election to continue to exclude accumulated other comprehensive income (“AOCI”) from regulatory capital. The Company has exercised its option to exclude AOCI from regulatory capital. The final rules also increased capital requirements for certain categories of assets, including higher-risk construction and real estate loans, certain past-due or nonaccrual loans, and certain exposures related to securitizations. The final rules permanently grandfather non-qualifying capital instruments (such as trust preferred securities and cumulative perpetual preferred stock) issued before May 19, 2010 for inclusion in the Tier 1 capital of banking organizations with total consolidated assets of less than $15 billion at December 31, 2009, subject to a limit of 25% of Tier 1 capital. All of the Company’s trust preferred securities were issued prior to that date, and they continue to qualify as Tier 1 capital.
Our Common Equity Tier 1 capital includes common stock, additional paid-in capital, and retained earnings, less the following: disallowed goodwill and intangibles, disallowed deferred tax assets, and any insufficient additional capital to cover the deductions. Tier 1 capital is generally defined as the sum of core capital elements, less the following: goodwill and other intangible assets, accumulated other comprehensive income, disallowed deferred tax assets, and certain other deductions. The following items are defined as core capital elements: (i) common shareholders’ equity; (ii) qualifying non-cumulative perpetual preferred stock and related surplus (and, in the case of holding companies, senior perpetual preferred stock issued to the U.S. Treasury Department pursuant to the Troubled Asset Relief Program); (iii) minority interests in the equity accounts of consolidated subsidiaries; and (iv) “restricted” core capital elements (which include qualifying trust preferred securities) up to 25% of all core capital elements. Tier 2 capital includes the following supplemental capital elements: (i) allowance for loan and lease losses (but not more than 1.25% of an institution’s risk-weighted assets); (ii) perpetual preferred stock and related surplus not qualifying as core capital; (iii) hybrid capital instruments, perpetual debt and mandatory convertible debt instruments; and, (iv) term subordinated debt and intermediate-term preferred stock and related surplus. The maximum amount of Tier 2 capital is capped at 100% of Tier 1 capital.
The final rules established a regulatory minimum of 4.5% for common equity Tier 1 capital to total risk weighted assets (“Common Equity Tier 1 RBC Ratio”), a minimum of 6.0% for Tier 1 capital to total risk weighted assets (“Tier 1 Risk-Based Capital Ratio” or “Tier 1 RBC Ratio”), a minimum of 8.0% for qualifying Tier 1 plus Tier 2 capital to total risk weighted assets (“Total Risk-Based Capital Ratio” or “Total RBC Ratio”), and a minimum of 4.0% for the Leverage Ratio, which is defined as Tier 1 capital to adjusted average assets (quarterly average assets less the disallowed capital items discussed above). In addition to the other minimum risk-based capital standards the final rules also require a Common Equity Tier 1 capital conservation buffer, which is being phased in over three years starting on January 1, 2016. The capital conservation buffer was 0.625% for 2016 and 1.25% for 2017. It increased to 1.875% for 2018 and will be fully phased in to 2.5% of risk-weighted assets beginning on January 1, 2019. At that point the buffer will effectively raise the minimum required Common Equity Tier 1 RBC Ratio to 7.0%, the Tier 1 RBC Ratio to 8.5%, and the Total RBC Ratio to 10.5%. Institutions that do not maintain the required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases, and on the payment of discretionary bonuses to executive management.
Based on our capital levels at December 31, 2017 and 2016, the Company and the Bank would have met all capital adequacy requirements under the Basel III Capital Rules on a fully phased-in basis. For more information on the Company’s capital, see Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operation - Capital Resources. Risk-based capital ratio (“RBC”) requirements are discussed in greater detail in the following section.
Prompt Corrective Action Provisions
Federal law requires each federal banking agency to take prompt corrective action to resolve the problems of insured financial institutions, including but not limited to those that fall below one or more of the prescribed minimum capital ratios. The federal banking agencies have by regulation defined the following five capital categories: “well capitalized” (Total RBC Ratio of 10%; Tier 1 RBC Ratio of 8%; Common Equity Tier 1 RBC Ratio of 6.5%; and Leverage Ratio of 5%); “adequately capitalized” (Total RBC Ratio of 8%; Tier 1 RBC Ratio of 6%; Common Equity Tier 1 RBC Ratio of 4.5%; and Leverage Ratio of 4%); “undercapitalized” (Total RBC Ratio of less than 8%; Tier 1 RBC Ratio of less than 6%; Common Equity Tier 1 RBC Ratio of less than 4.5%; or Leverage Ratio of less than 4%); “significantly undercapitalized” (Total RBC Ratio of less than 6%; Tier 1 RBC Ratio of less than 4%; Common Equity Tier 1 RBC Ratio of less than 3%; or Leverage Ratio less than 3%); and “critically undercapitalized” (tangible equity to total assets less than or equal to 2%). A bank may be treated as though it were in the next lower capital category if, after notice and the opportunity for a hearing, the appropriate federal agency finds an unsafe or unsound condition or practice merits a downgrade, but no bank may be treated as “critically undercapitalized” unless its actual tangible equity to assets ratio warrants such treatment. As of December 31, 2017 and 2016, both the Company and the Bank were deemed to be well capitalized for regulatory capital purposes.
At each successively lower capital category, an insured bank is subject to increased restrictions on its operations. For example, a bank is generally prohibited from paying management fees to any controlling persons or from making capital distributions if to do so would cause the bank to be “undercapitalized.” Asset growth and branching restrictions apply to undercapitalized banks, which are required to submit written capital restoration plans meeting specified requirements (including a guarantee by the parent holding company, if any). “Significantly undercapitalized” banks are subject to broad regulatory authority, including among other things capital directives, forced mergers, restrictions on the rates of interest they may pay on deposits, restrictions on asset growth and activities, and prohibitions on paying bonuses or increasing compensation to senior executive officers without FDIC approval. Even more severe restrictions apply to “critically undercapitalized” banks. Most importantly, except under limited circumstances, not later than 90 days after an insured bank becomes critically undercapitalized the appropriate federal banking agency is required to appoint a conservator or receiver for the bank.
In addition to measures taken under the prompt corrective action provisions, insured banks may be subject to potential actions by the federal regulators for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the issuance of cease and desist orders, termination of insurance on deposits (in the case of a bank), the imposition of civil money penalties, the issuance of directives to increase capital, formal and informal agreements, or removal and prohibition orders against “institution-affiliated” parties.
Safety and Soundness Standards
The federal banking agencies have also adopted guidelines establishing safety and soundness standards for all insured depository institutions. Those guidelines relate to internal controls, information systems, internal audit systems, loan underwriting and documentation, compensation, and liquidity and interest rate exposure. In general, the standards are designed to assist the federal banking agencies in identifying and addressing problems at insured depository institutions before capital becomes impaired. If an institution fails to meet the requisite standards, the appropriate federal banking agency may require the institution to submit a compliance plan and could institute enforcement proceedings if an acceptable compliance plan is not submitted or followed.
The Dodd-Frank Wall Street Reform and Consumer Protection Act
Legislation and regulations enacted and implemented since 2008 in response to the U.S. economic downturn and financial industry instability continue to impact most institutions in the banking sector. Certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), which was enacted in 2010, are now effective and have been fully implemented, including revisions to the deposit insurance assessment base for FDIC insurance and a permanent increase in coverage to $250,000; the permissibility of paying interest on business checking accounts; the removal of barriers to interstate branching; and, required disclosures and shareholder advisory votes on executive compensation. Additional actions taken to implement Dodd-Frank provisions include (i) final capital rules, (ii) a final rule to implement the so called Volcker rule restrictions on certain proprietary trading and
investment activities, and (iii) final rules and increased enforcement action by the Consumer Finance Protection Bureau (discussed further below in connection with consumer protection).
Some aspects of Dodd-Frank are still subject to rulemaking, making it difficult to anticipate the ultimate financial impact on the Company, its customers or the financial services industry more generally. However, many provisions of Dodd-Frank are already affecting our operations and expenses, including but not limited to changes in FDIC assessments, the permitted payment of interest on demand deposits, and enhanced compliance requirements. Some of the rules and regulations promulgated or yet to be promulgated under Dodd-Frank will apply directly only to institutions much larger than ours, but could indirectly impact smaller banks, either due to competitive influences or because certain required practices for larger institutions may subsequently become expected “best practices” for smaller institutions. We could see continued attention and resources devoted by the Company to ensure compliance with the statutory and regulatory requirements engendered by Dodd-Frank.
Tax Cuts and Jobs Act
On December 22, 2017, the Tax Cuts and Jobs Act (the “Act”) was signed into law. The Act makes significant changes that impact corporate taxation, including the reduction of the maximum federal income tax rate for corporations from 35% to 21% and changes or limitations to certain tax deductions. The reduced tax rate will have a favorable impact on our tax expense beginning in 2018, and we anticipate that our blended marginal income tax rate will drop to 29.56% in 2018 from 42.05% in 2017. The tax rate reduction also resulted an adjustment to our deferred tax assets and liabilities to reflect their value to the Company at the lower federal tax rate of 21%, with such revaluation required in the period in which the legislation was enacted. Subsequent to a detailed analysis of our deferred tax assets and liabilities we reduced our net deferred tax asset by $2.710 million via a charge to our income tax provision, and our net deferred tax asset totaled $6.527 million at December 31, 2017.
Deposit Insurance
The Bank’s deposits are insured up to maximum applicable limits under the Federal Deposit Insurance Act, and the Bank is subject to deposit insurance assessments to maintain the FDIC’s Deposit Insurance Fund (the “DIF”). In October 2010, the FDIC adopted a revised restoration plan to ensure that the DIF’s designated reserve ratio (“DRR”) reaches 1.35% of insured deposits by September 30, 2020, the deadline mandated by the Dodd-Frank Act. In August 2016 the FDIC announced that the DIF reserve ratio had surpassed 1.15% as of June 30, 2016 and assessment rates for most institutions were adjusted downward, but institutions with $10 billion or more in assets were assessed a quarterly surcharge which will continue until the reserve ratio reaches the statutory minimum of 1.35%. Furthermore, the restoration plan proposed an increase in the DRR to 2% of estimated insured deposits as a long-term goal for the fund.
As noted above, the Dodd-Frank Act provided for a permanent increase in FDIC deposit insurance per depositor from $100,000 to $250,000 retroactive to January 1, 2008. Furthermore, effective in the second quarter of 2011, FDIC deposit insurance premium assessment rates were adjusted, and the assessment base was established as an institution’s total assets less tangible equity. We are generally unable to control the amount of premiums that we are required to pay for FDIC deposit insurance. If there are additional bank or financial institution failures or if the FDIC otherwise determines, we may be required to pay higher FDIC premiums, which could have a material adverse effect on our earnings and/or on the value of, or market for, our common stock.
In addition to DIF assessments, banks must pay quarterly assessments that are applied to the retirement of Financing Corporation bonds issued in the 1980’s to assist in the recovery of the savings and loan industry. The assessment amount can fluctuate, but was 0.54 basis points of insured deposits for the fourth quarter of 2017. Those assessments will continue until the Financing Corporation bonds mature in 2019.
Community Reinvestment Act
The Bank is subject to certain requirements and reporting obligations involving Community Reinvestment Act (“CRA”) activities. The CRA generally requires federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of its local communities, including low and moderate income neighborhoods. The
CRA further requires the agencies to consider a financial institution’s efforts in meeting its community credit needs when evaluating applications for, among other things, domestic branches, mergers or acquisitions, or the formation of holding companies. In measuring a bank’s compliance with its CRA obligations, the regulators utilize a performance-based evaluation system under which CRA ratings are determined by the bank’s actual lending, service, and investment performance, rather than on the extent to which the institution conducts needs assessments, documents community outreach activities or complies with other procedural requirements. In connection with its assessment of CRA performance, the FDIC assigns a rating of “outstanding,” “satisfactory,” “needs to improve” or “substantial noncompliance.” The Bank most recently received a “satisfactory” CRA assessment rating in May 2016.
Privacy and Data Security
The Gramm-Leach-Bliley Act, also known as the Financial Modernization Act of 1999 (the “Financial Modernization Act”), imposed requirements on financial institutions with respect to consumer privacy. Financial institutions, however, are required to comply with state law if it is more protective of consumer privacy than the Financial Modernization Act. The Financial Modernization Act generally prohibits disclosure of consumer information to non-affiliated third parties unless the consumer has been given the opportunity to object and has not objected to such disclosure. The statute also directed federal regulators, including the Federal Reserve and the FDIC, to establish standards for the security of consumer information, and requires financial institutions to disclose their privacy policies to consumers annually.
Overdrafts
The Electronic Funds Transfer Act, as implemented by the Federal Reserve’s Regulation E, governs transfers initiated through automated teller machines (“ATMs”), point-of-sale terminals, and other electronic banking services. Regulation E prohibits financial institutions from assessing an overdraft fee for paying ATM and one-time point-of-sale debit card transactions, unless the customer affirmatively opts in to the overdraft service for those types of transactions. The opt-in provision establishes requirements for clear disclosure of fees and terms of overdraft services for ATM and one-time debit card transactions. The rule does not apply to other types of transactions, such as check, automated clearinghouse (“ACH”) and recurring debit card transactions. Additionally, in November 2010 the FDIC issued its Overdraft Guidance on automated overdraft service programs, to ensure that a bank mitigates the risks associated with offering automated overdraft payment programs and complies with all consumer protection laws and regulations.
Consumer Financial Protection and Financial Privacy
Dodd-Frank created the Consumer Finance Protection Bureau (the “CFPB”) as an independent entity with broad rulemaking, supervisory and enforcement authority over consumer financial products and services including deposit products, residential mortgages, home-equity loans and credit cards. The CFPB’s functions include investigating consumer complaints, conducting market research, rulemaking, supervising and examining bank consumer transactions, and enforcing rules related to consumer financial products and services. CFPB regulations and guidance apply to all financial institutions, including the Bank, although only banks with $10 billion or more in assets are subject to examination by the CFPB. Banks with less than $10 billion in assets, including the Bank, are examined for compliance by their primary federal banking agency.
In January 2013, the CFPB issued final regulations governing consumer mortgage lending. Certain rules which became effective in January 2014 impose additional requirements on lenders, including the directive that lenders need to ensure the ability of their borrowers to repay mortgages. The CFPB also finalized a rule on escrow accounts for higher priced mortgage loans and a rule expanding the scope of the high-cost mortgage provision in the Truth in Lending Act. The CFPB also issued final rules implementing provisions of the Dodd-Frank Act that relate to mortgage servicing. In November 2013 the CFPB issued a final rule on integrated and simplified mortgage disclosures under the Truth in Lending Act and the Real Estate Settlement Procedures Act, which became effective in October 2015.
The CFPB has broad rulemaking authority for a wide range of consumer financial laws that apply to all banks, including, among other things, the authority to prohibit “unfair, deceptive or abusive” acts and practices. Abusive acts or practices are defined as those that materially interfere with a consumer’s ability to understand a term or con
dition of a consumer financial product or service or take unreasonable advantage of a consumer’s: (i) lack of financial savvy, (ii) inability to protect himself in the selection or use of consumer financial products or services, or (iii) reasonable reliance on a covered entity to act in the consumer’s interests.
The Bank continues to be subject to numerous other federal and state consumer protection laws that extensively govern its relationship with its customers. Those laws include the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Truth in Lending Act, the Truth in Savings Act, the Electronic Fund Transfer Act, the Expedited Funds Availability Act, the Home Mortgage Disclosure Act, the Fair Housing Act, the Real Estate Settlement Procedures Act, the Fair Debt Collection Practices Act, the Right to Financial Privacy Act, the Service Members Civil Relief Act, and respective state-law counterparts to these laws, as well as state usury laws and laws regarding unfair and deceptive acts and practices. These and other laws require disclosures including the cost of credit and terms of deposit accounts, provide substantive consumer rights, prohibit discrimination in credit transactions, regulate the use of credit report information, provide financial privacy protections, prohibit unfair, deceptive and abusive practices, restrict the Company’s ability to raise interest rates and otherwise subject the Company to substantial regulatory oversight.
In addition, as is the case with all financial institutions, the Bank is required to maintain the privacy of its customers’ non-public, personal information. Such privacy requirements direct financial institutions to: (i) provide notice to customers regarding privacy policies and practices; (ii) inform customers regarding the conditions under which their non-public personal information may be disclosed to non-affiliated third parties; and (iii) give customers an option to prevent disclosure of such information to non-affiliated third parties.
Identity Theft
Under the Fair and Accurate Credit Transactions Act (the “FACT Act”), the Bank is required to develop and implement a written Identity Theft Prevention Program to detect, prevent and mitigate identity theft “red flags” in connection with certain existing accounts or the opening of certain accounts. Under the FACT Act, the Bank is required to adopt reasonable policies and procedures to (i) identify relevant red flags for covered accounts and incorporate those red flags into the program; (ii) detect red flags that have been incorporated into the program; (iii) respond appropriately to any red flags that are detected to prevent and mitigate identity theft; and (iv) ensure the program is updated periodically, to reflect changes in risks to customers or to the safety and soundness of the financial institution or creditor from identity theft. The Bank maintains a program to meet the requirements of the FACT Act and the Bank believes it is currently in compliance with these requirements.
Interstate Banking and Branching
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Interstate Act”), together with Dodd-Frank, relaxed prior interstate branching restrictions under federal law by permitting, subject to regulatory approval, state and federally chartered commercial banks to establish branches in states where the laws permit banks chartered in such states to establish branches. The Interstate Act requires regulators to consult with community organizations before permitting an interstate institution to close a branch in a low-income area. Federal banking agency regulations prohibit banks from using their interstate branches primarily for deposit production and the federal banking agencies have implemented a loan-to-deposit ratio screen to ensure compliance with this prohibition. Dodd-Frank effectively eliminated the prohibition under California law against interstate branching through de novo establishment of California branches. Interstate branches are subject to certain laws of the states in which they are located. The Bank presently does not have any interstate branches.
USA Patriot Act of 2001
The impact of the USA Patriot Act of 2001 (the “Patriot Act”) on financial institutions of all kinds has been significant and wide ranging. The Patriot Act substantially enhanced anti-money laundering and financial transparency laws, and required certain regulatory authorities to adopt rules that promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. Under the Patriot Act, financial institutions are subject to prohibitions regarding specified financial transactions and account relationships, as well as enhanced due diligence and “know your customer” standards in
their dealings with foreign financial institutions and foreign customers. The Patriot Act also requires all financial institutions to establish anti-money laundering programs. The Bank expanded its Bank Secrecy Act compliance staff and intensified due diligence procedures concerning the opening of new accounts to fulfill the anti-money laundering requirements of the Patriot Act, and also implemented systems and procedures to identify suspicious banking activity and report any such activity to the Financial Crimes Enforcement Network.
Incentive Compensation
In June 2010, the FRB and the FDIC issued comprehensive final guidance on incentive compensation policies intended to help ensure that banking organizations do not undermine their own safety and soundness by encouraging excessive risk-taking. The guidance, which covers all employees who have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization's board of directors. The regulatory agencies will review, as part of their regular risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Company, that are not “large, complex banking organizations.” Where appropriate, the regulatory agencies will take supervisory or enforcement action to address perceived deficiencies in an institution’s incentive compensation arrangements or related risk-management, control, and governance processes. The Company believes that it is in full compliance with the regulatory guidance on incentive compensation policies.
Sarbanes-Oxley Act of 2002
The Company is subject to the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”) which addresses, among other issues, corporate governance, auditing and accounting, executive compensation, and enhanced and timely disclosure of corporate information. Among other things, Sarbanes-Oxley mandates chief executive and chief financial officer certifications of periodic financial reports, additional financial disclosures concerning off-balance sheet items, and accelerated share transaction reporting for executive officers, directors and 10% shareholders. In addition, Sarbanes-Oxley increased penalties for non-compliance with the Exchange Act. SEC rules promulgated pursuant to Sarbanes-Oxley impose obligations and restrictions on auditors and audit committees intended to enhance their independence from Management, and include extensive additional disclosure, corporate governance and other related rules.
Commercial Real Estate Lending Concentrations
As a part of their regulatory oversight, the federal regulators have issued guidelines on sound risk management practices with respect to a financial institution’s concentrations in commercial real estate (“CRE”) lending activities. These guidelines were issued in response to the agencies’ concerns that rising CRE concentrations might expose institutions to unanticipated earnings and capital volatility in the event of adverse changes in the commercial real estate market. The guidelines identify certain concentration levels that, if exceeded, will expose the institution to additional supervisory analysis with regard to the institution’s CRE concentration risk. The guidelines are designed to promote appropriate levels of capital and sound loan and risk management practices for institutions with a concentration of CRE loans. In general, the guidelines establish the following supervisory criteria as preliminary indications of possible CRE concentration risk: (1) the institution’s total construction, land development and other land loans represent 100% or more of total risk-based capital; or (2) total CRE loans as defined in the regulatory guidelines represent 300% or more of total risk-based capital, and the institution’s CRE loan portfolio has increased by 50% or more during the prior 36 month period. The Bank believes that the guidelines are applicable to it, as it has a relatively high concentration in CRE loans. The Bank and its board of directors have discussed the guidelines and believe that the Bank’s underwriting policies, management information systems, independent credit administration process, and monitoring of real estate loan concentrations are sufficient to address the guidelines.
Other Pending and Proposed Legislation
Other legislative and regulatory initiatives which could affect the Company, the Bank and the banking industry in general are pending, and additional initiatives may be proposed or introduced before the United States Congress, the
California legislature and other governmental bodies in the future. Such proposals, if enacted, may further alter the structure, regulation and competitive relationship among financial institutions, and may subject the Bank to increased regulation, disclosure and reporting requirements. In addition, the various banking regulatory agencies often adopt new rules and regulations to implement and enforce existing legislation. It cannot be predicted whether, or in what form, any such legislation or regulations may be enacted or the extent to which the business of the Company or the Bank would be affected thereby.
Item 1A.
Item 1A. RISK FACTORS
You should carefully consider the following risk factors and all other information contained in this Annual Report before making investment decisions concerning the Company’s common stock. The risks and uncertainties described below are not the only ones the Company faces. Additional risks and uncertainties not presently known to the Company, or that the Company currently believes are immaterial, may also adversely impact the Company’s business. If any of the events described in the following risk factors occur, the Company’s business, results of operations and financial condition could be materially adversely affected. In addition, the trading price of the Company’s common stock could decline due to any of the events described in these risks.
Risks Relating to the Bank and to the Business of Banking in General
Our business has been and may in the future be adversely affected by volatile conditions in the financial markets and unfavorable economic conditions generally. National and global economies are constantly in flux, as evidenced by market volatility over the past decade. Future economic conditions cannot be predicted, and recurrent deterioration in the economies of the nation as a whole or in the Company’s markets could have an adverse effect, which could be material, on our business, financial condition, results of operations and future prospects, and could cause the market price of the Company’s stock to decline.
From December 2007 through June 2009, the U.S. economy was officially in recession. Business activity across a wide range of industries and regions in the U.S. was greatly reduced during and after the recession. The U.S. economy has undergone a continued and gradual expansion since 2009, but financial stress on borrowers as a result of an uncertain future economic environment could still have an adverse effect on ability of the Company’s borrowers to repay their loans, which could adversely affect the Company’s business, financial condition and results of operations.
California’s San Joaquin Valley, where the Company is headquartered and has many of its branch locations, was particularly hard hit by the most recent adverse economic cycle. Unemployment levels have historically been elevated in the San Joaquin Valley, including Tulare County which is our geographic center, but recessionary conditions pushed unemployment rates to exceptionally high levels. The unemployment rate for Tulare County reached a high of 19.3% in March 2010. It reflects a steady downward trend since 2010 and had declined to 10.1% by December 2017, but is still well above the 4.3% aggregate unemployment rate reported for California in December 2017. In addition, as discussed below in connection with challenges to the agricultural industry, the persistence of a California drought could have a significant negative impact on unemployment rates in our market areas. Furthermore, a drop in oil prices like the decline experienced in recent years could also negatively impact unemployment rates, particularly in Kern County.
Economic conditions are currently stable in most of our local markets, and the real estate sector appears to have gained momentum. However, any adverse developments could depress business and/or consumer confidence levels, negatively impact real estate values, and otherwise lead to economic weakness which could have one or more of the following undesirable effects on our business:
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a lack of demand for loans, or other products and services offered by us;
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a decline in the value of our loans or other assets secured by real estate;
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a decrease in deposit balances due to increased pressure on the liquidity of our customers;
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an impairment of our investment securities; or
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an increase in the number of borrowers who become delinquent, file for protection under bankruptcy laws or default on their loans or other obligations to us, which in turn could result in higher levels of nonperforming assets, net charge-offs and provisions for credit losses.
Challenges in the agricultural industry could have an adverse effect on our customers and their ability to make payments to us, particularly in view of recent drought conditions in California. While the Company’s nonperforming assets are currently comprised mainly of other real estate owned (“OREO”) and loans secured by non-agricultural real estate, difficulties experienced by the agricultural industry have led to relatively high levels of nonperforming assets in previous economic cycles. This is due to the fact that a considerable portion of our borrowers are involved in, or are impacted to some extent by, the agricultural industry. While a great number of our borrowers are not directly involved in agriculture, they would likely be impacted by difficulties in the agricultural industry since many jobs in our market areas are ancillary to the regular production, processing, marketing and sale of agricultural commodities.
The markets for agricultural products can be adversely impacted by increased supply from overseas competition, a drop in consumer demand, and numerous other factors. The ripple effect of any resulting drop in commodity prices could lower borrower income and depress collateral values. Weather patterns are also of critical importance to row crop, tree fruit, and citrus production. A degenerative cycle of weather has the potential to adversely affect agricultural industries as well as consumer purchasing power, and could lead to higher unemployment throughout the San Joaquin Valley. The state of California has recently experienced the worst drought in recorded history, and it is difficult to predict if the drought will resume and how long it might last. Another looming issue that could have a major impact on the agricultural industry involves water availability and distribution rights. If the amount of water available to agriculture becomes increasingly scarce as a result of diversion to other uses, farmers may not be able to continue to produce agricultural products at a reasonable profit, which has the potential to force many out of business. Such conditions have affected and may continue to adversely affect our borrowers and, by extension, our business, and if general agricultural conditions decline our level of nonperforming assets could increase.
While oil prices rebounded significantly in 2016 and 2017 subsequent to the precipitous drop in 2014 and 2015, the reversal of recent trends could have an adverse impact on our customers and their ability to make payments to us, particularly in areas such as Kern County where oil production is a key economic driver. The drop in oil prices led to related declines in oil property values and property taxes, and Kern County, which is home to about three quarters of California’s oil production, declared a fiscal emergency in January 2015 after projecting a potential material budget gap. Kern County had access to ample fiscal reserves and it cut expenses to help address the issue, thus the County was not ultimately forced to file bankruptcy. The Company does not have material direct exposure to oil producers, but does have some indirect exposure via loans outstanding to borrowers involved in servicing oil companies. Our energy-related credits totaled $16 million at December 31, 2017, relative to $23 million at December 31, 2016 and $43 million at December 31, 2015. If cash flows are disrupted for our remaining energy-related borrowers, or if other borrowers are indirectly impacted and/or non-oil property values decline, our level of nonperforming assets and loan charge-offs could increase. Furthermore, economic multipliers to a contracting oil industry include the prospects of a depressed residential housing market and a drop in commercial real estate values, in what was historically a strong growth region for us.
Concentrations of real estate loans have negatively impacted our performance in the past, and could subject us to further risks in the event of another real estate recession or natural disaster. Our loan portfolio is heavily concentrated in real estate loans, particularly commercial real estate. At December 31, 2017, 79% of our loan portfolio consisted of real estate loans, and a sizeable portion of the remaining loan portfolio had real estate collateral as a secondary source of repayment or as an abundance of caution. Loans on commercial buildings represented approximately 52% of all real estate loans, while construction/development and land loans were 11%, loans secured by residential properties accounted for 25%, and loans secured by farmland were 12% of real estate loans. The Company’s $9.4 million balance of nonperforming assets at December 31, 2017 includes nonperforming real estate loans totaling $2.5 million, and $5.5 million in foreclosed assets comprised primarily of OREO.
The Central Valley residential real estate market experienced significant deflation in property values during 2008 and 2009, and foreclosures occurred at relatively high rates during and after the recession. While residential real estate values in our market areas have stabilized or are increasing, if they were to slide again, or if commercial real estate values were to decline materially, the Company could experience additional migration into nonperforming
assets. An increase in nonperforming assets could have a material adverse effect on our financial condition and results of operations by reducing our income and increasing our expenses. Deterioration in real estate values might also further reduce the amount of loans the Company makes to businesses in the construction and real estate industry, which could negatively impact our organic growth prospects. Similarly, the occurrence of more natural disasters like those California has experienced recently, including fires, flooding, and earthquakes, could impair the value of the collateral we hold for real estate secured loans and negatively impact our results of operations.
Moreover, banking regulators give commercial real estate loans extremely close scrutiny due to risks relating to the cyclical nature of the real estate market and risks for lenders with high concentrations of such loans. The regulators have required banks with relatively high levels of CRE loans to implement enhanced underwriting standards, internal controls, risk management policies and portfolio stress testing, which has resulted in higher allowances for possible loan losses. Expectations for higher capital levels have also emerged. Any required increase in our allowance for loan losses could adversely affect our net income, and any requirement that we maintain higher capital levels could adversely impact financial performance measures such as earnings per share and return on equity.
Our concentration of commercial real estate, construction and land development, and commercial and industrial loans exposes us to increased lending risks. Commercial and agricultural real estate, construction and land development, and commercial and industrial loans and leases (including agricultural production loans but excluding mortgage warehouse loans), which comprised approximately 66% of our total loan portfolio as of December 31, 2017, expose the Company to a greater risk of loss than residential real estate and consumer loans, which were a smaller percentage of the total loan portfolio. Commercial real estate and land development loans typically involve relatively large balances to a borrower or a group of related borrowers, and an adverse development with respect to a larger commercial loan relationship would expose us to greater risk of loss than issues with respect to a smaller residential mortgage loan or consumer loan.
Repayment of our commercial loans is often dependent on the cash flows of the borrowers, which may be unpredictable, and the collateral securing these loans may fluctuate in value. At December 31, 2017, we had $182 million, or 12% of total loans, in commercial loans and leases (including agricultural production loans but excluding mortgage warehouse loans). Commercial lending involves risks that are different from those associated with real estate lending. Real estate lending is generally considered to be collateral based lending with loan amounts based on predetermined loan to collateral values and liquidation of the underlying real estate collateral being viewed as the primary source of repayment in the event of borrower default. Our commercial loans are primarily extended based on the cash flows of the borrowers, and secondarily on any underlying collateral provided by the borrowers. A borrower’s cash flows may be unpredictable, and collateral securing those loans may fluctuate in value. Although commercial loans are often collateralized by equipment, inventory, accounts receivable, or other business assets, the liquidation of such collateral in the event of default is often an insufficient source of repayment for a number of reasons, including uncollectible accounts receivable and obsolete or special-purpose inventories among other things.
Nonperforming assets adversely affect our results of operations and financial condition, and can take significant time to resolve. Our nonperforming loans may return to elevated levels, which would negatively impact earnings, possibly in a material way depending on the severity. We do not record interest income on non-accrual loans, thereby adversely affecting income levels. Furthermore, when we receive collateral through foreclosures and similar proceedings we are required to record the collateral at its fair market value less estimated selling costs, which may result in charges against our allowance for loan losses if that value is less than the book value of the related loan. Additionally, our non-interest expense has risen materially in adverse economic cycles due to the costs of reappraising adversely classified assets, write-downs on foreclosed assets resulting from declining property values, operating costs related to foreclosed assets, legal and other costs associated with loan collections, and various other expenses that would not typically be incurred in a normal operating environment. A relatively high level of nonperforming assets also increases our risk profile and may impact the capital levels our regulators believe is appropriate in light of such risks. We have utilized various techniques such as loan sales, workouts and restructurings to manage our problem assets. Deterioration in the value of these problem assets, the underlying collateral, or in the borrowers’ performance or financial condition, could adversely affect our business, results of operations and financial condition. In addition, the resolution of nonperforming assets requires a significant commitment of time from Management and staff, which can be detrimental to their performance of other responsibilities. There can be no assurance that we will avoid increases in nonperforming loans in the future.
We may experience loan and lease losses in excess of our allowance for such losses. We endeavor to limit the risk that borrowers might fail to repay; nevertheless, losses can and do occur. We have established an allowance for estimated loan and lease losses in our accounting records based on:
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historical experience with our loans;
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our evaluation of economic conditions;
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regular reviews of the quality, mix and size of the overall loan portfolio;
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a detailed cash flow analysis for nonperforming loans;
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regular reviews of delinquencies; and
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the quality of the collateral underlying our loans.
At any given date, we maintain an allowance for loan and lease losses that we believe is adequate to absorb specifically identified probable losses as well as any other losses inherent in our loan portfolio as of that date. While we strive to carefully monitor credit quality and to identify loans that may become nonperforming, at any given time there may be loans in our portfolio that could result in losses but have not been identified as nonperforming or potential problem loans. We cannot be sure that we will identify deteriorating loans before they become nonperforming assets, or that we will be able to limit losses on loans that have been so identified. Changes in economic, operating and other conditions which are beyond our control, including interest rate fluctuations, deteriorating collateral values, and changes in the financial condition of borrowers may lead to an increase in our estimate of probable losses, or could cause actual loan losses to exceed our current allowance. In addition, the FDIC and the DBO, as part of their supervisory functions, periodically review our allowance for loan and lease losses. Such agencies may require us to increase our provision for loan and lease losses or to recognize further losses based on their judgment, which may be different from that of our Management. Any such increase in the allowance required by regulators could also hurt our business.
Our use of appraisals in deciding whether to make a loan on or secured by real property does not ensure the value of the collateral. In considering whether to make a loan secured by real property, we generally require an appraisal of the property. However, an appraisal is only an estimate of the value of the property at the time the appraisal is made, and an error in fact or judgment could adversely affect the reliability of the appraisal. In addition, events occurring after the initial appraisal may cause the value of the real estate to decrease. As a result of any of these factors the value of the collateral backing a loan may be less than supposed, and if a default occurs we may not recover the entire outstanding balance of the loan via the liquidation of such collateral.
Our expenses could increase as a result of increases in FDIC insurance premiums or other regulatory assessments. The FDIC charges insured financial institutions a premium to maintain the DIF at a certain level. In the event that deteriorating economic conditions increase bank failures, the FDIC ensures payments of deposits up to insured limits from the DIF. In August 2016, the FDIC announced that the DIF reserve ratio had surpassed 1.15% as of June 30, 2016. As a result, beginning in the third quarter of 2016, the range of initial assessment rates for all institutions was adjusted downward, although institutions with $10 billion or more in assets were assessed a quarterly surcharge. The quarterly surcharge, which does not apply to the Bank, will continue to be assessed until such time as the reserve ratio reaches the statutory minimum of 1.35% required by the Dodd-Frank Act. Although the Bank's FDIC insurance assessments have not increased as a result of these changes, there can be no assurance that the FDIC will not increase assessment rates in the future or that the Bank will not be subject to higher assessment rates as a result of a change in its risk category, either of which could have an adverse effect on the Bank’s earnings.
The future impact of changes to the Internal Revenue Code is uncertain and may adversely affect our business. The Tax Cuts and Jobs Act was signed into law in December 2017, reforming the U.S. tax code. The ultimate impact of the Tax Act on our business, customers and shareholders is uncertain but some effects could be adverse. While the decline in the maximum federal corporate tax rate from 35 percent to 21 percent will reduce our income tax expense in 2018, the legislation initially resulted in a $2.7 million decrease in the value of our deferred tax asset, which materially reduced our net income via a charge to our income tax provision in that amount for the year ended December 31, 2017. Other provisions of the Tax Act could also negatively impact our consolidated financial statements and may adversely affect us in the future.
In addition, the Tax Act could negatively impact our customers because it lowers the existing caps on mortgage interest deductions and limits state and local tax deductions. These changes may adversely impact the property values of real estate used to secure loans and create an additional tax burden on certain individuals, particularly in high state tax jurisdictions such as California where we operate. These changes could therefore make it more difficult for some borrowers to make their loan payments and could also negatively impact the housing market, which could adversely affect our business and loan growth. Any negative financial impact to our customers resulting from tax reform could adversely impact our financial condition and earnings.
We may not be able to continue to attract and retain banking customers, and our efforts to compete may reduce our profitability. The banking business in our current and intended future market areas is highly competitive with respect to virtually all products and services, which may limit our ability to attract and retain banking customers. In California generally, and in our service areas specifically, branches of major banks dominate the commercial banking industry. Such banks have substantially greater lending limits than we have, offer certain services we cannot offer directly, and often operate with economies of scale that result in relatively low operating costs. We also compete with numerous financial and quasi-financial institutions for deposits and loans, including providers of financial services via the internet. Recent advances in technology and other changes have allowed parties to effectuate financial transactions that previously required the involvement of banks. For example, consumers can maintain funds in brokerage accounts or mutual funds that would have historically been held as bank deposits. Consumers can also complete transactions such as paying bills and transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as disintermediation, could result in the loss of customer deposits and the fee income generated by those deposits. The loss of these revenue streams and access to lower cost deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.
Moreover, with the large number of bank failures in the past decade some customers have become more concerned about the extent to which their deposits are insured by the FDIC. Customers may withdraw deposits in an effort to ensure that the amount they have on deposit with their bank is fully insured. Decreases in deposits may adversely affect our funding costs and net income. Ultimately, competition can and does increase our cost of funds, reduce loan yields and drive down our net interest margin, thereby reducing profitability. It can also make it more difficult for us to continue to increase the size of our loan portfolio and deposit base, and could cause us to rely more heavily on wholesale borrowings which are generally more expensive than retail deposits.
If we are not able to successfully keep pace with technological changes affecting the industry, our business could be hurt. The financial services industry is constantly undergoing technological change, with the frequent introduction of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve clients and reduce costs. Our future success depends, in part, upon our ability to respond to the needs of our clients by using technology to provide desired products and services and create additional operating efficiencies. Some of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our clients. Failure to keep pace with technological change in the financial services industry could have a material adverse impact on our business and, in turn, on our financial condition and results of operations.
Unauthorized disclosure of sensitive or confidential customer information, whether through a cyber-attack, other breach of our computer systems or any other means, could severely harm our business. In the normal course of business we collect, process and retain sensitive and confidential customer information. Despite the security measures we have in place, our facilities and systems may be vulnerable to cyber-attacks, security breaches, acts of vandalism, computer viruses, misplaced or lost data, programming and/or human errors, or other similar events.
In recent periods there has been a rise in fraudulent electronic activity, security breaches, and cyber-attacks, including in the banking sector. Some financial institutions have reported breaches of their websites and systems which have involved sophisticated and targeted attacks intended to misappropriate sensitive or confidential information, destroy or corrupt data, disable or degrade service, disrupt operations or sabotage systems. These breaches can remain undetected for an extended period of time. Furthermore, our customers and employees have been, and will continue to be, targeted by parties using fraudulent e-mails and other communications that may appear to be legitimate messages sent by the Bank, in attempts to misappropriate passwords, card numbers, bank account information
or other personal information or to introduce viruses or malware to personal computers. Information security risks for financial institutions have increased in part because of new technologies, mobile services and other web-based products used to conduct financial and other business transactions, as well as the increased sophistication and activities of organized crime, perpetrators of fraud, hackers, terrorists and others. The secure maintenance and transmission of confidential information, as well as the secure and reliable execution of transactions over our systems, are essential to protect us and our customers and to maintain our customers’ confidence. Despite our efforts to identify, contain and mitigate these threats through detection and response mechanisms, product improvement, the use of encryption and authentication technology, and customer and employee education, such attempted fraudulent activities directed against us, our customers, and third party service providers remain a serious issue. The pervasiveness of cyber security incidents in general and the risks of cyber-crime are complex and continue to evolve.
We also face risks related to cyber-attacks and other security breaches in connection with debit card transactions, which typically involve the transmission of sensitive information regarding our customers through various third parties. Some of these parties have in the past been the target of security breaches and cyber-attacks, and because the transactions involve third parties and environments that we do not control or secure, future security breaches or cyber-attacks affecting any of these third parties could impact us through no fault of our own, and in some cases we may have exposure and suffer losses for breaches or attacks relating to them. We also rely on third party service providers to conduct certain other aspects of our business operations, and face similar risks relating to them. While we regularly conduct security assessments on those third parties, we cannot be sure that their information security protocols are sufficient to withstand a cyber-attack or security breach.
Any cyber-attack or other security breach involving the misappropriation or loss of Company assets or those of its customers, or unauthorized disclosure of confidential customer information, could severely damage our reputation, erode confidence in the security of our systems, products and services, expose us to the risk of litigation and liability, disrupt our operations, and have a material adverse effect on our business.
If our information systems were to experience a system failure, our business and reputation could suffer. We rely heavily on communications and information systems to conduct our business. The computer systems and network infrastructure we use could be vulnerable to unforeseen problems. Our operations are dependent upon our ability to minimize service disruptions by protecting our computer equipment, systems, and network infrastructure from physical damage due to fire, power loss, telecommunications failure or a similar catastrophic event. We have protective measures in place to prevent or limit the effect of the failure or interruption of our information systems, and will continue to upgrade our security technology and update procedures to help prevent such events. However, if such failures or interruptions were to occur, they could result in damage to our reputation, a loss of customers, increased regulatory scrutiny, or possible exposure to financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
We are subject to a variety of operational risks, including reputational risk, legal risk, compliance risk, the risk of fraud or theft by employees or outsiders, and the risk of clerical or record-keeping errors, which may adversely affect our business and results of operations. If personal, non-public, confidential or proprietary customer information in our possession were to be mishandled or misused, we could suffer significant regulatory consequences, reputational damage and financial loss. This could occur, for example, if information was erroneously provided to parties who are not permitted to have the information, either by fault of our systems, employees, or counterparties, or where such information is intercepted or otherwise inappropriately taken by third parties.
Because the nature of the financial services business involves a high volume of transactions, certain errors may be repeated or compounded before they are discovered and successfully remediated. Our necessary dependence upon automated systems to record and process transactions and our large transaction volume may further increase the risk that technical flaws or employee tampering or manipulation of those systems could result in losses that are difficult to detect. We also may be subject to disruptions of our operating systems arising from events that are wholly or partially beyond our control (for example, computer viruses or electrical or telecommunications outages, or natural disasters, disease pandemics or other damage to property or physical assets) which may give rise to disruption of service to customers and to financial loss or liability. We are further exposed to the risk that our external vendors may be unable to fulfill their contractual obligations (or will be subject to the same risk of fraud or operational errors by their employees) and to the risk that our (or our vendors’) business continuity and data security efforts might prove to be inadequate. The occurrence of any of these risks could result in a diminished ability to operate our busi
ness (for example, by requiring us to expend significant resources to correct the defect), as well as potential liability to clients, reputational damage and regulatory intervention, which could adversely affect our business, financial condition and results of operations, perhaps materially.
Previously enacted and potential future regulations could have a significant impact on our business, financial condition and results of operations. Dodd-Frank, which was enacted in 2010, is having a broad impact on the financial services industry, including significant regulatory and compliance changes. Many of the requirements called for in Dodd-Frank will be implemented over time, and most will be facilitated by the enactment of regulations over the course of several years. Given the uncertainty associated with the manner in which the provisions of Dodd-Frank will be implemented, the full extent to which they will impact our operations is unclear. The changes resulting from Dodd-Frank may impact the profitability of business activities, require changes to certain business practices, impose more stringent capital, liquidity and leverage requirements or otherwise adversely affect our business. In particular, the potential impact of Dodd-Frank on our operations and activities, both currently and prospectively, include, among others:
•
an increase in our cost of operations due to greater regulatory oversight, supervision and examination of banks and bank holding companies, and higher deposit insurance premiums;
•
the limitation of our ability to expand consumer product and service offerings due to more stringent consumer protection laws and regulations;
•
a negative impact on our cost of funds in a rising interest rate environment, since financial institutions can now pay interest on business checking accounts;
•
a potential reduction in fee income, due to limits on interchange fees applicable to larger institutions which could ultimately lead to a competitive-driven reduction in the fees we receive; and
•
a potential increase in competition due to the elimination of the remaining barriers to de novo interstate branching.
Further, we may be required to invest significant management attention and resources to evaluate and make any changes necessary to comply with new statutory and regulatory requirements under the Dodd-Frank Act, which could negatively impact results of operations and financial condition. We cannot predict whether there will be additional laws or reforms that would affect the U.S. financial system or financial institutions, when such changes may be adopted, how such changes may be interpreted and enforced or how such changes may affect us. However, the costs of complying with any additional laws or regulations could have a material adverse effect on our financial condition and results of operations.
Growing by acquisition entails integration and certain other risks, and our financial condition and results of operations could be negatively affected if our expansion efforts are unsuccessful or we fail to manage our growth effectively. In addition to organic growth and the establishment of de novo branches, over the past several years we have engaged in expansion through acquisitions of branches and whole institutions. We intend to continue pursuing this growth strategy within our current footprint and via geographic expansion. There are risks associated with any such expansion. Those risks include, among others, incorrectly assessing the asset quality of a bank acquired in a particular transaction, encountering greater than anticipated costs in integrating acquired businesses, facing resistance from customers or employees, and being unable to profitably deploy assets acquired in the transaction. To the extent we issue capital stock in connection with additional transactions, if any, these transactions and related stock issuances may have a dilutive effect on earnings per share and share ownership.
Our earnings, financial condition, and prospects after a merger or acquisition depend in part on our ability to successfully integrate the operations of the acquired company. We may be unable to integrate operations successfully or to achieve expected cost savings. Any cost savings which are realized may be offset by losses in revenues or other charges to earnings. There also may be business disruptions that cause us to lose customers or cause customers to remove their accounts from us and move their business to competing financial institutions. In addition, our ability to grow may be limited if we cannot make acquisitions. We compete with other financial institutions with respect to proposed acquisitions. We cannot predict if or when we will be able to identify and attract acquisition candidates or make acquisitions on favorable terms.
We may experience future goodwill impairment. In accordance with GAAP, we record assets acquired and liabilities assumed at their fair value with the excess of the purchase consideration over the net assets acquired resulting in the recognition of goodwill. As a result, acquisitions typically result in recording goodwill, as was the case with our acquisition of OCB Bancorp in October 2017 which substantially increased our goodwill. We perform a goodwill evaluation at least annually to test for goodwill impairment. As part of our testing, we first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If we determine that the fair value of a reporting unit is less than its carrying amount using these qualitative factors, we then measure the impairment loss by comparing the implied fair value of goodwill with the carrying amount of that goodwill. Adverse conditions in our business climate, including a significant decline in future operating cash flows, a significant change in our stock price or market capitalization, or a deviation from our expected growth rate and performance may significantly affect the fair value of our goodwill and may trigger impairment losses, which could be materially adverse to our operating results and financial position. We cannot provide assurance that we will not be required to take an impairment charge in the future. Any impairment charge would have an adverse effect on our shareholders’ equity and financial results and could cause a decline in our stock price.
Changes in accounting standards may affect our performance. Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. From time to time the FASB and SEC change the financial accounting and reporting standards that govern the preparation of our financial statements. These changes can be difficult to predict and can materially impact how we report and record our financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retroactively, resulting in a retrospective adjustment to prior financial statements.
One such change is ASU 2016-13, which was released by the FASB in 2016 and which the Company is required to adopt no later than January 1, 2020, with early adoption permitted on January 1, 2019. ASU 2016-13 includes changes to the methodology for determining the amount of the allowance for credit losses, among other things. The new credit loss model will be a significant change from the standard in place today, as it requires the Company to calculate its allowance on the basis of current expected credit losses over the lifetime of its loans (commonly referred to as the “CECL” model), instead of losses inherent in the portfolio as of a point in time. On the effective date, institutions will record a cumulative-effect balance sheet adjustment for financial assets carried at amortized cost for any change in the related allowance for loan and lease losses generated by the adoption of the new standard. The Company’s preliminary evaluation indicates that when adopted, the provisions of ASU 2016-13 will impact our consolidated financial statements, particularly the level of our reserve for credit losses and shareholders’ equity, which could materially affect our financial condition and future results of operations. The extent of the impact is currently unknown, and will ultimately depend upon the nature and characteristics of our loan portfolio and the macroeconomic conditions and forecasts at the adoption date.
We may be adversely affected by the financial stability of other financial institutions. Our ability to engage in routine transactions could be adversely affected by the actions and liquidity of other financial institutions. Financial institutions are often interconnected as a result of trading, clearing, counterparty, or other business relationships. We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks, and other institutional clients. Many of these transactions expose us to credit risk in the event of a default by a counterparty or client. Even if the transactions are collateralized, credit risk could exist if the collateral held by us cannot be liquidated at prices sufficient to recover the full amount of the credit or derivative exposure due to us. Any such losses could adversely affect our business, financial condition or results of operations.
Changes in interest rates could adversely affect our profitability, business and prospects. Net interest income, and therefore earnings, can be adversely affected by differences or changes in the interest rates on, or the repricing frequency of, our financial instruments. In addition, fluctuations in interest rates can affect the demand of customers for products and services, and an increase in the general level of interest rates may adversely affect the ability of certain borrowers to make variable-rate loan payments. Accordingly, changes in market interest rates could have a material adverse effect on the Company’s asset quality, loan origination volume, financial condition, results of operations, and cash flows. This interest rate risk can arise from Federal Reserve Board monetary policies, as well as other economic, regulatory and competitive factors that are beyond our control.
We depend on our executive officers and key personnel to implement our business strategy, and could be harmed by the loss of their services. We believe that our continued growth and success depends in large part upon the skills of our management team and other key personnel. The competition for qualified personnel in the financial services industry is intense, and the loss of key personnel or an inability to attract, retain or motivate key personnel could adversely affect our business. If we are not able to retain our existing key personnel or attract additional qualified personnel, our business operations could be impaired. None of our executive officers have employment agreements.
The value of the securities in our investment portfolio may be negatively affected by market disruptions, adverse credit events or fluctuations in interest rates, which could have a material adverse impact on capital levels. Our available-for-sale investment securities are reported at their estimated fair values, and fluctuations in fair values can result from changes in market interest rates, rating agency actions, issuer defaults, illiquid markets and limited investor demand, among other things. As long as the change in the fair value of a security is not considered to be “other than temporary,” we directly increase or decrease accumulated other comprehensive income in shareholders’ equity by the amount of the change in fair value, net of the tax effect. Because of the size of our fixed income bond portfolio relative to total assets, a relatively large increase in market interest rates, in particular, could result in a material drop in fair values and, by extension, our capital. Investment securities that have an amortized cost in excess of their current fair value at the end of a reporting period are also evaluated for other-than-temporary impairment. If such impairment is indicated, the difference between the amortized cost and the fair value of those securities will be recorded as a charge in our income statement, which could also have a material adverse effect on our results of operations and capital levels.
We are exposed to the risk of environmental liabilities with respect to properties to which we obtain title. Approximately 79% of our loan portfolio at December 31, 2017 consisted of real estate loans. In the normal course of business we may foreclose and take title to real estate collateral, and could be subject to environmental liabilities with respect to those properties. We may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances, or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, if we are the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. These costs and claims could adversely affect our business and prospects.
Risks Related to our Common Stock
You may not be able to sell your shares at the times and in the amounts you want if the price of our stock fluctuates significantly or the trading market for our stock is not active. The trading price of our common stock could be impacted by a number of factors, many of which are outside our control. Although our stock has been listed on NASDAQ for many years and our trading volume has increased in recent periods, trading in our stock does not consistently occur in high volumes and the market for our stock cannot always be characterized as active. Thin trading in our stock may exaggerate fluctuations in the stock’s value, leading to price volatility in excess of that which would occur in a more active trading market. In addition, the stock market in general is subject to fluctuations that affect the share prices and trading volumes of many companies, and these broad market fluctuations could adversely affect the market price of our common stock. Factors that could affect our common stock price in the future include but are not necessarily limited to the following:
•
actual or anticipated fluctuations in our operating results and financial condition;
•
changes in revenue or earnings estimates or publication of research reports and recommendations by financial analysts;
•
failure to meet analysts’ revenue or earnings estimates;
•
speculation in the press or investment community;
•
strategic actions by us or our competitors, such as acquisitions or restructurings;
•
actions by shareholders;
•
sales of our equity or equity-related securities, or the perception that such sales may occur;
•
fluctuations in the trading volume of our common stock;
•
fluctuations in the stock prices, trading volumes, and operating results of our competitors;
•
market conditions in general and, in particular, for the financial services industry;
•
proposed or adopted regulatory changes or developments;
•
regulatory action against us;
•
actual, anticipated or pending investigations, proceedings, or litigation that involve or affect us; and
•
domestic and international economic factors unrelated to our performance.
The stock market and, more specifically, the market for financial institution stocks, has experienced significant volatility in the past. As a result, the market price of our common stock has at times been volatile, and could be in the future, as well. The capital and credit markets have also experienced volatility and disruption over the past several years, at times reaching unprecedented levels. In some cases, the markets have produced downward pressure on stock prices and adversely impacted credit availability for certain issuers without regard to the issuers’ underlying financial strength.
We could pursue additional capital in the future, which may or may not be available on acceptable terms, could dilute the holders of our outstanding common stock, and may adversely affect the market price of our common stock. Our ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at the time, which are outside of our control, and our financial performance. Furthermore, any capital raising activity could dilute the holders of our outstanding common stock, and may adversely affect the market price of our common stock and performance measures such as return on equity and earnings per share.
Future acquisitions may dilute shareholder ownership and value, especially tangible book value per share. We regularly evaluate opportunities to acquire other financial institutions and/or bank branches and intend to continue to pursue such acquisitions as part of our growth strategy. Such acquisitions may involve cash, debt, and/or equity securities. Acquisitions typically involve the payment of a premium over book and market values, and, therefore, some dilution of our tangible book value per common share may occur in connection with any future acquisitions. To the extent we issue capital stock in connection with such transactions, the share ownership of our existing shareholders may be diluted.
The Company relies heavily on the payment of dividends from the Bank. Other than $4.9 million in cash available at the holding company level at December 31, 2017, the Company’s ability to meet debt service requirements and to pay dividends depends on the Bank’s ability to pay dividends to the Company, as the Company has no other source of significant income. However, the Bank is subject to regulations limiting the amount of dividends it may pay. For example, the payment of dividends by the Bank is affected by the requirement to maintain adequate capital pursuant to the capital adequacy guidelines issued by the Federal Deposit Insurance Corporation. If (i) any capital requirements are increased; and/or (ii) the total risk-weighted assets of the Bank increase significantly; and/or (iii) the Bank’s income declines significantly, the Bank’s Board of Directors may decide or be required to retain a greater portion of the Bank’s earnings to achieve and maintain the required capital or asset ratios. This would reduce the amount of funds available for the payment of dividends by the Bank to the Company. Further, one or more of the Bank’s regulators could prohibit the Bank from paying dividends if, in their view, such payments would constitute unsafe or unsound banking practices. The Bank’s ability to pay dividends to the Company is also limited by the California Financial Code. Whether dividends are paid, and the frequency and amount of such dividends will also depend on the financial condition and performance of the Bank and the decision of the Bank’s Board of Directors. Information concerning the Company’s dividend policy and historical dividend practices is set forth in Item 5 below under “Dividends.” However, no assurance can be given that our future performance will justify the payment of dividends in any particular year.
Your investment may be diluted because of our ability to offer stock to others, and from the exercise of stock options. The shares of our common stock do not have preemptive rights, which means that you may not be entitled
to buy additional shares if shares are offered to others in the future. We are authorized to issue up to 24,000,000 shares of common stock, and as of December 31, 2017 we had 15,223,360 shares of common stock outstanding. Except for certain limitations imposed by NASDAQ, nothing restricts our ability to offer additional shares of stock for fair value to others in the future. Any issuances of common stock would dilute our shareholders’ ownership interests and may dilute the per share book value of our common stock. Furthermore, when our directors and officers exercise in-the-money stock options your ownership in the Company is diluted. As of December 31, 2017, there were outstanding options to purchase an aggregate of 455,040 shares of our common stock with an average exercise price of $16.33 per share. At the same date there were an additional 850,000 shares available to grant under our 2017 Stock Incentive Plan.
Shares of our preferred stock issued in the future could have dilutive and other effects on our common stock. Our Articles of Incorporation authorize us to issue 10,000,000 shares of preferred stock, none of which is presently outstanding. Although our Board of Directors has no present intention to authorize the issuance of shares of preferred stock, such shares could be authorized in the future. If such shares of preferred stock are made convertible into shares of common stock, there could be a dilutive effect on the shares of common stock then outstanding. In addition, shares of preferred stock may be provided a preference over holders of common stock upon our liquidation or with respect to the payment of dividends, in respect of voting rights, or in the redemption of our common stock. The rights, preferences, privileges and restrictions applicable to any series or preferred stock would be determined by resolution of our Board of Directors.
The holders of our debentures have rights that are senior to those of our shareholders. In 2004 we issued $15,464,000 of junior subordinated debt securities due March 17, 2034, and in 2006 we issued an additional $15,464,000 of junior subordinated debt securities due September 23, 2036 in order to supplement regulatory capital. Moreover, the Coast Bancorp acquisition included $7,217,000 of junior subordinated debt securities due December 15, 2037. All of these junior subordinated debt securities are senior to the shares of our common stock. As a result, we must make interest payments on the debentures before any dividends can be paid on our common stock, and in the event of our bankruptcy, dissolution or liquidation, the holders of debt securities must be paid in full before any distributions may be made to the holders of our common stock. In addition, we have the right to defer interest payments on the junior subordinated debt securities for up to five years, during which time no dividends may be paid to holders of our common stock. In the event that the Bank is unable to pay dividends to us, we may be unable to pay the amounts due to the holders of the junior subordinated debt securities and thus would be unable to declare and pay any dividends on our common stock.
Provisions in our articles of incorporation could delay or prevent changes in control of our corporation or our management. Our articles of incorporation contain provisions for staggered terms of office for members of the board of directors; no cumulative voting in the election of directors; and the requirement that our board of directors consider the potential social and economic effects on our employees, depositors, customers and the communities we serve as well as certain other factors, when evaluating a possible tender offer, merger or other acquisition of the Company. These provisions make it more difficult for another company to acquire us, which could cause our shareholders to lose an opportunity to be paid a premium for their shares in an acquisition transaction and reduce the current and future market price of our common stock.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
Not applicable.
Item 2.
Item 2. Properties
The Company’s administrative headquarters is housed in a 37,000 square foot, three-story office building located at 86 North Main Street, Porterville, California, and our main office consists of a one-story brick building located at 90 N. Main Street, Porterville, California, adjacent to our administrative headquarters. Both of those buildings are situated on unencumbered property owned by the Company. The Company also owns unencumbered property on which 17 of our other offices are located, namely the following branches: Porterville West Olive, Bakersfield Ming, California City, Dinuba, Exeter, Farmersville, Fresno Shaw, Hanford, Lindsay, San Luis Obispo, Santa Paula, Tehachapi Downtown, Tehachapi Old Town, Three Rivers, Tulare, Visalia Mooney and Woodlake. The remaining branches, as well as our technology center and remote ATM locations, are leased from unrelated parties. While
near-term expansion is planned, Management believes that existing back-office facilities are adequate to accommodate the Company’s operations for the immediately foreseeable future.
Item 3.
Item 3. Legal Proceedings
From time to time the Company is a party to claims and legal proceedings arising in the ordinary course of business. After taking into consideration information furnished by counsel to the Company as to the current status of these claims or proceedings to which the Company is a party, Management is of the opinion that the ultimate aggregate liability represented thereby, if any, will not have a material adverse effect on the financial condition of the Company.
Item 4.
Item 4. RESERVED
PART II
Item 5.
Item 5. Market for REGISTRANT’S Common Equity, Related Shareholder Matters AND ISSUER PURCHASES OF EQUITY SECURITIES
(a)
Market Information
Sierra Bancorp’s Common Stock trades on the NASDAQ Global Select Market under the symbol BSRR, and the CUSIP number for our stock is #82620P102. Trading in the Company’s Common Stock has not consistently occurred in high volumes, and such trading activity cannot always be characterized as an active trading market.
The following table summarizes trades of the Company’s Common Stock, setting forth the approximate high and low sales prices and volume of trading for the periods indicated, based upon information available via public sources:
(b)
Holders
As of January 31, 2018 there were an estimated 4,999 shareholders of the Company’s Common Stock. There were 734 registered holders of record on that date, and per Broadridge, an investor communication company, there were 4,265 beneficial holders with shares held under a street name, including “objecting beneficial owners” whose names and addresses are unavailable. Since some holders maintain multiple accounts, it is likely that the above numbers overstate the actual number of the Company’s shareholders to some extent.
(c)
Dividends
The Company paid cash dividends totaling $7.9 million, or $0.56 per share in 2017 and $6.5 million, or $0.48 per share in 2016, which represents 41% of annual net earnings for 2017 and 37% for 2016. The Company’s general dividend policy is to pay cash dividends within the range of typical peer payout ratios, provided that such payments do not adversely affect the Company’s financial condition and are not overly restrictive to its growth capacity. However, in the past when many of our peers elected to suspend dividend payments, the Company’s Board determined that we should continue to pay a certain level of dividends without regard to peer payout ratios, as long as our core operating performance was adequate and policy or regulatory restrictions did not preclude such payments. That said, no assurance can be given that our financial performance in any given year will justify the continued payment of a certain level of cash dividend, or any cash dividend at all.
As a bank holding company that currently has no significant assets other than its equity interest in the Bank, the Company’s ability to declare dividends depends upon cash on hand as supplemented by dividends from the Bank. The Bank’s dividend practices in turn depend upon the Bank’s earnings, financial position, regulatory standing, ability to meet current and anticipated regulatory capital requirements, and other factors deemed relevant by the Bank’s Board of Directors. The authority of the Bank’s Board of Directors to declare cash dividends is also subject to statutory restrictions. Under California banking law, the Bank may declare dividends in an amount not exceeding the lesser of its retained earnings or its net income for the last three fiscal years (reduced by distributions to the Bank’s shareholder during such period), or with the prior approval of the California Commissioner of Business Oversight in an amount not exceeding the greater of (i) the retained earnings of the Bank, (ii) the net income of the Bank for its last fiscal year, or (iii) the net income of the Bank for its current fiscal year.
The Company’s ability to pay dividends is also limited by state law. California law allows a California corporation to pay dividends if the company’s retained earnings equal at least the amount of the proposed dividend plus any preferred dividend arrears amount. If a California corporation does not have sufficient retained earnings available for the proposed dividend, it may still pay a dividend to its shareholders if immediately after the dividend the value of the company’s assets would equal or exceed the sum of its total liabilities plus any preferred dividend arrears amount. In addition, during any period in which the Company has deferred the payment of interest otherwise due and payable on its subordinated debt securities, it may not pay any dividends or make any distributions with respect to its capital stock (see “Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations - Capital Resources”).
(d)
Securities Authorized for Issuance under Equity Compensation Plans
On March 16, 2017 the Company’s Board of Directors approved and adopted the 2017 Stock Incentive Plan (the “2017 Plan”), which became effective May 24, 2017 pursuant to the approval of the Company’s shareholders. The 2017 Plan replaced the 2007 Stock Incentive Plan (the “2007 Plan”), which expired by its own terms on March 15, 2017. The total number of shares of the Company’s authorized but unissued stock reserved for issuance pursuant to awards under the 2017 Plan is 850,000 shares, and as of December 31, 2017 no awards had been granted under the 2017 Plan. The following table provides information as of December 31, 2017 with respect to options issued and still outstanding under the expired 2007 Plan, which was our only equity compensation plan with outstanding options, and options available to grant under the 2017 Plan, our only active equity compensation plan:
Plan Category
Number of Securities
to be Issued Upon Exercise
of Outstanding Options
Weighted-Average
Exercise Price of
Outstanding Options
Number of Securities
Remaining Available
for Future Issuance
Equity compensation plans
approved by security holders
455,040
$16.33
850,000
(e)
Performance Graph
Below is a five-year performance graph comparing the cumulative total return on the Company’s common stock to the cumulative total returns of the NASDAQ Composite Index (a broad equity market index), the SNL Bank Index, and the SNL $1 billion to $5 billion Bank Index (the latter two qualifying as peer bank indices), assuming a $100 investment on December 31, 2012 and the reinvestment of dividends.
Source: S&P Global Market Intelligence
(f)
Stock Repurchases
In September 2016 the Board authorized 500,000 shares of common stock for repurchase, subsequent to the completion of previous stock buyback plans. The authorization of shares for repurchase does not provide assurance that a specific quantity of shares will be repurchased, and the program may be suspended at any time at Management’s discretion. The Company did not repurchase any shares in the fourth quarter of 2017, and there were 478,954 authorized shares remaining available for repurchase at December 31, 2017. As of the date of this report, Management has no immediate plans to resume stock repurchase activity.
Item 6.
Item 6. Selected Financial Data
The following table presents selected historical financial information concerning the Company, which should be read in conjunction with our audited consolidated financial statements, including the related notes, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere herein. The selected financial data as of December 31, 2017 and 2016, and for each of the years in the three year period ended December 31, 2017, is derived from our audited consolidated financial statements and related notes which are included in this Annual Report. The selected financial data presented for earlier years is from our audited financial statements which are not included in this Annual Report. Throughout this Annual Report, information is for the consolidated Company unless otherwise stated.
(1)
Asset quality ratios are end of period ratios. Performance ratios are based on average daily balances during the periods indicated.
(2)
Performing TDR’s are not included in nonperforming loans and are therefore not included in the numerators used to calculate these ratios.
(3)
For definitions and further information relating to regulatory capital requirements, see “Item 1, Business - Supervision and Regulation - Capital Adequacy Requirements herein.
(4)
Represents the average rate earned on interest-earning assets less the average rate paid on interest-bearing liabilities.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This discussion presents Management’s analysis of the Company’s financial condition as of December 31, 2017 and 2016, and the results of operations for each of the years in the three-year period ended December 31, 2017. The discussion should be read in conjunction with the Company’s consolidated financial statements and the notes related thereto presented elsewhere in this Form 10-K Annual Report (see Item 8 below).
Statements contained in this report or incorporated by reference that are not purely historical are forward looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 as amended, including the Company’s expectations, intentions, beliefs, or strategies regarding the future. All forward-looking statements concerning economic conditions, growth rates, income, expenses, or other values which are included in this document are based on information available to the Company on the date noted, and the Company assumes no obligation to update any such forward-looking statements. It is important to note that the Company’s actual results could materially differ from those in such forward-looking statements. Risk factors that could cause actual results to differ materially from those in forward-looking statements include but are not limited to those outlined previously in Item 1A.
Critical Accounting Policies
The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The financial information and disclosures contained within those statements are significantly impacted by Management’s estimates and judgments, which are based on historical experience and incorporate various assumptions that are believed to be reasonable under current circumstances. Actual results may differ from those estimates under divergent conditions.
Critical accounting policies are those that involve the most complex and subjective decisions and assessments, and have the greatest potential impact on the Company’s stated results of operations. In Management’s opinion, the Company’s critical accounting policies deal with the following areas: the establishment of the allowance for loan and lease losses, as explained in detail in Note 2 to the consolidated financial statements and in the “Provision for Loan Losses” and “Allowance for Loan and Lease Losses” sections of this discussion and analysis; the valuation of impaired loans and foreclosed assets, as discussed in Note 2 to the consolidated financial statements; income taxes and deferred tax assets and liabilities, especially with regard to the ability of the Company to recover deferred tax assets as discussed in the “Provision for Income Taxes” and “Other Assets” sections of this discussion and analysis; and goodwill and other intangible assets, which are evaluated annually for impairment and for which we have determined that no impairment exists, as discussed in Note 2 to the consolidated financial statements and in the “Other Assets” section of this discussion and analysis. Critical accounting areas are evaluated on an ongoing basis to ensure that the Company’s financial statements incorporate the most recent expectations with regard to those areas.
Summary of Performance
Our operating results and balance sheet have been materially impacted by whole-bank acquisitions in 2014, 2016 and 2017, as discussed in greater detail in the applicable sections below. The Company recognized net income of $19.539 million in 2017, relative to $17.567 million in 2016 and $18.067 million in 2015. Net income per diluted share was $1.36 in 2017, as compared to $1.29 in 2016 and $1.33 for 2015. The Company’s return on average assets and return on average equity were 0.93% and 8.82%, respectively, in 2017, as compared to 0.95% and 8.71%, respectively, in 2016, and 1.07% and 9.59%, respectively, for 2015. The Company’s financial performance was unfavorably impacted by a $2.710 million charge to our income tax provision in 2017 as we revalued our net deferred tax asset to reflect a lower corporate income tax rate. Furthermore, we recognized nonrecurring acquisition costs in 2017 and 2016, but our core financial results have been trending better for the past several years due in part to a higher volume of loans, a strong base of core deposits, and reductions in nonperforming assets. The following are some of the major factors that impacted the Company’s results of operations for the years presented in the consolidated financial statements.
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Net interest income improved by 16% in 2017 over 2016 and 8% in 2016 over 2015, due primarily to growth in average interest-earning assets that was largely funded by low-cost non-maturity deposits. The increase in average earning assets in 2017 over 2016 was the result of our acquisitions of Coast National Bank
in mid-2016 and Ojai Community Bank in the fourth quarter of 2017, organic loan growth, and a higher level of investments, while growth in 2016 over 2015 came from the impact of the Coast acquisition, organic loan growth, and an increase in loan participations purchased. The positive impact of asset growth was enhanced in 2017 by net interest margin expansion of nine basis points resulting in part from short-term interest rate increases and discount accretion on acquisition loans. Net interest income has also been impacted by nonrecurring items, which added $736,000 to interest income in 2017, relative to $563,000 in 2016 and $825,000 in 2015.
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We recorded a negative loan loss provision of $1.140 million in 2017, and provisions were not required in 2016 or 2015. The provision reversal in 2017 was made possible by principal recovered on charged-off loan balances, and the zero provisions for 2016 and 2015 were facilitated by the reduction of impaired loan balances, lower loan losses, and tighter underwriting standards for new and renewed loans.
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Non-interest income increased by $2.541 million, or 13%, in 2017 over 2016, and by $1.523 million, or 9%, in 2016 compared to 2015. The improvement in 2017 is comprised primarily of growth in service charges on deposit accounts and other core fee income, but also includes nonrecurring items as discussed below. For 2016 over 2015, the increase includes nonrecurring income comprised of net proceeds from life insurance policies and core increases in fees and service charge income, partially offset by lower investment gains.
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Operating expense increased by $7.388 million, or 13%, in 2017 compared to 2016, and by $7.350 million, or 14%, in 2016 over 2015. Most of the 2017 increase came from higher operating costs associated with branches added via our acquisitions as well as de novo branch expansion. Operating expense also includes nonrecurring acquisition costs, which totaled $2.225 million for the year in 2017 as compared to $2.411 million in 2016. Other nonrecurring costs are delineated below. The increase in 2016 was impacted by non-recurring acquisition costs, which totaled only $101,000 in 2015, and also by ongoing operating costs associated with branch expansion and the Coast acquisition.
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The Company had tax provisions of $13.640 million, or 41% of pre-tax income in 2017; $8.800 million, or 33% of pre-tax income in 2016; and $9.071 million, or 33% of pre-tax income in 2015. The higher tax accrual rate for 2017 is primarily the result of the aforementioned $2.710 million deferred tax asset revaluation charge, but also reflects higher taxable income relative to available tax credits. Lower pre-tax income and higher non-taxable BOLI income benefitted our tax accrual rate for 2016 over 2015, although the impact of those factors was offset by declining tax credits.
The Company’s assets totaled $2.340 billion at December 31, 2017, relative to $2.033 billion at December 31, 2016. Total liabilities were $2.084 billion at the end of 2017 compared to $1.827 billion at the end of 2016, and shareholders’ equity totaled $256 million at December 31, 2017 relative to $206 million at December 31, 2016. The following is a summary of key balance sheet changes during 2017.
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Total assets increased by $307 million, or 15%. The increase resulted from higher loan and investment portfolio balances and a $23 million increase in goodwill and other intangible assets, partially offset by a reduction in cash and due from banks.
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Gross loans and leases were up $295 million, or 23%. Loan growth was favorably impacted by the Ojai acquisition, which added $218 million in loans as of the acquisition date, and strong organic growth in real estate loans, net of a drop of $25 million, or 15%, in mortgage warehouse loans.
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Cash balances declined by $50 million, or 42%. The reduction in cash balances includes a $32 million decrease in interest-earning balances held in our Federal Reserve Bank account and correspondent banks, and an $18 million drop in non-earning balances.
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Our allowance for loan and lease losses totaled $9.0 million as of December 31, 2017, a reduction of $658,000, or 7%, relative to year-end 2016. The allowance fell to 0.58% of total loans at December 31, 2017 from 0.77% of total loans at December 31, 2016, due to acquisition loans which were initially booked at their fair values and thus did not require loss reserves, and credit quality improvement in the remainder of the loan portfolio.
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Deposit balances reflect net growth of $293 million, or 17%. Deposit growth in 2017 includes balances from the Ojai Community Bank and Woodlake branch acquisitions in the fourth quarter, which added $231 million and $27 million, respectively, to deposit balances at the acquisition dates, although we have seen subsequent
runoff in some higher-rate deposits from the Ojai acquisition. Furthermore, while organic deposit growth was relatively strong in the first half of the year, if acquisition balances were excluded we would have experienced net deposit runoff during the latter half of 2017.
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Total capital increased by $50 million, or 24%, ending the year with a balance of $256 million. The increase in capital is primarily the result of 1,376,431 shares issued as part of the consideration for the Ojai acquisition, but also includes capital from stock options exercised and the addition of net income, less dividends paid. The Company’s regulatory capital ratios declined as a result of the acquisition and organic loan growth but remain relatively robust, and at December 31, 2017 our consolidated Common Equity Tier One Capital Ratio was 12.84%, our Tier One Risk-Based Capital Ratio was 14.79%, our Total Risk-Based Capital Ratio was 15.32%, and our Tier One Leverage Ratio was 11.32%.
Results of Operations
As noted above, acquisitions have had a material impact on our operating results in recent periods, including the recognition of nonrecurring acquisition costs as well as higher revenues and ongoing overhead expense. Net income was $19.539 million in 2017, an increase of $1.972 million, or 11%, compared to 2016. Net income dropped by $500,000, or 3%, in 2016 relative to 2015. The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on deposits and other borrowed money. The second is non-interest income, which primarily consists of customer service charges and fees but also comes from non-customer sources such as bank-owned life insurance and investment gains. The majority of the Company’s non-interest expense is comprised of operating costs that facilitate offering a full range of banking services to our customers.
Net Interest Income and Net Interest Margin
Net interest income was $75.701 million in 2017, compared to $65.182 million in 2016 and $60.126 million in 2015. This equates to increases of 16% in 2017 and 8% in 2016. The level of net interest income we recognize in any given period depends on a combination of factors including the average volume and yield for interest-earning assets, the average volume and cost of interest-bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other interest-bearing liabilities. Net interest income is also impacted by the reversal of interest for loans placed on non-accrual status, and the recovery of interest on loans that had been on non-accrual and were paid off, sold or returned to accrual status.
The following table shows average balances for significant balance sheet categories and the amount of interest income or interest expense associated with each category for each of the past three years. The table also displays calculated yields on each major component of the Company’s investment and loan portfolios, average rates paid on each key segment of the Company’s interest-bearing liabilities, and our net interest margin for the noted periods.
(1)
Average balances are obtained from the best available daily or monthly data and are net of deferred fees and related direct costs.
(2)
Yields and net interest margin have been computed on a tax equivalent basis.
(3)
Loans are gross of the allowance for possible loan losses. Net loan fees have been included in the calculation of interest income. Net loan fees and loan acquisition FMV amortization were $629,660, $461,003, and $276,596 for the years ended December 31, 2017, 2016, and 2015 respectively.
(4)
Non-accrual loans are slotted by loan type and have been included in total loans for purposes of total interest earning assets.
(5)
Net interest margin represents net interest income as a percentage of average interest-earning assets (tax-equivalent).
The Volume and Rate Variances table below sets forth the dollar difference for the comparative periods in interest earned or paid for each major category of interest-earning assets and interest-bearing liabilities, and the amount of such change attributable to fluctuations in average balances (volume) or differences in average interest rates. Volume variances are equal to the increase or decrease in average balances multiplied by prior period rates, and rate variances are equal to the change in rates multiplied by prior period average balances. Variances attributable to both rate and volume changes, calculated by multiplying the change in rates by the change in average balances, have been allocated to the rate variance.
The volume variance calculated for 2017 relative to 2016 was a favorable $9.829 million, due to an increase of $235 million, or 14%, in the average balance of interest-earning assets resulting from the impact of acquisitions and organic growth in loans and investments. There was also a favorable rate variance of $690,000 for 2017 over 2016. Our weighted average yield on interest-earning assets was up by 16 basis points while the weighted average cost of interest-bearing liabilities increased by 11 basis points, and the Company also benefited from the fact that the yield increase on earning assets was applied to a much higher balance than the rate change for interest-bearing liabilities. Investment yields have been increasing due to the current rising rate environment, and in response to limited investment portfolio restructuring which took place in 2017. Loan yields have risen due to the impact of higher
short-term interest rates on our variable-rate loans and discount accretion on acquisition loans. The comparative results were also impacted by non-recurring interest items, which can include things such as interest recoveries on non-accrual loans, interest reversals for loans placed on non-accrual status, accelerated fee recognition for loan prepayments, and late fees. We had net interest recoveries of $736,000 in 2017 relative to net interest recoveries of $563,000 in 2016, for an increase of $173,000. Our weighted average cost of interest-bearing liabilities increased primarily because of higher rates paid on adjustable-rate trust-preferred securities (“TRUPS”), short-term borrowings and large time deposits.
The Company’s net interest margin, which is tax-equivalent net interest income as a percentage of average interest-earning assets, was affected by the same factors discussed above relative to rate and volume variances. Our net interest margin was 4.04% in 2017, up nine basis points relative to 2016 primarily as the result of higher loan and investment yields.
For 2016 over 2015, a favorable volume variance of $6.343 million was partially offset by an unfavorable rate variance of $1.287 million. The volume variance was due to an increase of $143 million, or 9%, in average interest-earning assets resulting from growth in loans and investments, including the impact of the Coast acquisition. It was enhanced by strong growth in the average balance of loans relative to lower-yielding investments. The negative rate variance, which resulted from lower yields on investments and loans combined with a slightly higher weighted average rate on interest-bearing liabilities, was exacerbated by the volume differential between interest-earning assets and interest-bearing liabilities. Loan yields were impacted in part by nonrecurring interest income, which was down $262,000 in 2016 relative to 2015. Our net interest margin was 3.95% in 2016, or four basis points lower than in 2015.
Provision for Loan and Lease Losses
Credit risk is inherent in the business of making loans. The Company sets aside an allowance for loan and lease losses, a contra-asset account, through periodic charges to earnings which are reflected in the income statement as the provision for loan and lease losses. The Company recorded a negative loan loss provision of $1.140 million in 2017, and did not need to record provisions in 2016 or 2015. The provision reversal in 2017 was made possible by principal recovered on charged-off loan balances, and the zero provisions for 2016 and 2015 were facilitated by the reduction of impaired loan balances, lower loan losses, and tighter underwriting standards for new and renewed loans.
Even without a regular loan loss provision in recent periods we have been able to maintain our allowance for loan and lease losses at a level that, in Management’s judgment, is adequate to absorb probable loan losses related to specifically-identified impaired loans as well as probable incurred losses in the remaining loan portfolio. Specifically identifiable and quantifiable loan losses are immediately charged off against the allowance. The Company experienced net recoveries of $482,000 on charged off balances in 2017, as compared to net loan charge-offs totaling $722,000 in 2016 and $825,000 in 2015. The need for reserve replenishment via a loan loss provision has been minimized in recent periods for the following reasons: we had net principal recoveries in 2017, which went back into the allowance; with the exception of the unanticipated charge-off of a $225,000 overdraft in 2017, charge-offs have primarily been recorded against pre-established reserves which alleviated what otherwise might have been a need for reserve replenishment; all of our acquired loans were booked at their fair values, and thus did not initially require a loan loss allowance; loss rates have been declining, thus having a positive impact on general reserves for performing loans; and, new loans booked during and since the great recession have been underwritten using tighter credit standards than was the case for many legacy loans.
The Company’s policies for monitoring the adequacy of the allowance and determining loan amounts that should be charged off, and other detailed information with regard to changes in the allowance, are discussed in Note 2 to the consolidated financial statements and below under “Allowance for Loan and Lease Losses.” The process utilized to establish an appropriate allowance for loan and lease losses can result in a high degree of variability in the Company’s loan loss provision, and consequently in our net earnings.
Non-interest Revenue and Operating Expense
The table below sets forth the major components of the Company’s non-interest revenue and operating expense for the years indicated, along with relevant ratios:
(1)
Tax Equivalent
The Company’s results reflect increases in total non-interest income of $2.541 million, or 13%, in 2017 over 2016, and $1.523 million, or 9%, in 2016 over 2015. These are primarily core increases resulting from growth, as discussed in greater detail below, but several items of a nonrecurring nature have also had a significant impact over the past few years. In 2017, nonrecurring non-interest income includes $500,000 in gains on the sale of investments, $503,000 in life insurance proceeds, and $323,000 in gains from the dissolution of a low-income housing tax credit fund investment. Nonrecurring non-interest income for 2016 was comprised of $223,000 in gains on the sale of investments, $481,000 in net life insurance proceeds, and $276,000 in special dividends received pursuant to our equity investment in the Federal Home Loan Bank (“FHLB”), while 2015 includes $666,000 in investment gains
and $245,000 in special dividends from the FHLB. Total non-interest income was 1.13% of average interest-earning assets in 2017, relative to 1.14% in 2016 and 1.15% in 2015. The ratio has been trending slightly lower due mainly to a rising balance of interest-earning assets.
The principal component of the Company’s non-interest revenue, namely service charges on deposit accounts, increased by $1.079 million, or 11%, in 2017 relative to 2016, due to fees earned on a higher number of deposit accounts, as well as a higher level of commercial deposit account activity and additional fees on higher-risk accounts. Deposit service charges increased by $752,000, or 8%, in 2016 relative to 2015 for the same reasons. The Company’s ratio of service charge income to average transaction account balances was 1.0% in 2017, down slightly from 1.1% in 2016 and 2015.
The line item immediately following service charges on deposits is checkcard fees, consisting of interchange fees from our customers’ use of debit cards for electronic funds transactions. This category increased by $488,000, or 11%, in 2017 over 2016 and by $233,000, or 6%, in 2016 over 2015 as a result of growth in our deposit account base, including the addition of accounts pursuant to our acquisitions. Other service charges and fees, which also constitute a relatively large portion of non-interest income, increased by $187,000, or 5%, in 2017 over 2016 and by $248,000, or 7%, in 2016 over 2015. Factoring out the impact of nonrecurring special dividends from the FHLB, as noted above, and a declining level of regular FHLB dividends, the increase in this category reflects a stronger volume of fee-generating activities.
BOLI income increased by $646,000, or 65%, in 2017 over 2016. BOLI income is derived from two types of policies owned by the Company, namely “separate account” and “general account” life insurance, and the increase in 2017 is due in large part to higher income on separate account BOLI. The Company had $6.5 million invested in separate account BOLI at December 31, 2017, which produces income that helps offset expense accruals for deferred compensation accounts the Company maintains on behalf of certain directors and senior officers. Those accounts have returns pegged to participant-directed investment allocations that can include equity, bond, or real estate indices, and are thus subject to gains or losses which often contribute to significant fluctuations in income (and associated expense accruals). Gains on separate account BOLI totaled $689,000 in 2017 relative to $151,000 in 2016, for an increase of $538,000. As noted, gains and losses on separate account BOLI are related to expense accruals or reversals associated with participant gains and losses on deferred compensation balances, thus their net impact on taxable income tends to be minimal. The Company’s books also reflect a net cash surrender value of $40.6 million for general account BOLI at year-end 2017. General account BOLI generates income that is used to help offset expenses associated with executive salary continuation plans, director retirement plans and other employee benefits. Interest credit rates on general account BOLI do not change frequently so the income has typically been fairly consistent. While rate reductions and an increase in the cost of insurance for certain policies created downward pressure on general account BOLI income over the past few years, the average income crediting rate improved in 2017 due to the termination of a high-cost policy in late 2016. Furthermore, the Ojai acquisition included over $2 million in BOLI, thus income on general account BOLI reflects an increase of $108,000 for 2017.
As previously noted, we realized $500,000 in gains on the sale of investments in 2017, compared to $223,000 in 2016 and $666,000 in 2015. The next line item reflects pass-through expenses associated with our investments in low-income housing tax credit funds and other limited partnerships. Those expenses, which are netted out of revenue, increased by $17,000, or 2%, in 2017 relative to 2016, but dropped by $114,000, or 11%, in 2016 compared to 2015. If not for the aforementioned gain from the dissolution of one of the limited partnerships, the increase would have been even greater in 2017 due to new investments added in 2017 and 2016.
Other non-interest income includes gains and losses on the disposition of assets other than OREO, rent on bank-owned property other than OREO, life insurance proceeds, loan servicing income (net of amortization expense on our servicing asset), and other miscellaneous income. There was a drop of $119,000 in other non-interest income in 2017 relative to 2016 resulting from the disposition of certain fixed assets at a loss in 2017. As noted above, life insurance proceeds totaled $503,000 in 2017 relative to $481,000 in 2016, for an immaterial difference. The variance in other non-interest income for 2016 over 2015 reflects an absolute increase of $532,000, due primarily to the fact that no life insurance proceeds were received in 2015.
Total operating expense, or non-interest expense, increased by $7.388 million, or 13%, in 2017 over 2016, and by $7.350 million, or 14%, in 2016 relative to 2015. The increase for 2017 is comprised in large part of ongoing oper
ating costs incidental to our acquisitions and de novo branch expansion. The increase in 2016 includes nonrecurring acquisition costs, as well as core operating expenses required to support a larger number of branches. Non-interest expense includes the following items of a nonrecurring nature: for 2017, acquisition costs of $2.225 million, lending-related costs totaling about $300,000, and net OREO expense of $270,000; for 2016, acquisition costs of $2.411 million, net OREO expense of $657,000, and a nonrecurring expense reversal of $173,000 in director retirement plan accruals subsequent to the death of a former director and the payment of split-dollar life insurance proceeds to his beneficiary; and for 2015, net OREO expense of $153,000 and one-time acquisition costs totaling $101,000. Non-interest expense was 3.40% of average earning assets in 2017, relative to 3.43% for 2016 and 3.28% in 2015. The ratios were higher in 2017 and 2016 largely because of acquisition costs.
The largest component of operating expense, namely salaries and employee benefits, was up $4.054 million, or 15%, in 2017 over 2016, and $2.581 million, or 10%, in 2016 over 2015. Personnel costs increased in 2017 due to expenses for employees retained subsequent to our acquisitions, staffing costs for de novo branch offices that commenced operations in 2017, and higher costs for temporary employees and overtime related to the Ojai whole-bank and Woodlake branch acquisitions and system conversions. The increase also includes salary adjustments in the normal course of business, costs for non-acquisition related staff additions, a relatively large increase in group health insurance costs, and higher equity incentive compensation expense related to stock options. Personnel costs for 2016 were up relative to 2015 due to the impact of the acquisition and the de novo branch, as well as salary adjustments in the normal course of business, higher staffing levels as vacant positions were filled, and higher temporary salaries and overtime costs. Components of compensation expense that can experience significant variability and are typically difficult to predict include salaries associated with successful loan originations, which are accounted for in accordance with Financial Accounting Standards Board (“FASB”) guidelines on the recognition and measurement of non-refundable fees and origination costs for lending activities, and accruals associated with employee deferred compensation plans. Loan origination salaries that were deferred from current expense for recognition over the life of related loans totaled $3.854 million for 2017, $3.430 million for 2016, and $3.058 million for 2015, with the fluctuations due to variability in successful organic loan origination activity. Employee deferred compensation expense accruals totaled $217,000 in 2017, relative to $141,000 in 2016 and $37,000 in 2015. As noted above in our discussion of BOLI income, employee deferred compensation plan accruals are related to separate account BOLI income and losses, as are directors deferred compensation accruals that are included in “other professional services,” and the net income impact of all income/expense accruals related to deferred compensation is usually minimal. Salaries and benefits were 48.14% of total operating expense in 2017, relative to 47.29% in 2016 and 49.05% in 2015. The number of full-time equivalent staff employed by the Company totaled 560 at the end of 2017, 479 at the end of 2016, and 417 at the end of 2015. The increase in 2017 over 2016 is due to the addition of former Ojai Community Bank employees and Woodlake branch staff, personnel for de novo branches opened in 2017, and certain back office additions deemed necessary to ensure a continued high level of customer service.
Total rent and occupancy expense, including furniture and equipment costs, increased by $1.824 million, or 23%, in 2017 over 2016, and by $867,000, or 13%, in 2016 over 2015. The increase in 2017 was primarily the result of expenses associated with locations added during the year, including certain non-recurring start-up costs associated with outfitting new branches, but it also includes inflationary increases related to other locations. The increase in 2016 is due to occupancy costs associated with acquisitions and branch openings, rent escalations in the normal course of business, and depreciation expense on office renovations.
Advertising and promotion costs were up by $128,000, or 5%, in 2017 over 2016, and by $67,000, or 3%, in 2016 over 2015. The increases are mainly the result of marketing efforts targeting our expanded geography, and other promotional expenses associated with opening new branches. Data processing costs increased by $758,000, or 21%, in 2017 over 2016, and by $181,000, or 5%, in 2016 over 2015. The increase in 2017 is primarily from ongoing expenses related to our acquisitions and new branches, but also includes costs associated with an online lending platform that was implemented at the beginning of 2017. The increase in 2016 is largely due to ongoing costs associated with the Coast acquisition which were partially offset by efforts to manage network and other information technology costs. Deposit services costs also increased by $689,000, or 18%, in 2017 over 2016, and by $555,000, or 17%, in 2016 over 2015. As with data processing costs, much of the increase in deposit costs is the result of ongoing expenses associated with our acquisitions, including operational costs as well as amortization expense for our core deposit intangible, and expenses for other new offices. Deposit costs were further impacted by increases in debit card processing costs due to higher activity levels.
Loan services costs are comprised of loan processing costs, and net costs associated with foreclosed assets. Loan processing costs, which include expenses for property appraisals and inspections, loan collections, demand and foreclosure activities, loan servicing, loan sales, and other miscellaneous lending costs, increased by $394,000, or 62%, in 2017 relative to 2016, but reflect a drop of $256,000, or 29%, in 2016 as compared to 2015. The increase in 2017 is due primarily to $300,000 in nonrecurring lending costs as noted above, but it also includes a higher level of appraisal, inspection and credit reporting costs incidental to more robust lending activity. The reduction in 2016 includes lower appraisal and inspection costs, and declining collection costs. Foreclosed assets costs are comprised of write-downs taken subsequent to reappraisals, OREO operating expense (including property taxes), and losses on the sale of foreclosed assets, net of rental income on OREO properties and gains on the sale of foreclosed assets. Those costs reflect a drop of $387,000 in 2017 over 2016 and an increase of $504,000 in 2016 relative to 2015. The decline in 2017 came primarily in lower OREO write-downs, while the increase in 2016 is the result of additional OREO write-downs, higher OREO operating expense, and lower gains on the sale of foreclosed assets.
The “other operating costs” category includes telecommunications expense, postage, and other miscellaneous costs. Telecommunications expense increased by $102,000, or 7%, in 2017 relative to 2016, following a reduction of $305,000, or 16%, in 2016 over 2015. The increase in 2017 is reflective of branch expansion, while the reduction for 2016 includes non-recurring credits received from prior period overbillings, but was also the result of focused efforts to increase efficiencies. Postage expense increased by $67,000, or 7%, in 2017 over 2016 and by $74,000, or 8%, in 2016 over 2015, due mainly to statements and disclosures mailed to an expanding customer base. The “Other” category under other operating costs was up by $187,000, or 21%, in 2017 over 2016 and by $102,000, or 13%, in 2016 over 2015, due primarily to higher travel costs. Travel costs rose in connection with our acquisitions and conversions, de novo branches, and increased frequency of offsite meetings.
Legal and accounting costs declined $143,000, or 9%, in 2017 relative to 2016 due to lower legal expense, primarily in the collections area. This line item increased by $338,000, or 25%, in 2016 over 2015, however, due to higher audit costs and higher legal expense. Acquisition costs, or one-time expenses directly attributable to our whole-bank and branch acquisitions, totaled $2.225 million in 2017, $2.411 million in 2016, and $101,000 in 2015. Those nonrecurring expenses are comprised primarily of termination fees for core processing contracts and certain other contracts, software conversion costs, financial advisor fees, legal costs, severance and retention amounts paid to employees of the acquired institutions, and the write-off of furniture, fixtures and equipment that were not utilized by the Company.
Other professional services costs include FDIC assessments and other regulatory expenses, directors’ costs, and certain insurance costs among other things. This category increased by $270,000, or 14%, in 2017 over 2016 and $211,000, or 12%, in 2016 over 2015. The increase in 2017 includes higher director’s deferred compensation expense, an increase stemming from a nonrecurring reversal of $173,000 in director retirement plan accruals in 2016, and higher stock option expense, partially offset by lower regulatory assessments. The increase for 2016 includes higher deferred compensation expense, an increase in directors’ fees due to an expanded Board, and equity incentive compensation costs for stock options issued to directors in 2016, partially offset by the aforementioned reversal of certain director retirement plan accruals in 2016. As with deferred compensation accruals for employees, directors’ deferred compensation accruals are related to separate account BOLI income and losses, and the net income impact of all income/expense accruals related to deferred compensation is usually minimal. Directors’ deferred compensation expense accruals totaled $598,000 in 2017, $173,000 in 2016, and $57,000 in 2015.
Stationery and supply costs fell by $116,000, or 8%, in 2017 over 2016, but increased by $129,000, or 10%, in 2016 over 2015. The drop in 2017 is primarily due to costs associated with the issuance of new debit cards incorporating EMV technology in 2016; both 2017 and 2016 include recurring costs stemming from our whole-bank acquisitions and branch expansion, as well as one-time costs to outfit new branches with Bank of the Sierra supplies. Sundry and teller costs reflect a reduction of $253,000, or 30%, in 2017 relative to 2016 due to reduced debit card losses and lower operations-related losses within our branch system. These costs were about the same in 2016 as in 2015.
The Company’s tax-equivalent overhead efficiency ratio was 65.52% in 2017, relative to 67.23% in 2016 and 63.98% in 2015. The overhead efficiency ratio represents total non-interest expense divided by the sum of fully tax-equivalent net interest and non-interest income, with the provision for loan losses and investment gains/losses excluded from the equation. The ratio was higher in 2017 and 2016 due in part to non-recurring acquisition costs incurred in those periods.
Income Taxes
Our income tax provision was $13.640 million, or 41% of pre-tax income in 2017, relative to provisions of $8.800 million, or 33% of pre-tax income in 2016 and $9.071 million, or 33% of pre-tax income in 2015. The tax accrual rate for 2017 was higher primarily because of the $2.710 million deferred tax asset revaluation charge, but it also reflects higher taxable income relative to available tax credits. Our tax accrual rate would have been even higher in 2017 if not for our adoption of FASB’s Accounting Standards Update 2016-09 effective January 1, 2017, and the subsequent change in accounting methodology associated with the disqualifying disposition of Company shares issued pursuant to the exercise of incentive stock options. Prior to January 1, 2017, the favorable tax impact of disqualifying dispositions was recorded directly to equity, whereas it is now reflected in the income statement as an adjustment to our income tax provision. Disqualifying dispositions had a small impact on our tax accrual rate during the fourth quarter, but they occurred at a higher rate during the first half of 2017 and thus had a larger favorable impact on our year-to-date income tax accrual.
The Company sets aside a provision for income taxes on a monthly basis. The amount of that provision is determined by first applying the Company’s statutory income tax rates to estimated taxable income, which is pre-tax book income adjusted for permanent differences, and then subtracting available tax credits. Permanent differences include but are not limited to tax-exempt interest income, BOLI income, and certain book expenses that are not allowed as tax deductions. The Company’s investments in state, county and municipal bonds provided $3.711million in federal tax-exempt income in 2017, $3.001 million in 2016, and $2.953 million in 2015. Moreover, in addition to life insurance proceeds of $503,000 in 2017 and $481,000 in 2016, our bank-owned life insurance generated $1.640 million in tax-exempt income in 2017, compared to $994,000 in 2016 and $907,000 in 2015.
Our tax credits consist primarily of those generated by investments in low-income housing tax credit funds, and California state employment tax credits. We had a total of $8.4 million invested in low-income housing tax credit funds as of December 31, 2017, which are included in other assets rather than in our investment portfolio. Those investments have generated substantial tax credits over the past few years, with about $711,000 in credits available for the 2017 tax year, $686,000 in tax credits utilized in 2016, and $770,000 in tax credits utilized in 2015. The credits are dependent upon the occupancy level of the housing projects and income of the tenants, and cannot be projected with certainty. Furthermore, our capacity to utilize them will continue to depend on our ability to generate sufficient pre-tax income. We plan to invest in additional tax credit funds in the future, but if the economics of such transactions do not justify continued investments then the level of low-income housing tax credits will taper off in future years until they are substantially utilized by the end of 2028. That means that even if taxable income stayed at the same level through 2028, our tax accrual rate would gradually increase.
Financial Condition
Our acquisitions had a significant impact on balance sheet growth in 2017, as discussed in the following sections. Assets totaled $2.340 billion at the end of 2017, reflecting an increase of $307 million, or 15%, for the year. Asset growth came primarily from increases of $295 million, or 23%, in gross loan balances, $28 million, or 5%, in investment securities, and close to $23 million in goodwill and other intangible assets, offset in part by a $50 million reduction in cash and cash equivalents. Deposits were up $293 million, or 17%, reflecting very balanced growth relative to loans, while non-deposit borrowings, including junior subordinated debentures, were reduced by a net $43 million, or 40%. Total capital increased by $50 million, or 24%. The major components of the Company’s balance sheet are individually analyzed below, along with information on off-balance sheet activities and exposure.
Loan and Lease Portfolio
The Company’s loan and lease portfolio represents the single largest portion of invested assets, substantially greater than the investment portfolio or any other asset category, and the quality and diversification of the loan and lease portfolio are important considerations when reviewing the Company’s financial condition.
The Selected Financial Data table in Item 6 above reflects the amount of loans and leases outstanding at December 31st for each year from 2013 through 2017, net of deferred fees and origination costs and the allowance for loan and lease losses. The Loan and Lease Distribution table that follows sets forth by loan type the Company’s gross loans
and leases outstanding, and the percentage distribution in each category at the dates indicated. The balances for each loan type include nonperforming loans, if any, but do not reflect any deferred or unamortized loan origination, extension, or commitment fees, or deferred loan origination costs. Although not reflected in the loan totals below and not currently comprising a material part of our lending activities, the Company occasionally originates and sells, or participates out portions of, loans to non-affiliated investors.
The Company has experienced net growth in loan and lease balances every year since 2013, in spite of fluctuations caused by variability in outstanding balances on mortgage warehouse lines, reductions associated with the resolution of impaired loans, weak loan demand in some of those years, tightened underwriting standards, and intense competi
tion. This growth is due in part to acquisitions, including Santa Clara Valley Bank in 2014, Coast National Bank in 2016 and Ojai Community Bank in 2017, as well as whole loan purchases and participations purchased in 2015 and 2016. Organic loan growth has also been relatively robust in recent periods, particularly with regard to commercial real estate, construction and single-family loans.
For 2017, gross loans were up by $295 million, or 23%, due to the addition of $218 million in loans via the Ojai acquisition and strong organic growth in real estate loans, net of a $25 million reduction in outstanding balances on mortgage warehouse lines. Total real estate loans increased by $309 million, or 34%, due to $189 million in balances from the Ojai acquisition and net organic growth. Agricultural production loan balances were up earlier in 2017, but due to subsequent payoffs ended the year with almost no net growth. Commercial loans reflect a net increase of $12 million, or 10%, due to $28 million in loans from the Ojai acquisition partially offset by runoff in our legacy portfolio. One large commercial relationship, in particular, had an undesirable impact when the borrower sold the business in 2017 and paid off $14 million in loans. Outstanding balances on mortgage warehouse lines declined by $25 million, or 15%, as the utilization rate on those lines dropped to 34% at December 31, 2017 from 48% at December 31, 2016. Mortgage lending activity is highly correlated with changes in interest rates and refinancing activity and has historically been subject to significant fluctuations, so no assurance can be provided with regard to our ability to maintain or grow mortgage warehouse balances. Consumer loans fell by $2 million, or 13%, during 2017. We continue to actively seek quality loan participations to supplement organic growth, but despite almost $5 million in loan participations inherited from Ojai Community Bank, the Company’s total loan participations purchased declined to $32 million at December 31, 2017 from $41 million at December 31, 2016 due to paydowns during the year. Loan participations are included in the balances shown in the table above.
Management remains focused on loan growth, which combined with stronger economic activity in some of our markets has led to recent record levels in our pipeline of loans in process of approval. However, we are still experiencing a relatively high level of prepayments and mortgage warehouse lending is subject to significant fluctuations, thus no assurance can be provided with regard to future net growth in aggregate loan balances.
Loan and Lease Maturities
The following table shows the maturity distribution for total loans and leases outstanding as of December 31, 2017, including non-accruing loans, grouped by remaining scheduled principal payments:
For a comprehensive discussion of the Company’s liquidity position, balance sheet re-pricing characteristics, and sensitivity to interest rates changes, refer to the “Liquidity and Market Risk” section of this discussion and analysis.
Off-Balance Sheet Arrangements
The Company maintains commitments to extend credit in the normal course of business, as long as there are no violations of conditions established in the outstanding contractual arrangements. Unused commitments to extend credit totaled $692 million at December 31, 2017 and $464 million at December 31, 2016, although it is not likely that all
of those commitments will ultimately be drawn down. Unused commitments represented approximately 44% of gross loans outstanding at December 31, 2017 and 37% at December 31, 2016, with the increase due in part to a higher level of construction loans, which fund incrementally rather than immediately at booking, and lower utilization on mortgage warehouse lines. The Company also had undrawn letters of credit issued to customers totaling $9 million at December 31, 2017 and 2016. Off-balance sheet obligations pose potential credit risk to the Company, and a $334,000 reserve for unfunded commitments is reflected as a liability in our consolidated balance sheet at December 31, 2017. The effect on the Company’s revenues, expenses, cash flows and liquidity from the unused portion of the commitments to provide credit cannot be reasonably predicted because there is no guarantee that the lines of credit will ever be used. However, the “Liquidity” section in this Form 10-K outlines resources available to draw upon should we be required to fund a significant portion of unused commitments.
In addition to unused commitments to provide credit, the Company is utilizing an $86 million letter of credit issued by the Federal Home Loan Bank on the Company’s behalf as security for certain deposits and to facilitate certain credit arrangements with the Company’s customers. That letter of credit is backed by loans which are pledged to the FHLB by the Company. For more information regarding the Company’s off-balance sheet arrangements, see Note 12 to the consolidated financial statements in Item 8 herein.
Contractual Obligations
At the end of 2017, the Company had contractual obligations for the following payments, by type and period due:
Nonperforming Assets
Nonperforming assets (“NPAs”) are comprised of loans for which the Company is no longer accruing interest, and foreclosed assets including mobile homes and OREO. If the Company grants a concession to a borrower in financial difficulty, the loan falls into the category of a troubled debt restructuring (“TDR”), which may be designated as either nonperforming or performing depending on the loan’s accrual status. The following table presents comparative data for the Company’s NPAs and performing TDRs as of the dates noted:
(1)
Performing TDRs are not included in nonperforming loans above, nor are they included in the numerators used to calculate the ratios disclosed in this table.
Total NPAs were reduced to $9.4 million, or 0.60% of gross loans and leases plus foreclosed assets at the end of 2017, from $45.6 million, or 5.62% of gross loans and leases plus foreclosed assets at the end of 2013. This reduction has occurred in response to better economic conditions and our continuous efforts to improve credit quality. The contraction in NPAs includes a drop in nonperforming loans of $2.4 million, or 38%, during 2017, but foreclosed assets were up by $3.3 million for the year due to the addition of a single property that was on the books of Ojai Community Bank on the acquisition date. The $4.0 million balance of nonperforming loans at December 31, 2017 includes $1.6 million in TDRs and other loans that were paying as agreed, but which met the technical definition of nonperforming and were classified as such. We also had $12.0 million in loans classified as performing TDRs for which we were still accruing interest at December 31, 2017, a drop of $2.2 million, or 15%, relative to December 31, 2016. Notes 2 and 4 to the consolidated financial statements provide a more comprehensive disclosure of TDR balances and activity within recent periods.
Non-accruing loan balances secured by real estate comprised $2.5 million of total nonperforming loans at December 31, 2017, down $2.6 million, or 51%, since December 31, 2016. The balance of nonperforming commercial loans increased by $609,000, or 88%, during 2017, ending the period at $1.3 million. We have no reason to believe that there will be further material increases in nonperforming commercial loans in the near term, but no assurance can be provided in that regard. Nonperforming consumer loans, which are largely unsecured, declined by $319,000, or 69%, to a balance of only $140,000 at December 31, 2017.
The balance of foreclosed assets had a carrying value of $5.5 million at December 31, 2017, and was comprised of 13 properties classified as OREO and three mobile homes. At the end of 2016 foreclosed assets totaled just over $2.2 million, consisting of 11 properties classified as OREO and two mobile homes. All foreclosed assets are periodically evaluated and written down to their fair value less expected disposition costs, if lower than the then-current carrying value.
An action plan is in place for each of our non-accruing loans and foreclosed assets and they are all being actively managed. Collection efforts are continuously pursued for all nonperforming loans, but no assurance can be provided that they will be resolved in a timely manner or that nonperforming balances will not increase.
Allowance for Loan and Lease Losses
The allowance for loan and lease losses, a contra-asset, is established through a provision for loan and lease losses. It is maintained at a level that is considered adequate to absorb probable losses on specifically identified impaired loans, as well as probable incurred losses inherent in the remaining loan portfolio. Specifically identifiable and quantifiable losses are immediately charged off against the allowance; recoveries are generally recorded only when sufficient cash payments are received subsequent to the charge off. Note 2 to the consolidated financial statements provides a more comprehensive discussion of the accounting guidance we conform to and the methodology we use to determine an appropriate allowance for loan and lease losses.
The Company’s allowance for loan and lease losses was $9.0 million, or 0.58% of gross loans at December 31, 2017, relative to $9.7 million, or 0.77% of gross loans at December 31, 2016. The reduction in the allowance resulted from a net provision reversal of $1.1 million in 2017, partially offset by $482,000 in net principal recoveries. While reserves were established for losses inherent in incremental loan balances and unanticipated charge-offs in 2017, the net decline in the allowance was made possible by the following circumstances: charge-offs were primarily recorded against pre-established reserves, which alleviated what otherwise might have been a need for reserve replenishment; all acquired loans were booked at their fair values, and thus did not initially require a loan loss allowance; loan loss rates have been declining, having a positive impact on general reserves established for performing loans; and, new loans booked during and since the great recession have been underwritten using tighter credit standards than was the case for many legacy loans. The ratio of the allowance to nonperforming loans was 228.19% at December 31, 2017, relative to 152.41% at December 31, 2016 and 108.19% at December 31, 2015. A separate allowance of $334,000 for potential losses inherent in unused commitments is included in other liabilities at December 31, 2017.
The table that follows summarizes the activity in the allowance for loan and lease losses for the periods indicated:
As shown in the table above, the Company recorded a negative loan loss provision of $1.140 million in 2017, and was not required to record provisions in 2016 or 2015. As previously noted, there were $482,000 in net recoveries on previously charged-off balances in 2017, relative to net charged-off loan balances totaling $722,000 in 2016 and $825,000 in 2015. Any shortfall in the allowance identified pursuant to our analysis of remaining probable losses is covered by quarter-end. Our allowance for probable losses on specifically identified impaired loans was reduced by
$209,000, or 15%, during 2017, due to the charge-off of losses against the allowance and the release of reserves subsequent to the resolution of certain non-performing loans. The allowance for probable losses inherent in non-impaired loans was also down by $449,000, or 5%, as a result of credit quality improvement. The “Provision for Loan and Lease Losses” section above includes additional details on our provision and its relationship to actual charge-offs.
Provided below is a summary of the allocation of the allowance for loan and lease losses for specific loan categories at the dates indicated. The allocation presented should not be viewed as an indication that charges to the allowance will be incurred in these amounts or proportions, or that the portion of the allowance allocated to a particular loan category represents the total amount available for charge-offs that may occur within that category.
(1)
Represents percentage of loans in category to total loans
(2)
Includes mortgage warehouse lines
The Company’s allowance for loan and lease losses at December 31, 2017 represents Management’s best estimate of probable losses in the loan portfolio as of that date, but no assurance can be given that the Company will not experience substantial losses relative to the size of the allowance. Furthermore, fluctuations in credit quality, changes in economic conditions, updated accounting or regulatory requirements, and/or other factors could induce us to augment or reduce the allowance.
Investments
The Company’s investments can at any given time consist of debt and marketable equity securities (together, the “investment portfolio”), investments in the time deposits of other banks, surplus interest-earning balances in our Federal Reserve Bank (“FRB”) account, and overnight fed funds sold. Surplus FRB balances and fed funds sold to correspondent banks represent the temporary investment of excess liquidity. The Company’s investments serve several purposes: 1) they provide liquidity to even out cash flows from the loan and deposit activities of customers; 2) they provide a source of pledged assets for securing public deposits, bankruptcy deposits and certain borrowed funds which require collateral; 3) they constitute a large base of assets with maturity and interest rate characteristics that can be changed more readily than the loan portfolio, to better match changes in the deposit base and other funding sources of the Company; 4) they are another interest-earning option for surplus funds when loan demand is light; and 5) they can provide partially tax exempt income. Aggregate investments totaled $567 million, or 24% of total assets at December 31, 2017, compared to $571 million, or 28% of total assets at December 31, 2016.
We had no fed funds sold at December 31, 2017 or 2016. Interest-bearing deposits held at other banks were reduced by $32 million during the year to a balance of $9 million at December 31, 2017, due to the deployment of excess liquidity. The Company’s investment portfolio had a book balance of $558 million at December 31, 2017, reflecting an increase of $28 million, or 5%, for 2017 due to the investment of excess liquidity. The Company carries investments at their fair market values. We currently have the intent and ability to hold our investment securities to maturity, but the securities are all marketable and are classified as “available for sale” to allow maximum flexibility with regard to interest rate risk and liquidity management. The expected average life for bonds in our investment
portfolio was 4.0 years and their average effective duration was 3.1 years at December 31, 2017, up from 3.9 years and 2.6 years, respectively, at year-end 2016 due to relatively strong growth in longer-term municipal bond balances during 2017.
The following Investment Portfolio table reflects the amortized cost and fair market values for each primary category of investment securities for the past three years:
We had a net unrealized loss of $3.3 million on our investment portfolio at December 31, 2017 relative to a net unrealized loss of $3.0 million at December 31, 2016, with the increase due to the unfavorable impact of higher interest rates on fixed-rate bond values. The net unrealized gain or loss represents the difference between the fair market value and amortized cost of our investments. The balance of U.S. Government agency securities fell by over $5 million, or 19%, during 2017, due to bond maturities and declining market values. Mortgage-backed securities increased by $6 million, or 2%, due to bond purchases during the year, net of the impact of lower market valuations and prepayments. Municipal bond balances were up by $29 million, or 25%, due to bond purchases, less the drop in market value caused by rising interest rates. This segment of our portfolio experienced the strongest growth in 2017, as we felt that it presented the greatest potential value. All newly purchased municipal bonds have strong underlying ratings, and all municipal bonds in our portfolio are evaluated quarterly for potential impairment. Equity securities reflect a drop of $1.5 million, falling to a zero balance as we successfully liquidated our remaining equity position in 2017.
Investment securities pledged as collateral for borrowings from the Federal Home Loan Bank of San Francisco (“FHLB”), repurchase agreements, public deposits and other purposes as required or permitted by law totaled $183 million at December 31, 2017 and $194 million at December 31, 2016, leaving $376 million in unpledged debt securities at December 31, 2017 and $335 million at December 31, 2016. Securities pledged in excess of actual pledging needs and thus available for liquidity purposes, if necessary, totaled $40 million at December 31, 2017 and $51 million at December 31, 2016.
The table below groups the Company’s investment securities by their remaining time to maturity as of December 31, 2017, and provides weighted average yields for each segment. Since the actual timing of principal payments may differ from contractual maturities when obligors have the right to prepay principal, maturities for mortgage-backed securities (including collateralized mortgage obligations) were determined by incorporating expected prepayments.
Cash and Due from Banks
Cash on hand and non-interest bearing balances due from correspondent banks totaled $61 million, or 3% of total assets at December 31, 2017, and $79 million, or 4% of total assets at December 31, 2016. The balance of cash and due from banks at any given time depends on the timing of collection of outstanding cash items (checks), the level of vault cash kept on hand at our branches, and our reserve requirement among other things, and is subject to significant fluctuation in the normal course of business. While cash flows are normally predictable within limits, those limits are fairly broad and the Company manages its short-term cash position through the utilization of overnight loans to and borrowings from correspondent banks, including the Federal Reserve Bank and the Federal Home Loan Bank. Should a large “short” overnight position persist for any length of time, the Company typically raises money through focused retail deposit gathering efforts or by adding brokered time deposits. If a “long” position is prevalent, the Company will let brokered deposits or other wholesale borrowings roll off as they mature, or might invest excess liquidity in higher-yielding, longer-term bonds. The average balance of cash and due from banks, which is a better measure for ascertaining trends, was $53 million for 2017 relative to an average balance of $46 million in 2016. The increase in the average balance in 2017 is due to vault cash required for acquired and de novo branches, as well as a larger average volume of cash items in process of collection incidental to an expanding base of deposit customers.
Premises and Equipment
Premises and equipment are stated on our books at cost, less accumulated depreciation and amortization. The cost of furniture and equipment is expensed as depreciation over the estimated useful life of the related assets, and leasehold improvements are amortized over the term of the related lease or the estimated useful life of the improvements, whichever is shorter. The following premises and equipment table reflects the original cost, accumulated depreciation and amortization, and net book value of fixed assets by major category, for the years noted:
Net premises and equipment increased by $495,000, or 2%, in 2017 due primarily to the addition of the Woodlake branch and tenant improvements at de novo branches, net of depreciation expense recorded during the year; all of the locations associated with the Ojai acquisition and our de novo expansion in 2017 are leased from non-affiliated parties. The net book value of the Company’s premises and equipment was 1.3% of total assets at December 31, 2017, and 1.4% of total assets at December 31, 2016. Depreciation and amortization included in occupancy and equipment expense totaled $2.9 million in 2017, as compared to $2.5 million in 2016.
Other Assets
The Company’s goodwill and other intangible assets totaled $33.6 million at December 31, 2017, relative to $11.1 million at December 31, 2016. The increase during 2017 represents goodwill and the core deposit intangible from the Ojai acquisition plus a core deposit intangible from the Woodlake branch acquisition, less amortization expense on our core deposit intangibles. The Company’s goodwill and other intangible assets are evaluated for potential impairment every year following FASB guidelines, and pursuant to those analytics Management has determined that no impairment exists as of December 31, 2017.
The net cash surrender value of bank-owned life insurance increased to $47.1 million at December 31, 2017 from $43.7 million at December 31, 2016. The increase is from BOLI policies that were part of the Ojai acquisition and the addition of BOLI income to the net cash surrender value of our policies, net of the reduction resulting from the elimination of cash surrender values for policies that paid out in 2017. Refer to the “Non-Interest Revenue and Operating Expense” section above for a more detailed discussion of BOLI and the income it generates.
The line item for “other assets” on the Company’s balance sheet totaled $44.7 million at December 31, 2017, an increase of $4.0 million relative to the $40.7 million balance at December 31, 2016. The growth is due mainly to increases of $1.7 million in restricted stock, $1.3 million in accrued interest receivable, $1.6 million in our investment in low-income housing tax credit funds and $1.9 million in our capital commitment to a small business investment corporation. Those increases were partially offset by a $3.0 million reduction in our net deferred tax asset, due in part to the revaluation required by a lower corporate income tax rate. At year-end 2017, the balance of other assets included as its largest components a $10.2 million investment in restricted stock, an $8.4 million investment in low-income housing tax credit funds, accrued interest receivable totaling $7.7 million, a net deferred tax asset of $6.5 million, and a $3.1 million investment in a small business investment corporation. Restricted stock is comprised primarily of Federal Home Loan Bank of San Francisco stock held in conjunction with our FHLB borrowings, and is not deemed to be marketable or liquid. Our net deferred tax asset is evaluated as of every reporting date pursuant to FASB guidance, and we have determined that no impairment exists.
Deposits
Deposits are another key balance sheet component impacting the Company’s net interest margin and other profitability metrics. Deposits provide liquidity to fund growth in earning assets, and the Company’s net interest margin is improved to the extent that growth in deposits is concentrated in less volatile and typically less costly non-maturity deposits such as demand deposit accounts, NOW accounts, savings accounts, and money market demand accounts. Information concerning average balances and rates paid by deposit type for the past three fiscal years is contained in the Distribution, Rate, and Yield table located in the previous section under “Results of Operations-Net Interest Income and Net Interest Margin.” A distribution of the Company’s deposits showing the balance and percentage of total deposits by type is presented as of the dates noted in the following table:
Total deposit balances reflect a net increase of $293 million, or 17%, during 2017. Growth resulted primarily from the Ojai Community Bank and Woodlake branch acquisitions in the fourth quarter, which added $231 million and $27 million, respectively, to deposit balances at the acquisition dates, although we experienced runoff for some higher-rate deposits from the Ojai acquisition prior to year-end. Time deposits comprised $22 million of acquired deposits for Ojai and $4 million for Woodlake at the respective acquisition dates, with the remainder consisting of non-maturity balances. There was also limited net organic growth in deposits in 2017, with strong second quarter growth followed by net runoff in the latter half of the year.
Core non-maturity deposits were up by $255 million, or 19%, and within non-maturity deposits we saw the following changes during 2017: an increase of $136 million, or 13%, in transaction account balances (demand deposits and NOW accounts); an increase of $67 million, or 31%, in savings deposits; and an increase of $52 million, or 44%, in money market deposits. Total time deposits were up by $38 million, or 11%. Management is of the opinion that a relatively high level of core customer deposits is one of the Company’s key strengths and we continue to strive for deposit retention and growth. Our deposit-targeted promotions are still favorably impacting
growth in the number of accounts and it is expected that balances in these accounts will grow over time consistent with our past experience, although no assurance can be provided with regard to future core deposit increases.
The scheduled maturity distribution of the Company’s time deposits at the end of 2017 was as follows:
Other Borrowings
The Company’s non-deposit borrowings may, at any given time, include fed funds purchased from correspondent banks, borrowings from the Federal Home Loan Bank, advances from the Federal Reserve Bank, securities sold under agreement to repurchase, and/or junior subordinated debentures. The Company uses short-term FHLB advances and fed funds purchased on uncommitted lines to support liquidity needs created by seasonal deposit flows, to temporarily satisfy funding needs from increased loan demand, and for other short-term purposes. The FHLB line is committed, but the amount of available credit depends on the level of pledged collateral.
Total non-deposit interest-bearing liabilities were reduced by $43 million, or 40%, in 2017, due to a drop in FHLB borrowings facilitated by the increase in deposits. There was a total of $22 million in overnight borrowings from the FHLB at December 31, 2017, down from $65 million at December 31, 2016. There were no overnight funds purchased from other correspondent banks at December 31, 2017 and 2016, nor were there advances from the FRB on our books at those dates. Repurchase agreements totaled $8 million at December 31, 2017 and 2016. Repurchase agreements represent “sweep accounts”, where commercial deposit balances above a specified threshold are transferred at the close of each business day into non-deposit accounts secured by investment securities. The Company had junior subordinated debentures totaling $34.6 million at December 31, 2017 and $34.4 million December 31, 2016, in the form of long-term borrowings from trust subsidiaries formed specifically to issue trust preferred securities. The small increase resulted from the amortization of the discount on junior subordinated debentures acquired with Coast Bancorp in 2016.
The details of the Company’s short-term borrowings are presented in the table below, for the years noted:
Other Non-Interest Bearing Liabilities
Other liabilities are principally comprised of accrued interest payable, other accrued but unpaid expenses, and certain clearing amounts. The balance of other liabilities was up $7 million, or 30%, in 2017 due primarily to an increase in income taxes payable, a higher accrued liability for deferred compensation, and increases in accruals for capital commitments to low-income housing tax credit funds and a small business investment corporation.
Capital Resources
The Company had total shareholders’ equity of $256 million at December 31, 2017, compared to shareholders’ equity of $206 million at the end of 2016. The increase of $50 million, or 24%, is due in large part to the impact of 1,376,431 shares issued as consideration for the Ojai acquisition, but also includes a rising level of retained earnings and capital from stock options exercised, net of dividends paid and a small increase in our accumulated other comprehensive loss. We maintained a very strong capital position throughout the recession and in the ensuing years, and our capital remains at relatively high levels in comparison to peer banks.
The Company uses a variety of measures to evaluate its capital adequacy, including risk-based capital and leverage ratios that are calculated separately for the Company and the Bank. Management reviews these capital measurements on a quarterly basis and takes appropriate action to help ensure that they meet or surpass established internal and external guidelines. As permitted by the regulators for financial institutions that are not deemed to be “advanced approaches” institutions, the Company has elected to opt out of the Basel III requirement to include accumulated other comprehensive income in risk-based capital. The following table sets forth the Company’s and the Bank’s regulatory capital ratios at the dates indicated:
At the end of 2017 the Company and the Bank were both classified as “well capitalized,” the highest rating of the categories defined under the Bank Holding Company Act and the Federal Deposit Insurance Corporation Improvement Act of 1991, and our regulatory capital ratios were well above the median for peer financial institutions. We do not foresee any circumstances that would cause the Company or the Bank to be less than well capitalized, although no assurance can be given that this will not occur. A more detailed table of regulatory capital ratios, which includes the capital amounts and ratios to qualify as “well capitalized” as well as minimum capital ratios, appears in Note 14 to the Consolidated Financial Statements in Item 8 herein. For additional details on risk-based and leverage capital guidelines, requirements, and calculations and for a summary of changes to risk-based capital calculations which were recently approved by federal banking regulators, see “Item 1, Business - Supervision and Regulation - Capital Adequacy Requirements” and “Item 1, Business - Supervision and Regulation - Prompt Corrective Action Provisions” herein.
Liquidity and Market Risk Management
Liquidity
Liquidity management refers to the Company’s ability to maintain cash flows that are adequate to fund operations and meet other obligations and commitments in a timely and cost-effective manner. Detailed cash flow projections are reviewed by Management on a monthly basis, with various stress scenarios applied to assess our ability to meet liquidity needs under unusual or adverse conditions. Liquidity ratios are also calculated and reviewed on a regular basis. While those ratios are merely indicators and are not measures of actual liquidity, they are closely monitored and we are committed to maintaining adequate liquidity resources to draw upon should unexpected needs arise.
The Company, on occasion, experiences cash needs as the result of loan growth, deposit outflows, asset purchases or liability repayments. To meet short-term needs, the Company can borrow overnight funds from other financial institutions, draw advances via Federal Home Loan Bank lines of credit, or solicit brokered deposits if customer deposits are not immediately obtainable from local sources. Availability on lines of credit from correspondent banks and the FHLB totaled $394 million at December 31, 2017. An additional $96 million in credit is available from the FHLB if the Company were to pledge sufficient collateral and maintain the required amount of FHLB stock. The Company was also eligible to borrow approximately $68 million at the Federal Reserve Discount Window based on pledged assets at December 31, 2017. Furthermore, funds can be obtained by drawing down any cash available in the Company’s correspondent bank deposit accounts, or by liquidating unpledged investments or other readily saleable assets. In addition, the Company can raise immediate cash for temporary needs by selling under agreement to repurchase those investments in its portfolio which are not pledged as collateral. As of December 31, 2017, unpledged debt securities plus pledged securities in excess of current pledging requirements comprised $415 million of the Company’s investment balances, compared to $386 million at December 31, 2016. Other sources of potential liquidity include but are not necessarily limited to any outstanding fed funds sold and vault cash. The Company has a higher level of actual balance sheet liquidity than might otherwise be the case, since we utilize a letter of credit
from the FHLB rather than investment securities for certain pledging requirements. That letter of credit, which is backed by loans pledged to the FHLB by the Company, totaled $86 million at December 31, 2017. Management is of the opinion that available investments and other potentially liquid assets, along with the standby funding sources it has arranged, are more than sufficient to meet the Company’s current and anticipated short-term liquidity needs.
The Company’s net loans to assets and available investments to assets ratios were 67% and 18%, respectively, at December 31, 2017, as compared to internal policy guidelines of “less than 78%” and “greater than 3%.” Other liquidity ratios reviewed periodically by Management and the Board include net loans to total deposits and wholesale funding to total assets (including ratios and sub-limits for the various components comprising wholesale funding), which were well within policy guidelines at December 31, 2017. Strong levels of core deposits and a relatively high balance of liquid investments have had a positive impact on our liquidity position in recent periods, but no assurance can be provided that our liquidity will continue at current robust levels.
The holding company’s primary uses of funds include operating expenses incurred in the normal course of business, shareholder dividends, and stock repurchases. Its primary source of funds is dividends from the Bank, since the holding company does not conduct regular banking operations. Management anticipates that the Bank will have sufficient earnings to provide dividends to the holding company to meet its funding requirements for the foreseeable future. Both the holding company and the Bank are subject to legal and regulatory limitations on dividend payments, as outlined in Item 5(c) Dividends in this Form 10-K.
Interest Rate Risk Management
Market risk arises from changes in interest rates, exchange rates, commodity prices and equity prices. The Company does not engage in the trading of financial instruments, nor does it have exposure to currency exchange rates. Our market risk exposure is primarily that of interest rate risk, and we have established policies and procedures to monitor and limit our earnings and balance sheet exposure to changes in interest rates. The principal objective of interest rate risk management is to manage the financial components of the Company’s balance sheet in a manner that will optimize the risk/reward equation for earnings and capital under a variety of interest rate scenarios.
To identify areas of potential exposure to interest rate changes, we utilize commercially available modeling software to perform monthly earnings simulations and calculate the Company’s market value of portfolio equity under varying interest rate scenarios. The model imports relevant information for the Company’s financial instruments and incorporates Management’s assumptions on pricing, duration, and optionality for anticipated new volumes. Various rate scenarios consisting of key rate and yield curve projections are then applied in order to calculate the expected effect of a given interest rate change on interest income, interest expense, and the value of the Company’s financial instruments. The rate projections can be shocked (an immediate and parallel change in all base rates, up or down), ramped (an incremental increase or decrease in rates over a specified time period), economic (based on current trends and econometric models) or stable (unchanged from current actual levels).
In addition to a stable rate scenario, which presumes that there are no changes in interest rates, we typically use at least six other interest rate scenarios in conducting our rolling 12-month net interest income simulations: upward shocks of 100, 200, and 300 basis points, and downward shocks of 100, 200, and 300 basis points. These scenarios may be supplemented, reduced in number, or otherwise adjusted as determined by Management to provide the most meaningful simulations in light of economic conditions and expectations at the time. We have currently added an upward rate shock scenario of 400 basis points. Pursuant to policy guidelines, we generally attempt to limit the projected decline in net interest income relative to the stable rate scenario to no more than 5% for a 100 basis point (bp) interest rate shock, 10% for a 200 bp shock, 15% for a 300 bp shock, and 20% for a 400 bp shock. As of December 31, 2017 the Company had the following estimated net interest income sensitivity profile, without factoring in any potential negative impact on spreads resulting from competitive pressures or credit quality deterioration:
Our current simulations indicate that the Company has an asset-sensitive profile, meaning that net interest income increases with a parallel shift up in the yield curve but a drop in interest rates could have a negative impact. This
profile is consistent with the Company’s relatively large balance of less rate-sensitive non-maturity deposits and large volume of variable-rate loans, which contributes to higher net interest income in rising rate scenarios and compression in net interest income in declining rate scenarios.
If there were an immediate and sustained upward adjustment of 100 basis points in interest rates, all else being equal, net interest income over the next 12 months is projected to improve by $1.196 million, or 1.33%, relative to a stable interest rate scenario, with the favorable variance continuing to expand slightly as interest rates rise higher. If interest rates were to decline by 100 basis points, however, net interest income would likely be around $5.880 million lower than in a stable interest rate scenario, for a negative variance of 6.55%. The unfavorable variance increases when rates drop 200 or 300 basis points, due to the fact that certain deposit rates are already relatively low (on NOW accounts and savings accounts, for example), and will hit a natural floor of close to zero while non-floored variable-rate loan yields continue to drop. This effect is exacerbated by accelerated prepayments on fixed-rate loans and mortgage-backed securities when rates decline, although rate floors on some of our variable-rate loans partially offset other negative pressures. While we view material interest rate reductions as unlikely in the near term, the potential percentage drop in net interest income exceeds our internal policy guidelines in declining interest rate scenarios and we will continue to monitor our interest rate risk profile and take corrective action as deemed appropriate.
In addition to the net interest income simulations shown above, we run stress scenarios for the unconsolidated Bank modeling the possibility of no balance sheet growth, the potential runoff of “surge” core deposits which flowed into the Company in the most recent economic cycle, and potential unfavorable movement in deposit rates relative to yields on earning assets (i.e., higher deposit betas). Projected net interest income is close to $3 million lower in the stable rate scenario if no balance sheet growth is assumed, but the rate-shock variances predicted for net interest income in a static growth environment are similar to the variances noted above for our standard projections. When a greater level of non-maturity deposit runoff is assumed or unfavorable deposit rate changes are factored into the model, projected net interest income in declining and flat rate scenarios does not change materially relative to standard rate projections, but net interest income drops and the slope reverses in rising rate scenarios.
The economic value (or “fair value”) of financial instruments on the Company’s balance sheet will also vary under the interest rate scenarios previously discussed. The difference between the projected fair value of the Company’s financial assets and the fair value of its financial liabilities is referred to as the economic value of equity (“EVE”), and changes in EVE under different interest rate scenarios are effectively a gauge of the Company’s longer-term exposure to interest rate fluctuations. Fair values for financial instruments are estimated by discounting projected cash flows (principal and interest) at projected replacement interest rates for each account type, while the fair value of non-financial accounts is assumed to equal their book value for all rate scenarios. An economic value simulation is a static measure utilizing balance sheet accounts at a given point in time, and the measurement can change substantially over time as the characteristics of the Company’s balance sheet evolve and interest rate and yield curve assumptions are updated.
The change in economic value under different interest rate scenarios depends on the characteristics of each class of financial instrument, including stated interest rates or spreads relative to current or projected market-level interest rates or spreads, the likelihood of principal prepayments, whether contractual interest rates are fixed or floating, and the average remaining time to maturity. As a general rule, fixed-rate financial assets become more valuable in declining rate scenarios and less valuable in rising rate scenarios, while fixed-rate financial liabilities gain in value as interest rates rise and lose value as interest rates decline. The longer the duration of the financial instrument, the greater the impact a rate change will have on its value. In our economic value simulations, estimated prepayments are factored in for financial instruments with stated maturity dates, and decay rates for non-maturity deposits are projected based on historical patterns and Management’s best estimates. The table below shows estimated changes in the Company’s EVE as of December 31, 2017, under different interest rate scenarios relative to a base case of current interest rates:
The table shows that our EVE will generally deteriorate in declining rate scenarios, but should benefit from a parallel shift upward in the yield curve. While still negative relative to the base case we see a favorable swing in EVE as interest rates drop more than 200 basis points, while the rate of increase in EVE begins to taper off the higher interest rates rise. This is due to the relative durations of our fixed-rate assets and liabilities, combined with the optionality inherent in our balance sheet. We also run stress scenarios for the unconsolidated Bank’s EVE to simulate the possibility of higher loan prepayment rates, unfavorable changes in deposit rates, and higher deposit decay rates. Model results are highly sensitive to changes in assumed decay rates for non-maturity deposits, in particular, with material unfavorable variances occurring relative to the standard simulations shown above as decay rates are increased. Furthermore, while not as extreme as the variances produced by increasing non-maturity deposit decay rates, EVE also displays a relatively high level of sensitivity to unfavorable changes in deposit rate betas in higher rate scenarios.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
The information concerning quantitative and qualitative disclosures of market risk called for by Item 305 of Regulation S-K is included as part of Item 7 above. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Market Risk Management”.
Item 8.
Item 8. Financial Statements and Supplementary Data
The following financial statements and independent auditors’ reports listed below are included herein:
Page
I.
Report of Independent Registered Public Accounting Firm from Vavrinek, Trine, Day & Co., LLP
II.
Consolidated Balance Sheets - December 31, 2017 and 2016
III.
Consolidated Statements of Income - Years Ended December 31, 2017, 2016, and 2015
IV.
Consolidated Statements of Comprehensive Income - Years Ended December 31, 2017, 2016, and 2015
V.
Consolidated Statements of Changes in Shareholders’ Equity - Years Ended December 31, 2017, 2016, and 2015
VI.
Consolidated Statements of Cash Flows - Years Ended December 31, 2017, 2016, and 2015
VII.
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
Board of Directors and Shareholders
Sierra Bancorp and Subsidiary
Porterville, California
Opinions on the Consolidated Financial Statements and Internal Control over Financial Reporting
We have audited the accompanying consolidated balance sheets of Sierra Bancorp and Subsidiary (the “Company”) as of December 31, 2017 and 2016, and the related consolidated statements of income and comprehensive income, of changes in shareholders’ equity, and of cash flows for each of the years in the three year period ended December 31, 2017, and the related notes (collectively referred to as the “financial statements”). We also have audited the Company’s internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework: (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the years in the three year period ended December 31, 2017 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework: (2013) issued by the COSO.
Basis for Opinions
The Company’s management is responsible for these financial statements, 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 on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s financial statements and on the Company’s internal control over financial reporting based on our integrated audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.
Our audits of the financial statements included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
Definition and Limitations of Internal Control Over Financial Reporting
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.
/s/ Vavrinek, Trine, Day & Co., LLP
We have served as the Company’s auditor since 2004.
Rancho Cucamonga, California
March 13, 2018
SIERRA BANCORP AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
December 31, 2017 and 2016
(dollars in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
SIERRA BANCORP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2017, 2016 and 2015
(dollars in thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
SIERRA BANCORP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Years Ended December 31, 2017, 2016 and 2015
(dollars in thousands, except footnotes)
(1)
Amounts are included in net gains on securities available-for-sale on the Consolidated Statements of Income in non-interest income. Income tax expense associated with the reclassification adjustment for the years ended 2017, 2016 and 2015 was $210,000, $94,000 and $280,000 respectively.
The accompanying notes are an integral part of these consolidated financial statements.
SIERRA BANCORP AND SUBSIDIARY
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY
For the Three Years Ended December 31, 2017
(dollars in thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
SIERRA BANCORP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2017, 2016, and 2015
(dollars in thousands)
SIERRA BANCORP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Continued)
Years Ended December 31, 2017, 2016 and 2015
(dollars in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
SIERRA BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1.
THE BUSINESS OF SIERRA BANCORP
Sierra Bancorp (the “Company”) is a California corporation registered as a bank holding company under the Bank Holding Company Act of 1956, as amended, and is headquartered in Porterville, California. The Company was incorporated in November 2000 and acquired all of the outstanding shares of Bank of the Sierra (the “Bank”) in August 2001. The Company’s principal subsidiary is the Bank, and the Company exists primarily for the purpose of holding the stock of the Bank and of such other subsidiaries it may acquire or establish. The Company’s only other direct subsidiaries are Sierra Statutory Trust II, Sierra Capital Trust III and Coast Bancorp Statutory Trust II, which were formed solely to facilitate the issuance of capital trust pass-through securities.
At December 31, 2017, the Bank operated 39 full service branch offices, an online branch, a real estate industries group, an agricultural credit division, and an SBA lending unit. The Bank’s deposits are insured by the Federal Deposit Insurance Corporation (FDIC) up to applicable legal limits. The Bank maintains a diversified loan portfolio comprised of agricultural, commercial, consumer, real estate construction and mortgage loans. Loans are made in California within the market area of the South Central San Joaquin Valley, the Central Coast, Ventura County and neighboring communities. These areas have diverse economies with principal industries being agriculture, real estate and light manufacturing.
2.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Consolidation and Basis of Presentation
The consolidated financial statements include the accounts of the Company and the consolidated accounts of its wholly-owned subsidiary, Bank of the Sierra. All significant intercompany balances and transactions have been eliminated. Certain reclassifications have been made to prior years' balances to conform to classifications used in 2017. The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America (U.S. GAAP) and prevailing practices within the banking industry.
In accordance with U.S. GAAP, the Company’s investments in Sierra Statutory Trust II, Sierra Capital Trust III and Coast Bancorp Statutory Trust II are not consolidated and are accounted for under the equity method and included in other assets on the consolidated balance sheet. The subordinated debentures issued and guaranteed by the Company and held by the trusts are reflected on the Company’s consolidated balance sheet.
Use of Estimates
The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and actual results could differ.
Material estimates that are particularly susceptible to significant changes in the near-term relate to the determination of the allowance for loan and lease losses and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowances for loan and lease losses and other real estate, management obtains independent appraisals for significant properties, evaluates the overall loan portfolio characteristics and delinquencies and monitors economic conditions.
Cash Flows
For purposes of reporting cash flows, cash and cash equivalents include cash and deposits with other financial institutions that mature within 90 days, and federal funds sold. Net cash flows are reported for customer loan and deposit transactions, interest bearing deposits in other financial institutions, and fed funds purchased and repurchase agreements.
SIERRA BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
Securities
Debt securities may be classified as held to maturity and carried at amortized cost when management has the positive ability and intent to hold them to maturity. Debt securities are classified as available for sale when they might be sold before maturity. Equity securities with readily determinable fair values are classified as available for sale. Securities available for sale are carried at fair value with unrealized holding gains and losses reported in other comprehensive income, net of tax.
Interest income includes amortization of purchase premium or discount. Premiums or discounts on securities are amortized on the level-yield method without anticipating prepayments. Gains and losses on sales are recorded on the trade date and determined using the specific identification method.
Management determines the appropriate classification of its investments at the time of purchase and may only change the classification in certain limited circumstances. All transfers between categories are accounted for at fair value. Although the Company currently has the intent and the ability to hold the securities in its investment portfolio to maturity, the securities are all marketable and are currently classified as “available for sale” to allow maximum flexibility with regard to interest rate risk and liquidity management.
Management evaluates securities for other-than-temporary impairment (“OTTI”) on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of the impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement and 2) OTTI related to other factors, which is recognized in other comprehensive income. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. For equity securities, the entire amount of impairment is recognized through earnings.
Loans Held for Sale
The Company may originate loans intended to be sold on the secondary market. Loans originated and intended for sale in the secondary market are carried at cost which approximates fair value since these loans are typically sold shortly after origination. The loan’s cost basis includes unearned deferred fees and costs, and premiums and discounts. If loans held for sale remain on our books for an extended period of time the fair value of those loans is determined using quoted secondary market prices. Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings.
Loans that might be held for sale by the Company typically consist of residential real estate loans. Loans classified as held for sale, if any, are disclosed in Note 4 to the consolidated financial statements.
Gains and losses on sales of loans are recognized at the time of sale and are calculated based on the difference between the selling price and the allocated book value of loans sold. Book value allocations are determined in accordance with U.S. GAAP. Any inherent risk of loss on loans sold is transferred to the buyer at the date of sale.
The Company has issued various representations and warranties associated with the sale of loans. These representations and warranties may require the Company to repurchase loans with underwriting deficiencies as defined per the applicable sales agreements and certain past due loans within 90 days of the sale. The Company did not experience losses during the years ended December 31, 2017, 2016, or 2015 regarding these representations and warranties.
SIERRA BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
Loans and Leases (Financing Receivables)
Our credit quality classifications of Loans and Leases include Pass, Special Mention, Substandard and Impaired. These classifications are defined in Note 4 to the consolidated financial statements.
Loans and leases that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of deferred loan fees and costs, purchase premiums and discounts, write-downs, and an allowance for loan and lease losses. Loan and lease origination fees, net of certain deferred origination costs, and purchase premiums and discounts are recognized in interest income as an adjustment to yield of the related loans and leases over the contractual life of the loan using both the effective interest and straight line methods without anticipating prepayments.
Interest income for all performing loans, regardless of classification (Pass, Special Mention, Substandard and Impaired), is recognized on an accrual basis, with interest accrued daily. Costs associated with successful loan originations are netted from loan origination fees, with the net amount (net deferred loan fees) amortized over the contractual life of the loan in interest income. If a loan has scheduled periodic payments, the amortization of the net deferred loan fee is calculated using the effective 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. 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 deferred fees and costs are accounted for through interest income.
Generally, the Company places a loan or lease on nonaccrual status and ceases recognizing interest income when it has become delinquent 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 on nonaccrual status, any accrued but uncollected interest for the loan is reversed out of interest income in the period in which the loan’s status changed. For loans with an interest reserve, i.e., where loan proceeds are advanced to the borrower to make interest payments, all interest recognized from the inception of the loan is reversed when the loan is placed on non-accrual. Once a loan is on non-accrual status 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. Generally, loans and leases are not restored to accrual status until the obligation is brought current and has performed in accordance with the contractual terms for a reasonable period of time, and the ultimate collectability of the total contractual principal and interest is no longer in doubt.
Impaired loans are classified as either nonaccrual or accrual, depending on individual circumstances regarding the collectability of interest and principal according to the contractual terms.
Purchased Credit Impaired Loans
The Company purchases individual loans and groups of loans, some of which may show evidence of credit deterioration since origination. These purchased credit impaired (“PCI”) loans are recorded at the amount paid, since there is no carryover of the seller’s allowance for loan losses. After acquisition, losses are recognized by an increase in the allowance for loan losses.
Such PCI loans are accounted for individually or aggregated into pools of loans based on common risk characteristics. The Company estimates the amount and timing of expected cash flows for the loan or pool, and the expected cash flows in excess of amount paid is recorded as interest income over the remaining life of the loan or pool (accretable yield). The excess of the loan’s or pool’s contractual principal and interest over expected cash flows is not recorded (nonaccretable difference).
Over the life of the loan or pool, expected cash flows continue to be estimated. If the present value of expected cash flows is less than the carrying amount, a loss is recorded as a provision for loan and lease losses. If the present value of expected cash flows is greater than the carrying amount, it is recognized as part of future interest income
SIERRA BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
Loans Modified in a Troubled Debt Restructuring
Loans are considered to have been modified in a troubled debt restructuring (“TDR”) when due to a borrower’s financial difficulties the Company makes certain concessions to the borrower that it would not otherwise consider. Modifications may include interest rate reductions, principal or interest forgiveness, forbearance, and other actions intended to minimize economic loss and to avoid foreclosure or repossession of collateral. Generally, a non-accrual loan that has been modified in a TDR remains on non-accrual status for a period of six months to demonstrate that the borrower is able to meet the terms of the modified loan. However, performance prior to the modification, or significant events that coincide with the modification, are included in assessing whether the borrower can meet the new terms and may result in the loan being returned to accrual status at the time of loan modification or after a shorter performance period. If the borrower’s ability to meet the revised payment schedule is uncertain, the loan remains on non-accrual status.
A TDR is generally considered to be in default when it appears likely that the customer will not be able to repay all principal and interest pursuant to the terms of the restructured agreement.
Allowance for Loan and Lease Losses
The allowance for loan and lease losses is maintained at a level which, in management’s judgment, is adequate to absorb loan and lease losses inherent in the loan and lease portfolio. The allowance for loan and lease losses is increased by a provision for loan and lease losses, which is charged to expense, and by principal recovered on charged-off balances. It is reduced by principal charge-offs. The amount of the allowance is based on management’s evaluation of the collectability of the loan and lease portfolio, changes in its risk profile, credit concentrations, historical trends, and economic conditions. This evaluation also considers the balance of impaired loans and leases. A loan or lease is impaired when it is probable that the Company will be unable to collect all contractual principal and interest payments due in accordance with the terms of the loan or lease agreement. The impairment on certain individually identified loans or leases is measured based on the present value of expected future cash flows discounted at the original effective interest rate of the loan or lease. As a practical expedient, impairment may be measured based on the loan’s or lease’s observable market price or the fair value of collateral if the loan or lease is collateral dependent. The amount of impairment, if any, is recorded through the provision for loan and lease losses and is added to the allowance for loan and lease losses, with any changes over time recognized as additional bad debt expense in our provision for loan losses. Impaired loans with homogenous characteristics, such as one-to-four family residential mortgages and consumer installment loans, may be subjected to a collective evaluation for impairment, considering delinquency and repossession statistics, historical loss experience, and other factors.
General reserves cover non-impaired loans and are based on historical net loss rates for each portfolio segment by call report code, adjusted for the effects of qualitative or environmental factors that are likely to cause estimated credit losses as of the evaluation date to differ from the portfolio segment’s historical loss experience. Qualitative factors include consideration of the following: changes in lending policies and procedures; changes in international, national, regional, and local economic and business conditions and developments; changes in the nature and volume of the portfolio; changes in the experience, ability and depth of lending management and staff; changes in the volume and severity of past due, nonaccrual and other adversely graded loans; changes in quality of the loan review system; changes in the value of the underlying collateral for collateral-dependent loans; concentrations of credit; and the effect of the other external factors such as competition and legal and regulatory requirements.
Most of the Company’s business activity is with customers located in California within the Southern Central San Joaquin Valley; in the corridor stretching between Santa Paula and Santa Clarita in Southern California, and on the Central Coast. Therefore the Company’s exposure to credit risk is significantly affected by changes in the economy in those regions. The Company considers this concentration of credit risk when assessing and assigning qualitative factors in the allowance for loan losses. Portfolio segments identified by the Company include Agricultural, Commercial and Industrial, Real Estate, Small Business Administration, and Consumer loans. Relevant risk characteristics for these portfolio segments generally include debt service coverage, loan-to-value ratios and financial performance on non-consumer loans; and credit scores, debt-to-income ratios, collateral type and loan-to-value ratios for consumer loans.
SIERRA BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
Though management believes the allowance for loan and lease losses to be adequate, ultimate losses may vary from their estimates. However, estimates are reviewed periodically, and as adjustments become necessary they are reported in earnings during the periods they become known. In addition, the FDIC and the California Department of Business Oversight, as an integral part of their examination processes, review the allowance for loan and lease losses. These agencies may require additions to the allowance for loan and lease losses based on their judgment about information available at the time of their examinations.
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 commitments from revolving lines of credit, mortgage warehouse lines of credit, construction loans and commercial and standby letters of credit. Because the available funds have not yet been disbursed on these commitments the estimated losses are not included in the calculation of the ALLL. The reserve for off-balance sheet commitments is an estimated loss contingency which is included in other liabilities on the Consolidated Balance Sheets. The adjustments to the reserve for off-balance sheet commitments are reported as a noninterest expense. This reserve is for estimated losses that could occur when the Company is contractually obligated to make a payment under these instruments and must seek repayment from a party that may not be as financially sound in the current period as it was when the commitment was originally made.
Premises and Equipment
Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. The useful lives of premises range between twenty-five to thirty-nine years. The useful lives of furniture, fixtures and equipment range between three to twenty years. Leasehold improvements are amortized over the life of the asset or the term of the related lease, whichever is shorter. When assets are sold or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts, and any resulting gain or loss is recognized in income for the period. The cost of maintenance and repairs is charged to expense as incurred.
Impairment of long-lived assets is evaluated by management based upon an event or changes in circumstances surrounding the underlying assets which indicate long-lived assets may be impaired.
Foreclosed Assets
Foreclosed assets include real estate and other property acquired in full or partial settlement of loan obligations. Upon acquisition, any excess of the recorded investment in the loan balance over the appraised fair market value, net of estimated selling costs, is charged against the allowance for loan and lease losses. A valuation allowance for losses on foreclosed assets is maintained to provide for declines in value. The allowance is established through a provision for losses on foreclosed assets which is included in other non-interest expense. Subsequent gains or losses on sales or write-downs resulting from permanent impairments are recorded in other non-interest expense as incurred. Operating costs after acquisition are expensed.
The Company had two foreclosed residential real estate properties recorded at December 31, 2017, as a result of obtaining physical possession of the property. At December 31, 2017, the recorded investment of consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceeds were in process was $354,000.
Goodwill and Other Intangible Assets
The Company acquired Sierra National Bank in 2000, Santa Clara Valley Bank in 2014, Coast National Bank in 2016, and Ojai Community Bank and the Woodlake Branch of Citizen’s Business Bank in 2017. Goodwill resulting from business combinations after January 1, 2009 is generally determined as the excess of the fair value of the consideration transferred, plus the fair value of any noncontrolling interests in the acquiree, over the fair value of the net assets acquired and liabilities assumed as of the acquisition date.
SIERRA BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but are tested for impairment at least annually or more frequently if events and circumstances exist which indicate that an impairment test should be performed. The Company selected December 31, 2017 as the date to perform the annual impairment test for 2017. Goodwill is the only intangible asset with an indefinite life on our balance sheet. There was no impairment recognized for the years ended December 31, 2017, 2016, and 2015.
Intangible assets with definite useful lives are amortized over their estimated useful lives to their estimated residual values. The Company’s other intangible assets consist solely of core deposit intangible assets (CDI’s) arising from the acquisitions of Santa Clara Valley Bank, Coast National Bank, a Citizen’s Business Bank Porterville branch deposit portfolio, Ojai Community Bank and the Woodlake Branch of Citizen’s Business Bank. All of the CDI’s are being amortized on a straight line basis over eight years, except for the Citizen’s Business Bank Porterville branch deposit portfolio which is being amortized on a straightline basis over five years.
Loan Commitments and Related Financial Instruments
Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded. Details regarding these commitments and financial instruments are discussed in detail in Note 12 to the consolidated financial statements.
Income Taxes
The Company files its income taxes on a consolidated basis with its subsidiary. The allocation of income tax expense represents each entity’s proportionate share of the consolidated provision for income taxes.
Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax basis of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.
A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely to be realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. We have determined that as of December 31, 2017 all tax positions taken to date are highly certain and, accordingly, no accounting adjustment has been made to the financial statements.
The Company recognizes interest and penalties related to uncertain tax positions as part of income tax expense.
Salary Continuation Agreements and Directors’ Retirement Plan
The Company has entered into agreements to provide members of the Board of Directors and certain key executives, or their designated beneficiaries, with annual benefits for up to fifteen years after retirement or death. The Company accrues for these future benefits from the effective date of the plan until the director’s or executive’s expected retirement date in a systematic and rational manner. At the consolidated balance sheet date, the amount of accrued benefits equals the then present value of the benefits expected to be provided to the director or employee, any beneficiaries, and covered dependents in exchange for the director’s or employee’s services to that date.
SIERRA BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
Comprehensive Income
Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses on securities available for sale, net of an adjustment for the effects of realized gains and losses and any applicable tax. Comprehensive income is a more inclusive financial reporting methodology that includes disclosure of other comprehensive income that historically has not been recognized in the calculation of net income. Unrealized gains and losses on the Company’s available for sale securities are included in other comprehensive income after adjusting for the effects of realized gains and losses. Total comprehensive income and the components of accumulated other comprehensive income (loss) are presented in the consolidated statements of comprehensive income.
Stock-Based Compensation
At December 31, 2017, the Company had one stock-based compensation plan, the Sierra Bancorp 2017 Stock Incentive Plan (the “2017 Plan”), which was adopted by the Company’s Board of Directors on March 16, 2017 and approved by the Company’s shareholders on May 24, 2017. The 2017 Plan replaced the Company’s 2007 Stock Incentive Plan (the “2007” Plan), which expired by its own terms on March 15, 2017. Options to purchase shares granted under the 2007 Plan that remained outstanding were unaffected by the plan’s termination. The 2017 Plan covers 850,000 shares of the Company’s authorized but unissued common stock, subject to adjustment for stock splits and dividends, and provides for the issuance of both “incentive” and “nonqualified” stock options to salaried officers and employees, and of “nonqualified” stock options to non-employee directors. The 2017 Plan also provides for the issuance of restricted stock awards to these same classes of eligible participants. We have not issued, nor do we currently have plans to issue, restricted stock awards.
Compensation cost and director’s expense is recognized for stock options issued to employees and directors and is recognized over the required service period, generally defined as the vesting period. The Company is using the Black-Scholes model to value stock options. The “multiple option” approach is used to allocate the resulting valuation to actual expense for current period. Expected volatility is based on historical volatility of the Company’s common stock. The Company uses historical data to estimate option exercise and post-vesting termination behavior. The expected term of options granted is based on historical data and represents the period of time that options granted are expected to be outstanding subsequent to vesting, which takes into account that the options are not transferable. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant. The fair value of each option is estimated on the date of grant using the following assumptions:
Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board issued ASU No. 2014-09 Revenue from Contracts with Customers. This update to the ASC is the culmination of efforts by the FASB and the International Accounting Standards Board (IASB) to develop a common revenue standard for U.S. GAAP and International Financial Reporting Standards (IFRS). ASU 2014-09 supersedes Topic 605 - Revenue Recognition and most industry-specific guidance. The core principal of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance in ASU 2014-09 describes a 5-step process entities can apply to achieve the core principle of revenue recognition and requires disclosures sufficient to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers and the significant judgments
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used in determining that information. This update was originally effective for annual reporting periods beginning on or after December 15, 2016 and interim periods therein and requires expanded disclosures. In July 2015 the FASB issued a deferral of ASU 2014-09 of one year making it effective for annual reporting periods beginning on or after December 15, 2017 while also providing for early adoption but not before the original effective date. Since the guidance does not apply to revenue associated with financial instruments, such as loans and securities that are accounted for under other GAAP, the Company does not expect the new guidance to have a material impact on revenue most closely associated with financial instruments, including interest income. The Company performed an overall assessment of revenue streams potentially affected by the ASU including deposit related fees and interchange fees to determine the potential impact the new guidance is expected to have on the Company’s Consolidated Financial Statements. The Company’s assessment did not identify any significant changes in the timing of revenue recognition under those contracts within the scope of ASU 2014-09. The Company plans to adopt ASU No. 2017-09 on January 1, 2018 utilizing the modified retrospective approach.
In June 2014 the FASB issued ASU 2014-12, Compensation-Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period. These amendments to existing guidance require that a performance target be treated as a “performance condition” if it affects vesting and can be achieved after the requisite service period. To account for such awards, a reporting entity should apply existing guidance in Topic 718 as it relates to awards with performance conditions that affect vesting. The total amount of compensation cost recognized during and after the requisite service period should reflect the number of awards that are expected to vest, and should be adjusted to reflect those awards that ultimately vest. The requisite period ends when the employee can cease rendering service and still be eligible to vest in the award if the performance target is achieved. ASU 2014-12 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. It was adopted by the Company for the first quarter of 2016, and because our stock compensation practices do not currently utilize performance-based criteria there was no impact upon our financial statements or operations upon adoption.
On January 5, 2016, the FASB issued Accounting Standards Update 2016-01, Financial Instruments-Overall: Recognition and Measurement of Financial Assets and Financial Liabilities. Changes made to the current measurement model primarily affect the accounting for equity securities with readily determinable fair values, where changes in fair value will impact earnings instead of other comprehensive income. The accounting for other financial instruments, such as loans, investments in debt securities, and financial liabilities is largely unchanged. The Update also changes the presentation and disclosure requirements for financial instruments including a requirement that public business entities use exit price when measuring the fair value of financial instruments measured at amortized cost for disclosure purposes. This Update is generally effective for public business entities in fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Based on Management’s evaluation of the provisions of ASU 2016-01 and the fact that we had no equity positions with readily determinable market values remaining at December 31, 2017, we do not anticipate any impact on our consolidated financial statements upon adoption of ASU 2016-01.
On February 25, 2016, the FASB issued Accounting Standards Update 2016-02, Leases (Topic 842). The new standard is being issued to increase the transparency and comparability around lease obligations. Previously unrecorded off-balance sheet obligations will now be brought more prominently to light by presenting lease liabilities on the face of the balance sheet, accompanied by enhanced qualitative and quantitative disclosures in the notes to the financial statements. This Update is generally effective for public business entities in fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company has several lease agreements, including 21 branch locations, and one administrative office which are currently considered operating leases, and therefore, not recognized on the Company’s consolidated statements of condition. The Company expects the new guidance will require some of these lease agreements to now be recognized on the consolidated statements of condition as a right-of-use asset and a corresponding lease liability. Therefore, the Company’s preliminary evaluation indicates the provisions of ASU No. 2016-02 are expected to impact the Company’s consolidated statements of condition. However, the Company continues to evaluate the extent of the impact the new guidance will have on the Company’s Consolidated Financial Statements.
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On March 30, 2016 the FASB issued ASU 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, as part of its simplification initiative. Currently, as they relate to share-based payments, tax benefits in excess of compensation costs (“windfalls”) are recorded in equity, and tax deficiencies (“shortfalls”) are recorded in equity to the extent of previous windfalls, and then to the income statement. ASU 2016-09 will reduce some of the administrative complexities by eliminating the need to track a windfall “pool,” but could increase the volatility of income tax expense. This change is required to be applied prospectively to all excess tax benefits and tax deficiencies resulting from settlements after the date of adoption. ASU 2016-09 also removes the requirement to delay recognition of a windfall tax benefit until it reduces current taxes payable. Under the new guidance, the benefit will be recorded when it arises, subject to normal valuation allowance considerations. This change is required to be applied on a modified retrospective basis, with a cumulative-effect adjustment to opening retained earnings. Furthermore, all tax-related cash flows resulting from share-based payments are to be reported as operating activities on the statement of cash flows, a change from the current requirement to present windfall tax benefits as an inflow from financing activities and an outflow from operating activities. However, cash paid by an employer when directly withholding shares for tax withholding purposes should be classified as a financing activity. Under the new guidance, entities are also permitted to make an accounting policy election for the impact of forfeitures on expense recognition for share-based payment awards. Forfeitures can be estimated in advance, as required today, or recognized as they occur. Estimates will still be required in certain circumstances, such as at the time of modification of an award or issuance of a replacement award in a business combination. If elected, the change to recognize forfeitures when they occur needs to be adopted using a modified retrospective approach, with a cumulative effect adjustment recorded to opening retained earnings. ASU 2016-09 is effective for public business entities for annual reporting periods beginning after December 15, 2016, and interim periods within that reporting period. The Company adopted ASU No. 2016-09 on January 1, 2017 and did not elect to recognize forfeitures as they occur, but rather to continue with current GAAP and estimate the number of awards that are expected to vest. The Company expects that the adoption of ASU No. 2016-09 could result in increased volatility to reported income tax expense related to excess tax benefits and tax.
In June 2016 the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which eliminates the probable initial recognition threshold for credit losses in current U.S. GAAP, and instead requires an organization to record a current estimate of all expected credit losses over the contractual term for financial assets carried at amortized cost. This is commonly referred to as the current expected credit losses (“CECL”) methodology. Expected credit losses for financial assets held at the reporting date will be measured based on historical experience, current conditions, and reasonable and supportable forecasts. Another change from existing U.S. GAAP involves the treatment of purchased credit deteriorated assets, which are more broadly defined than purchased credit impaired assets in current accounting standards. When such assets are purchased, institutions will estimate and record an allowance for credit losses that is added to the purchase price rather than being reported as a credit loss expense. Furthermore, ASU 2016-13 updates the measurement of credit losses on available-for-sale debt securities, by mandating that institutions record credit losses on available-for-sale debt securities through an allowance for credit losses rather than the current practice of writing down securities for other-than-temporary impairment. ASU 2016-13 will also require the enhancement of financial statement disclosures regarding estimates used in calculating credit losses. ASU 2016-13 does not change the existing write-off principle in U.S. GAAP or current nonaccrual practices, nor does it change accounting requirements for loans held for sale or certain other financial assets which are measured at the lower of amortized cost or fair value. As a public business entity that is an SEC filer, ASU 2016-13 becomes effective for the Company on January 1, 2020, although early application is permitted for 2019. On the effective date, institutions will apply the new accounting standard as follows: for financial assets carried at amortized cost, a cumulative-effect adjustment will be recognized on the balance sheet for any change in the related allowance for loan and lease losses generated by the adoption of the new standard; financial assets classified as purchased credit impaired assets prior to the effective date will be reclassified as purchased credit deteriorated assets as of the effective date, and will be grossed up for the related allowance for expected credit losses created as of the effective date; and, debt securities on which other-than-temporary impairment had been recognized prior to the effective date will transition to the new guidance prospectively with no change in their amortized cost basis. The Company has begun its implementation efforts by establishing an implementation team chaired by
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the Company’s Chief Lending Officer and composed of members of the Company’s credit administration and finance departments. The Company’s preliminary evaluation indicates that the provisions of ASU No. 2016-13 will likely impact the Company’s Consolidated Financial Statements, in particular the level of the reserve for credit losses. However, the Company continues to evaluate the extent of the potential impact.
In January 2017 the FASB issued ASU 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business. Currently, Topic 805 specifies three elements of a business - inputs, processes, and outputs. While an integrated set of assets and activities (collectively referred to as a “set”) that is a business usually has outputs, outputs are not required. In addition, all the inputs and processes that a seller uses in operating a set are not required if market participants can acquire the set and continue to produce outputs, for example, by integrating the acquired set with their own inputs and processes. This led many transactions to be accounted for as business combinations rather than asset purchases under legacy GAAP. The primary goal of ASU 2017-01 is to narrow the definition of a business, and the guidance in this update provides a screen to determine when a set is not a business. The screen requires that when substantially all of the fair value of the gross assets acquired (or disposed of) is concentrated in a single identifiable asset or a group of similar identifiable assets, the set is not a business. This screen reduces the number of transactions that need to be further evaluated. The amendments in this update are effective for public business entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The amendments in this update should be applied prospectively on or after the effective date. The Company is currently evaluating this ASU to determine the impact on its consolidated financial position, results of operations and cash flows.
In January 2017 the FASB issued ASU 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Accounting for Goodwill Impairment. This guidance removes Step 2 of the goodwill impairment test, which requires a hypothetical purchase price allocation, and goodwill impairment will simply be the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. All other goodwill impairment guidance will remain largely unchanged. Entities will continue to have the option to perform a qualitative assessment to determine if a quantitative impairment test is necessary. The same one-step impairment test will be applied to goodwill at all reporting units, even those with zero or negative carrying amounts. Entities will be required to disclose the amount of goodwill at reporting units with zero or negative carrying amounts. The amendments in this update are effective for public business entities for fiscal years beginning after December 15, 2019. We have not been required to record any goodwill impairment to date, and after a preliminary review do not expect that this guidance would require us to do so given current circumstances. Nevertheless, we will continue to evaluate ASU 2017-04 to more definitely determine its potential impact on the Company’s consolidated financial position, results of operations and cash flows.
In March 2017 the FASB issued ASU 2017-08, Receivables - Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. The amendments in this update shorten the amortization period for certain callable debt securities held at a premium, by requiring the premium to be amortized to the earliest call date. Under current guidance, the premium on a callable debt security is generally amortized as an adjustment to yield over the contractual life of the instrument, and any unamortized premium is recorded as a loss in earnings upon the debtor’s exercise of a call provision. Under ASU 2017-08, because the premium will be amortized to the earliest call date, entities will no longer recognize a loss in earnings if a debt security is called prior to the contractual maturity date. The amendments do not require an accounting change for securities held at a discount; discounts will continue to be amortized as an adjustment to yield over the contractual life of the debt instrument. ASU 2017-08 is effective for public business entities, including the Company, for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. Early adoption is permitted, including adoption in an interim period. If an entity early adopts in an interim period, any adjustments must be reflected as of the beginning of the fiscal year that includes that interim period. To apply ASU 2017-08, entities must use a modified retrospective approach, with the cumulative-effect adjustment recognized to retained earnings at the beginning of the period of adoption. Entities are also
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required to provide disclosures about a change in accounting principle in the period of adoption. The Company has evaluated the potential impact of this guidance, and does not expect the adoption of ASU 2017-08 to have a material impact on our financial statements or operations.
In May 2017 the FASB issued ASU 2017-09, Compensation-Stock Compensation (Topic 718): Scope of Modification Accounting. This update was issued to provide clarity, reduce diversity in practice, and lower cost and complexity when applying the guidance in Topic 718. Under the updated guidance, an entity will be expected to account for the effects of an equity award modification unless all the following are met: 1) the fair value of the modified award is the same as the fair value of the original award immediately before the original award is modified; 2) the vesting conditions of the modified award are the same as the vesting conditions of the original award immediately before the original award is modified; 3) the classification of the modified award as an equity instrument or a liability instrument is the same as the classification of the original award immediately before the original award is modified. The current disclosure requirements in Topic 718 continue to apply. ASU 2017-09 is effective for public business entities, including the Company, for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. Early adoption is permitted, including adoption in an interim period for public business entities for reporting periods for which financial statements have not yet been issued. Since the Company has not modified equity awards in the past and does not expect to do so in the future, we do not anticipate any impact on our financial statements or operations from the adoption of ASU 2017-09.
In February 2018 the FASB issued ASU 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income This ASU requires a reclassification from accumulated other comprehensive income (AOCI) to retained earnings for stranded tax effects resulting from the newly enacted federal corporate income tax rate in the Tax Cuts and Jobs Act of 2017 (Tax Act), which was enacted on December 22, 2017. The Tax Act included a reduction to the corporate income tax rate from 35 percent to 21 percent effective January 1, 2018. The amount of the reclassification would be the difference between the historical corporate income tax rate and the newly enacted 21 percent corporate income tax rate. The amendments in this ASU are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. We have adopted the guidance during the first quarter of 2018, retrospectively to December 31, 2017. The change in accounting principle will be accounted for as a cumulative-effect adjustment to the balance sheet resulting in a $413 thousand increase to retained earnings and a corresponding decrease to AOCI on December 31, 2017.
3.
SECURITIES AVAILABLE-FOR-SALE
The amortized cost and fair value of the securities available-for-sale are as follows (dollars in thousands):
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For the years ended December 31, 2017, 2016, and 2015, proceeds from sales of securities available-for-sale were $45.7 million, $21.5 million, and $31.2 million, respectively. Gains and losses on the sale of investment securities are recorded on the trade date and are determined using the specific identification method.
Gross gains and losses from the sales and calls of securities for the years ended were as follows (dollars in thousands):
At December 31, 2017 and 2016, the Company had 396 and 431 securities with unrealized gross losses, respectively. Information pertaining to these securities aggregated by investment category and length of time that individual securities have been in a continuous loss position, follows (dollars in thousands):
The Company has reviewed all sectors and securities in the portfolio for impairment. During the year ended December 31, 2017 the Company realized gains through earnings from the sale and call of 24 debt securities for $106,000 and one equity position for $116,000. The securities were sold with 59 other debt securities, for which a $524,000 loss was realized, to raise liquidity at year end. During the year ended December 31, 2016, the Company realized gains through earnings from the sale and call of 94 debt securities for $127,000 and one equity position for $95,000. The securities were sold with one other debt security, for which a $1,000 loss was realized, to improve the structure in the portfolio.
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The Company has concluded as of December 31, 2017 that all remaining securities, currently in an unrealized loss position, are not other-than-temporarily-impaired. This assessment was based on the following factors: 1) the Company has the ability to hold the securities, 2) the Company does not intend to sell the securities, 3) the Company does not anticipate it will be required to sell the securities before recovery, 4) and the Company expects to eventually recover the entire amortized cost basis of the securities.
The amortized cost and estimated fair value of securities available-for-sale at December 31, 2017 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because the issuers of the securities may have the right to call or prepay obligations with or without penalties (dollars in thousands):
Securities available-for-sale with amortized costs totaling $183,941,000 and estimated fair values totaling $182,717,000 were pledged to secure other contractual obligations and short-term borrowing arrangements at December 31, 2017 (see Note 9).
Securities available-for-sale with amortized costs totaling $193,981,000 and estimated fair values totaling $193,542,000 were pledged to secure public deposits, other contractual obligations and short-term borrowing arrangements at December 31, 2016 (see Note 9).
At December 31, 2017, the Company’s investment portfolio included securities issued by 262 different government municipalities and agencies located within 31 states with a fair value of $143,201,000. The largest exposure to any single municipality or agency was $2.5 million (fair value) in six bonds issued for the renovation, modernization and construction of various school facilities by the Lindsay Unified School District, to be repaid by future tax revenues.
The Company’s investments in bonds issued by states, municipalities and political subdivisions are evaluated in accordance with Supervision and Regulation Letter 12-15 (SR 12-15) issued by the Board of Governors of the Federal Reserve System, “Investing in Securities without Reliance on Nationally Recognized Statistical Rating Organization Ratings”, and other regulatory guidance. Credit ratings are considered in our analysis only as a guide to the historical default rate associated with similarly-rated bonds. There have been no significant differences in our internal analyses compared with the ratings assigned by the third party credit rating agencies.
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The following table summarizes the amortized cost and fair values of general obligation and revenue bonds in the Company’s investment securities portfolio at the indicated dates, identifying the state in which the issuing municipality or agency operates for our largest geographic concentrations (dollars in thousands):
The following table summarizes the amortized cost and fair value of revenue bonds in the Company’s investment securities portfolio at the indicated dates, identifying the revenue source of repayment for our largest source concentrations (dollars in thousands):
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4.
LOANS AND LEASES
The composition of the loan and lease portfolio is as follows (dollars in thousands):
The Company monitors the credit quality of loans on a continuous basis using the regulatory and accounting classifications of pass, special mention, substandard and impaired to characterize and qualify the associated credit risk. Loans classified as “loss” are immediately charged-off. The Company uses the following definitions of risk classifications:
Pass - Loans listed as pass include larger non-homogeneous loans not meeting the risk rating definitions below and smaller, homogeneous loans not assessed on an individual basis.
Special Mention - Loans classified as special mention have the potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position and some future date.
Substandard - Loans classified as substandard are those loans with clear and well-defined weaknesses such as a highly leveraged position, unfavorable financial operating results and/or trends, or uncertain repayment sources or poor financial condition, which may jeopardize ultimate recoverability of the debt.
Impaired - A loan is considered impaired, when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Additionally, all loans classified as troubled debt restructurings are considered impaired.
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Credit quality classifications as of December 31, 2017 were as follows (dollars in thousands):
Credit quality classifications as of December 31, 2016 were as follows (dollars in thousands):
Loans may or may not be collateralized, and collection efforts are continuously pursued. Loans or leases may be restructured by management when a borrower has experienced some change in financial status causing an inability to meet the original repayment terms and where the Company believes the borrower will eventually overcome those circumstances and make full restitution. Loans and leases are charged off when they are deemed to be uncollectible, while recoveries are generally recorded only when cash payments are received subsequent to the charge-off.
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The following tables present the activity in the allowance for loan losses and the recorded investment in loans and impairment method by portfolio segment for each of the years ending December 31, 2017, 2016, and 2015 (dollars in thousands):
Loans evaluated for impairment:
(1)
Includes mortgage warehouse lines
Reserves based on method of evaluation for impairment:
(1)
Includes mortgage warehouse lines
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The following tables present the recorded investment in nonaccrual loans and loans past due over 30 days as of December 31, 2017 and December 31, 2016 (dollars in thousands, except footnotes):
(1)
Included in Total Financing Receivables
(2)
As of December 31, 2017 there was one 1-4 family closed end loan over 90 days past due and still accruing for $277,000.
(1)
Included in Total Financing Receivables
(2)
As of December 31, 2016 there were no loans over 90 days past due and still accruing.
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Generally, the Company places a loan or lease on nonaccrual status and ceases recognizing interest income when it has become delinquent 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 on nonaccrual status, any accrued but uncollected interest for the loan is reversed out of interest income in the period in which the loan’s status 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.
Individually impaired loans as of December 31, 2017 and December 31, 2016 were as follows (dollars in thousands):
(1)
Contractual principal balance due from customer.
(2)
Principal balance on Company's books, less any direct charge offs.
(3)
Interest income is recognized on performing balances on a regular accrual basis.
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(1)
Contractual principal balance due from customer.
(2)
Principal balance on Company's books, less any direct charge offs.
(3)
Interest income is recognized on performing balances on a regular accrual basis.
Included in loans above are troubled debt restructurings that were classified as impaired. The Company had $908,000 and $1,873,000 in commercial loans, $11,410,000 and $13,704,000 in real estate secured loans and $1,158,000 and $1,513,000 in consumer loans, which were modified as troubled debt restructurings and consequently classified as impaired at December 31, 2017 and 2016, respectively.
Additional commitments to existing customers with restructured loans totaled $1,831,000 and $4,384,000 at December 31, 2017 and 2016, respectively.
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Interest income recognized on impaired loans was $784,000, $1,041,000, and $983,000, for the years ended December 31, 2017, 2016, and 2015, respectively. There was no interest income recognized on a cash basis on impaired loans for the years ended December 31, 2017, 2016, and 2015, respectively.
The following is a summary of interest income from non-accrual loans in the portfolio at year-end that was not recognized (dollars in thousands):
Certain loans have been pledged to secure short-term borrowing arrangements (see Note 9). These loans totaled $693,531,000 and $628,074,000 at December 31, 2017 and 2016, respectively.
Salaries and employee benefits totaling $3,854,000, $3,430,000, and $3,058,000, have been deferred as loan and lease origination costs to be amortized over the estimated lives of the related loans and leases for the years ended December 31, 2017, 2016, and 2015, respectively.
During the periods ended December 31, 2017 and 2016, the terms of certain loans were modified as troubled debt restructurings. Types of modifications applied to these loans include a reduction of the stated interest rate, a modification of term, an agreement to collect only interest rather than principal and interest for a specified period, or any combination thereof.
The following tables present troubled debt restructurings by type of modification during the period ending December 31, 2017 and December 31, 2016 (dollars in thousands):
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The following tables present loans by class modified as troubled debt restructurings including any subsequent defaults during the period ending December 31, 2017 and December 31, 2017 (dollars in thousands):
(1)
This represents the increase or (decrease) in the allowance for loans and lease losses reserve for these credits measured as the difference between the specific post-modification impairment reserve and the pre-modification reserve calculated under our general allowance for loan loss methodology.
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(1)
This represents the increase or (decrease) in the allowance for loans and lease losses reserve for these credits measured as the difference between the specific post-modification impairment reserve and the pre-modification reserve calculated under our general allowance for loan loss methodology.
In the tables above, there were no TDRs that subsequently defaulted necessitating an increase in the allowance for loan and lease losses for the years ended December 31, 2017 and 2016. The total allowance for loan and lease losses specifically allocated to the balances that were classified as TDRs during the year ended December 31, 2017 and 2016 is $116,000 and $79,000, respectively.
Loan Servicing
The Company originates mortgage loans for sale to investors. During the years ended December 31, 2017, 2016, and 2015, all mortgage loans that were sold by the Company were sold without retention of related servicing. The Company’s servicing portfolio at December 31, 2017, 2016, and 2015 totaled $-0-, $72,000, and $425,000, respectively.
Purchased Credit Impaired Loans
As part of the acquisitions described in Note 21 Business Combinations, the Company has purchased loans, some of which have shown evidence of credit deterioration since origination and it was probable at acquisition that all contractually required payments would not be collected. The carrying amount and unpaid principal balance of those loans are as follows (dollars in thousands):
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For those purchased credit impaired loans disclosed above, the Company had increased the allowance for loan losses by $-0-, $58,000, and $-0- during 2017, 2016 and 2015. Purchased credit impaired loans acquired during the years ended December 31, 2017 and 2016 for which it was probable at acquisition that not all contractually required payments would be collected are as follows (dollars in thousands):
There is no accretable yield, or income expected to be collected.
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5.
PREMISES AND EQUIPMENT
Premises and equipment at cost consisted of the following (dollars in thousands):
Depreciation and amortization included in occupancy and equipment expense totaled $2,852,000, $2,524,000, and $2,272,000, for the years ended December 31, 2017, 2016, and 2015, respectively.
Operating Leases
The Company leases certain of its properties under non-cancelable operating leases. Rental expense included in occupancy and equipment expense totaled $2,482,000, $1,623,000, and $1,256,000 and for the years ended December 31, 2017, 2016, and 2015, respectively.
Rent commitments, before considering renewal options that generally are present, were as follows (dollars in thousands):
The Company generally has options to renew its properties facilities after the initial leases expire. The renewal options range from one to ten years and are not included in the payments reflected above.
6.
GOODWILL AND INTANGIBLE ASSETS
Goodwill
The change in goodwill during the year is as follows (dollars in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
Impairment exists when a reporting unit’s carrying value of goodwill exceeds its fair value. Bank of the Sierra (the “Bank”) is the only subsidiary of the Company that meets the materiality criteria necessary to be deemed an operating segment, and because the Company exists primarily for the purpose of holding the stock of the Bank we have determined that only one unified operating segment (the consolidated Company) exists. At December 31, 2017, the Company had positive equity and the Company elected to perform a qualitative assessment to determine if it was more likely than not that the fair value of the Company exceeded its carrying value, including goodwill. The qualitative assessment indicated that it was more likely than not that the fair value of the reporting unit exceeded its carrying value, resulting in no impairment.
Acquired Intangible Assets
Acquired intangible assets were as follows at year-end (dollars in thousands):
Aggregate amortization expense was $508,000, $272,000, and $134,000 for 2017, 2016, and 2015.
Estimated amortization expense for each of the next five years and thereafter (dollars in thousands):
7.
OTHER ASSETS
Other assets consisted of the following (dollars in thousands):
The Company has invested in limited partnerships that operate qualified affordable housing projects to receive tax benefits in the form of tax deductions from operating losses and tax credits. The Company accounts for these investments under the cost method and management analyzes these investments annually for potential impairment. The Company had $3,321,000 in remaining capital commitments to these partnerships at December 31, 2017.
The Company holds certain equity investments that are not readily marketable securities and thus are classified as “other assets” on the Company’s balance sheet. These include investments in Pacific Coast Bankers Bancshares, California Economic Development Lending Initiative, and the Federal Home Loan Bank
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
(“FHLB”). The largest of these is the Company’s $9,594,000 investment in FHLB stock, carried at cost. Quarterly, the FHLB evaluates and adjusts the Company’s minimum stock requirement based on the Company’s borrowing activity and membership requirements. Any stock deemed in excess is automatically repurchased by the FHLB at cost.
8.
DEPOSITS
Interest-bearing deposits consisted of the following (dollars in thousands):
Aggregate annual maturities of time deposits were as follows (dollars in thousands):
Interest expense recognized on interest-bearing deposits consisted of the following (dollars in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
9.
OTHER BORROWING ARRANGEMENTS
At year end, short-term borrowings consisted of the following (dollars in thousands):
Each advance is payable at its maturity date, with a prepayment penalty for fixed rate advances. The advances were collateralized by $606,374,000 of first mortgage loans under a blanket lien arrangement at year end 2017. Based on this collateral and the Company’s holdings of FHLB stock, the Company was eligible to borrow up to the total of $390,662,000 at year-end 2017, with a remaining borrowing capacity of $313,947,000 if sufficient additional collateral was pledged.
The Company had no long-term borrowings at December 31, 2017 and 2016, respectively.
The Company had unsecured lines of credit with its correspondent banks which, in the aggregate, amounted to $80,000,000 at December 31, 2017 and 2016, respectively, at interest rates which vary with market conditions. There was $0 outstanding under these lines of credit at December 31, 2017 and December 31, 2016, respectively.
10.
INCOME TAXES
The provision for income taxes follows (dollars in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
The components of the net deferred tax asset, included in other assets, are as follows (dollars in thousands):
On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (“Tax Act”). Amont other changes, the Tax Act reduces the U.S. federal corporate tax rate from 35% to 21%. The Company has recorded an income tax expense of $2.7 million related to the remeasurement of federal net deferred tax assets resulting from the permanent reduction in the U.S. statutory corporate tax rate to 21% from 35%. The Company is still completing its analysis of the impact of the Tax Act and will record any adjustments to the provisional amount as a component of income tax expense during the measurement period provided for in SAB 118.
The expense for income taxes differs from amounts computed by applying the statutory Federal income tax rates to income before income taxes. The significant items comprising these differences consisted of the following (dollars in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
The Company is subject to federal income tax and income tax of the state of California. Our federal income tax returns for the years ended December 31, 2014, 2015 and 2016 are open to audit by the federal authorities and our California state tax returns for the years ended December 31, 2013, 2014, 2015 and 2016 are open to audit by the state authorities.
The Company has net operating loss carry forwards of approximately $7,794,000 for federal income and approximately $8,376,000 for California franchise tax purposes. Net operating loss carry forwards, to the extent not used will begin to expire in 2030. Net operating loss carry forwards available from acquisitions are substantially limited by Section 382 of the Internal Revenue Code and benefits not expected to be realized due to the limitation have been excluded from the deferred tax asset and net operating loss carry forward amounts noted above.
There were no recorded interest or penalties related to uncertain tax positions as part of income tax for the years ended December 31, 2017, 2016, and 2015, respectively. We do not expect the total amount of unrecognized tax benefits to significantly increase or decrease within the next twelve months.
11.
SUBORDINATED DEBENTURES
Sierra Statutory Trust II (“Trust II”), Sierra Capital Trust III (“Trust III”), and Coast Bancorp Statutory Trust II (“Trust IV”), (collectively, the “Trusts”) exist solely for the purpose of issuing trust preferred securities fully and unconditionally guaranteed by the Company. For financial reporting purposes, the Trusts are not consolidated and the Floating Rate Junior Subordinated Deferrable Interest Debentures (the “Subordinated Debentures”) held by the Trusts and issued and guaranteed by the Company are reflected in the Company’s consolidated balance sheet in accordance with provisions of ASC Topic 810. Under applicable regulatory guidance, the amount of trust preferred securities that is eligible as Tier 1 capital is limited to twenty-five percent of the Company’s Tier 1 capital on a pro forma basis. At December 31, 2017, all $34,588,000 of the Company’s trust preferred securities qualified as Tier 1 capital.
During the first quarter of 2004, Sierra Statutory Trust II issued 15,000 Floating Rate Capital Trust Pass-Through Securities (TRUPS II), with a liquidation value of $1,000 per security, for gross proceeds of $15,000,000. The entire proceeds of the issuance were invested by Trust II in $15,464,000 of Subordinated Debentures issued by the Company, with identical maturity, re-pricing and payment terms as the TRUPS II. The Subordinated Debentures, purchased by Trust II, represent the sole assets of the Trust II. Those Subordinated Debentures mature on March 17, 2034, bear a current interest rate of 4.35% (based on 3-month LIBOR plus 2.75%), with re-pricing and payments due quarterly.
Those Subordinated Debentures are currently redeemable by the Company, subject to receipt by the Company of prior approval from the Federal Reserve Bank, on any March 17th, June 17th, September 17th, or December 17th. The redemption price is par plus accrued and unpaid interest, except in the case of redemption under a special event which is defined in the debenture.
The TRUPS II are subject to mandatory redemption to the extent of any early redemption of the related Subordinated Debentures and upon maturity of the Subordinated Debentures on March 17, 2034.
Trust II has the option to defer payment of the distributions for a period of up to five years, subject to certain conditions, including that the Company may not pay dividends on its common stock during such period. The TRUPS II issued in the offering were sold in private transactions pursuant to an exemption from registration under the Securities Act of 1933, as amended. The Company has guaranteed, on a subordinated basis, distributions and other payments due on the TRUPS II.
During the second quarter of 2006, Sierra Capital Trust III issued 15,000 Floating Rate Capital Trust Pass-Through Securities (TRUPS III), with a liquidation value of $1,000 per security, for gross proceeds of $15,000,000. The entire proceeds of the issuance were invested by Trust III in $15,464,000 of Subordinated Debentures issued by the Company, with identical maturity, repricing and payment terms as the TRUPS III. The Subordinated Debentures, purchased by Trust III, represent the sole assets of the Trust III. Those Subordinated Debentures mature on September 23, 2036, bear a current interest rate of 3.07% (based on 3-month LIBOR plus 1.40%), with repricing and payments due quarterly.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
Those Subordinated Debentures are redeemable by the Company, subject to receipt by the Company of prior approval from the Federal Reserve Bank, on any March 23rd, June 23rd, September 23rd, or December 23rd. The redemption price is par plus accrued and unpaid interest, except in the case of redemption under a special event which is defined in the debenture. The TRUPS III are subject to mandatory redemption to the extent of any early redemption of the related Subordinated Debentures and upon maturity of the Subordinated Debentures on September 23, 2036.
Trust III has the option to defer payment of the distributions for a period of up to five years, subject to certain conditions, including that the Company may not pay dividends on its common stock during such period. The TRUPS III issued in the offering were sold in private transactions pursuant to an exemption from registration under the Securities Act of 1933, as amended. The Company has guaranteed, on a subordinated basis, distributions and other payments due on the TRUPS III.
During the third quarter of 2016, the Company acquired Coast Bancorp Statutory Trust II, which had issued 7,000 Floating Rate Capital Trust Pass-Through Securities (TRUPS IV), with a liquidation value of $1,000 per security, for gross proceeds of $7,000,000. The entire proceeds of the issuance were invested by Trust IV in $7,217,000 of Subordinated Debentures issued by Coast Bancorp with identical maturity, re-pricing and payment terms as the TRUPS IV. The Subordinated Debentures, purchased by Trust IV, represent the sole assets of the Trust IV. Those Subordinated Debentures mature on December 15, 2037, bear a current interest rate of 3.09% (based on 3-month LIBOR plus 1.50%), with re-pricing and payments due quarterly.
Those Subordinated Debentures are currently redeemable by the Company, subject to receipt by the Company of prior approval from the Federal Reserve Bank, on any March 15th, June 15th, September 15th, or December 15th. The redemption price is par plus accrued and unpaid interest, except in the case of redemption under a special event which is defined in the debenture.
The TRUPS IV are subject to mandatory redemption to the extent of any early redemption of the related Subordinated Debentures and upon maturity of the Subordinated Debentures on December 15, 2037.
Coast Bancorp Statutory Trust II has the option to defer payment of the distributions for a period of up to five years, subject to certain conditions, including that the Company may not pay dividends on its common stock during such period. The TRUPS IV issued in the offering were sold in private transactions pursuant to an exemption from registration under the Securities Act of 1933, as amended. The Company has guaranteed, on a subordinated basis, distributions and other payments due on the TRUPS IV.
12.
COMMITMENTS AND CONTINGENCIES
Letter of Credit
The Company holds two letters of credit with the Federal Home Loan Bank of San Francisco totaling $86,013,000. An $80,000,000 letter of credit is pledged to secure public deposits at December 31, 2017 and a $6,013,000 standby letter of credit was obtained on behalf of one of our customers to guarantee financial performance. Should the standby letter of credit be drawn upon, the customer would reimburse the Company from an existing line of credit.
Federal Reserve Requirements
Banks are required to maintain reserves with the Federal Reserve Bank equal to a specified percentage of their reservable deposits less vault cash. There were no reserve balances maintained at the Federal Reserve Bank at December 31, 2017 and 2016, respectively.
Financial Instruments with Off-Balance-Sheet Risk
The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business. These financial instruments consist of commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
The Company’s exposure to credit loss in the event of nonperformance by the other party for commitments to extend credit and letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and letters of credit as it does for loans included on the balance sheet.
The following financial instruments represent off-balance-sheet credit risk (dollars in thousands):
Commitments to extend credit consist primarily of the unused or unfunded portions of the following: home equity lines of credit; commercial real estate construction loans, where disbursements are made over the course of construction; commercial revolving lines of credit; mortgage warehouse lines of credit; unsecured personal lines of credit; and formalized (disclosed) deposit account overdraft lines. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Commitments to extend credit are made at both fixed and variable rates of interest as stated in the table above. Standby letters of credit are generally unsecured and are issued by the Company to guarantee the performance of a customer to a third party, while commercial letters of credit represent the Company’s commitment to pay a third party on behalf of a customer upon fulfillment of contractual requirements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers.
Concentration in Real Estate Lending
At December 31, 2017, in management’s judgment the Company had, a concentration of loans secured by real estate. At that date, approximately 79% of the Company’s loans were real estate related. Balances secured by commercial buildings and construction and development loans represented 63% of all real estate loans, while loans secured by non-construction residential properties accounted for 25%, and loans secured by farmland were 11% of real estate loans. Although management believes the loans within these concentrations have no more than the normal risk of collectability, a decline in the performance of the economy in general or a decline in real estate values in the Company’s primary market areas, in particular, could have an adverse impact on collectability.
Concentration by Geographic Location
The Company extends commercial, real estate mortgage, real estate construction and consumer loans to customers primarily in the South Central San Joaquin Valley of California, specifically Tulare, Fresno, Kern, Kings and Madera counties; the Southern California corridor between Santa Paula and Santa Clarita in the counties of Ventura and Los Angeles; and the Coastal counties of San Luis Obispo, Ventura and Santa Barbara. The ability of a substantial portion of the Company’s customers to honor their contracts is dependent on the economy in these areas. Although the Company’s loan portfolio is diversified, there is a relationship in those regions between the local agricultural economy and the economic performance of loans made to non-agricultural customers.
Contingencies
The Company is subject to legal proceedings and claims which arise in the ordinary course of business. In the opinion of management, the amount of ultimate liability with respect to such actions will not materially affect the consolidated financial position or results of operations of the Company.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
13.
SHAREHOLDERS’ EQUITY
Share Repurchase Plan
At December 31, 2017, the Company had a stock repurchase plan which has no expiration date. During the year ended December 31, 2017, the Company did not repurchase any shares. The total number of shares available for repurchase at December 31, 2017 was 478,954. Repurchases are generally made in the open market at market prices.
Earnings Per Share
A reconciliation of the numerators and denominators of the basic and diluted earnings per share computations is as follows:
Stock Options
On March 16, 2017 the Company’s Board of Directors approved and adopted the 2017 Stock Incentive Plan (the “2017 Plan”), which became effective May 24, 2017 pursuant to the approval of the Company’s shareholders. The 2017 Plan replaced the Company’s 2007 Stock Incentive Plan (the “2007 Plan”), which expired by its own terms on March 15, 2017. Options to purchase 690,260 shares that were granted under the 2007 Plan were still outstanding as of December 31, 2017, and remain unaffected by that plan’s expiration. The 2017 Plan provides for the issuance of both “incentive” and “nonqualified” stock options to officers and employees, and of “nonqualified” stock options to non-employee directors and consultants of the Company. The 2017 Plan also provides for the issuance of restricted stock awards to these same classes of eligible participants, although no restricted stock awards have ever been issued by the Company. The total number of shares of the Company’s authorized but unissued stock reserved for issuance pursuant to awards under the 2017 Plan is 850,000 shares; no shares had been issued under this plan as of December 31, 2017.
All options granted under the 2017 and 2007 Plans have been or will be granted at an exercise price of not less than 100% of the fair market value of the stock on the date of grant, exercisable in installments as provided in individual stock option agreements. In the event of a “Change in Control” as defined in the 2017 Plan, all outstanding options shall become exercisable in full (subject to certain notification requirements), and shall terminate if not exercised within a specified period of time unless such options are assumed by the successor corporation or substitute options are granted. Options also terminate in the event an optionee ceases to be employed by or to serve as a director of the Company or its subsidiaries, and the vested portion thereof must be exercised within a specified period after such cessation of employment or service.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
A summary of the Company’s stock option activity follows (shares in thousands, except exercise price):
(1)
The aggregate intrinsic value of stock option in the table above represents the total pre-tax intrinsic value (the amount by which the current market value of the underlying stock exceeds the exercise price of the option) that would have been received by the option holders had all option holders exercised their options on December 31, 2017. This amount changes based on changes in the market value of the Company's stock.
(2)
The weighted average remaining contractual life of stock options outstanding and exercisable on December 31, 2017 was 5.74 years and 5.38 years, respectively.
Information related to stock options during each year follows:
Cash received from the exercise of 70,340 shares was $874,000 for the period ended December 31, 2017 with a related tax benefit of $372,000.
The Company is using the Black-Scholes model to value stock options. In accordance with U.S. GAAP, charges of $476,000, $188,000, and $35,000 are reflected in the Company’s income statements for the years ended December 31, 2017, 2016, and 2015, respectively, as pre-tax compensation and directors’ expense related to stock options. The related tax benefit of these options is $141,000, $43,000, and $0 for the years ended December 31, 2017, 2016, and 2015, respectively.
Unamortized compensation expense associated with unvested stock options outstanding at December 31, 2017 was $104,000, which will be recognized over a weighted average period of 5.0 years.
14.
REGULATORY MATTERS
The Company and the Bank are subject to certain regulatory capital requirements administered by the Board of Governors of the Federal Reserve System and the FDIC. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgements by regulators. Failure to meet capital requirements can initiate regulatory action. The final rules implementing Basel Committee on Banking Supervision’s capital guidelines for U.S. banks (Basel III rules) became effective for the Company on January 1, 2015 with full compliance with all of the requirements being phased in over a multi-year schedule, and fully phased in by January 1, 2019. Under the Basel III rules, the Company must hold a capital conservation buffer above the adequately capitalized risk-based capital ratios. The capital conservation buffer is being phased in from 0.0% for 2015 to 2.50% by 2019. The capital conservation buffer for 2017 is 1.25%. The net unrealized gain on available for
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
sale securities is not included in computing regulatory capital. Management believes as of December 31, 2017, the Company and the Bank meet all capital adequacy requirements to which they are subject.
Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required. At year-end December 31, 2017 and 2016, notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank’s category.
Actual and required capital amounts (in thousands) and ratios are presented below at year end.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
Under current rules of the Federal Reserve Board, qualified trust preferred securities are one of several “restricted” core capital elements which may be included in Tier 1 capital in an aggregate amount limited to 25% of all core capital elements, net of goodwill less any associated deferred tax liability. Amounts of restricted core capital elements in excess of these limits generally may be included in Tier 2 capital. Since the Company had less than $15 billion in assets at December 31, 2017, under the Dodd-Frank Act the Company will be able to continue to include its existing trust preferred securities in Tier 1 Capital to the extent permitted by FRB guidelines.
Dividend Restrictions
The Company’s ability to pay cash dividends is dependent on dividends paid to it by the Bank, and is also limited by state corporation law. California law allows a California corporation to pay dividends if the company’s retained earnings equal at least the amount of the proposed dividend plus any preferred dividend arrears amount. If a California corporation does not have sufficient retained earnings available for the proposed dividend, it may still pay a dividend to its shareholders if immediately after the dividend the value of the company’s assets would equal or exceed the sum of its total liabilities plus any preferred dividend arrears amount.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
Dividends from the Bank to the Company are restricted under California law to the lesser of the Bank’s retained earnings or the Bank’s net income for the latest three fiscal years, less dividends previously declared during that period, or, with the approval of the Department of Business Oversight, to the greater of the retained earnings of the Bank, the net income of the Bank for its last fiscal year, or the net income of the Bank for its current fiscal year. As of December 31, 2017, the maximum amount available for dividend distribution under this restriction was approximately $12,850,000.
15.
BENEFIT PLANS
Salary Continuation Agreements, Directors’ Retirement and Officer Supplemental Life Insurance Plans
The Company has entered into salary continuation agreements with its executive officers, and has established retirement plans for qualifying members of the Board of Directors. The plans provide for annual benefits for up to fifteen years after retirement or death. The benefit obligation under these plans totaled $5,150,000 and $5,079,000 and was fully accrued for the years ended December 31, 2017 and 2016, respectively. The expense recognized under these arrangements totaled $325,000, $141,000 and $345,000 for the years ended December 31, 2017, 2016 and 2015, respectively. Salary continuation benefits paid to former directors or executives of the Company or their beneficiaries totaled $254,000, $275,000 and $291,000 for the years ended December 31, 2017, 2016 and 2015. Certain officers of the Company have supplemental life insurance policies with death benefits available to the officers’ beneficiaries.
In connection with these plans the Company has purchased, or acquired through the merger, single premium life insurance policies with cash surrender values totaling $40,588,000 and $38,330,000 at December 31, 2017 and 2016, respectively.
Officer and Director Deferred Compensation Plan
The Company has established a deferred compensation plan for certain members of the management group and a deferred fee plan for directors for the purpose of providing the opportunity for participants to defer compensation. The Company bears the costs for the plan’s administration and the interest earned on participant deferrals. The related administrative expense was not material for the years ended December 31, 2017, 2016 and 2015. In connection with this plan, life insurance policies with cash surrender values totaling $6,520,000 and $5,376,000 at December 31, 2017 and 2016, respectively, are included on the consolidated balance sheet in other assets.
401(k) Savings Plan
The 401(k) savings plan (the “Plan”) allows participants to defer, on a pre-tax basis, up to 15% of their salary (subject to Internal Revenue Service limitations) and accumulate tax-deferred earnings as a retirement fund. The Bank may make a discretionary contribution to match a specified percentage of the first 6% of the participants’ contributions annually. The amount of the matching contribution was 75%, for the years ended December 31, 2017, 2016 and 2015. The matching contribution is discretionary, vests over a period of five years from the participants’ hire date, and is subject to the approval of the Board of Directors. The Company contributed $745,000, $623,000, and $543,000 to the Plan in 2017, 2016 and 2015, respectively.
16.
NON-INTEREST REVENUE
The major grouping of non-interest revenue on the consolidated income statements includes several specific items: service charges on deposit accounts, gains on the sale of loans, credit card fees, check card fees, the net gain (loss) on sales and calls of investment securities available for sale, and the net increase (decrease) in the cash surrender value of life insurance.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
Non-interest revenue also includes one general category of “other income” of which the following are major components (dollars in thousands):
17.
OTHER NON-INTEREST EXPENSE
Other non-interest expense consisted of the following (dollars in thousands):
18.
RELATED PARTY TRANSACTIONS
During the normal course of business, the Bank enters into loans with related parties, including executive officers and directors. These loans are made with substantially the same terms, including rates and collateral, as loans to unrelated parties. The following is a summary of the aggregate activity involving related party borrowers (dollars in thousands):
Deposits from related parties held by the Bank at December 31, 2017 and 2016 amounted to $7,742,000 and $3,780,000, respectively.
19.
FAIR VALUE
Fair value is defined by U.S. GAAP as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
orderly transaction between market participants on the measurement date. U.S. GAAP also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:
▪
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
▪
Level 2: Significant observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.
▪
Level 3: Significant unobservable inputs that reflect a company’s own assumptions about the factors that market participants would use in pricing an asset or liability.
The Company used the following methods and significant assumptions to estimate fair values for each category of financial asset noted below:
Securities: The fair values of securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges or by matrix pricing, which is a mathematical technique used widely in the industry to value debt securities by relying on their relationship to other benchmark quoted securities.
Collateral-dependent impaired loans: A specific loss allowance is created for collateral dependent impaired loans, representing the difference between the face value of the loan and its current appraised value less estimated disposition costs.
Foreclosed assets: Repossessed real estate (OREO) and other assets are carried at the lower of cost or fair value. Fair value is the appraised value less expected selling costs for OREO and some other assets such as mobile homes, and for all other assets fair value is represented by the estimated sales proceeds as determined using reasonably available sources. Foreclosed assets for which appraisals can be feasibly obtained are periodically measured for impairment using updated appraisals. Fair values for other foreclosed assets are adjusted as necessary, subsequent to a periodic re-evaluation of expected cash flows and the timing of resolution. If impairment is determined to exist, the book value of a foreclosed asset is immediately written down to its estimated impaired value through the income statement, thus the carrying amount is equal to the fair value and there is no valuation allowance.
Assets and liabilities measured at fair value on a recurring basis, including financial liabilities for which the Company has elected the fair value option, are summarized below (dollars in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
Assets and liabilities measured at fair market value on a non-recurring basis are summarized below (dollars in thousands):
20.
DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
Disclosures include estimated fair values for financial instruments for which it is practicable to estimate fair value. These estimates are made at a specific point in time based on relevant market data and information about the financial instruments. These estimates do not reflect any premium or discount that could result from offering the Company’s entire holdings of a particular financial instrument for sale at one time, nor do they attempt to estimate the value of anticipated future business related to the instruments. In addition, the tax ramifications related to the realization of unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of these estimates.
Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the fair values presented. The following methods and assumptions were used by the Company to estimate the fair value of its financial instruments at December 31, 2017 and 2016:
Cash and cash equivalents, and fed funds sold: For cash and cash equivalents and fed funds sold, the carrying amount is estimated to be fair value.
Securities: The fair values of investment securities are determined by obtaining quoted prices on nationally recognized securities exchanges or by matrix pricing, which is a mathematical technique used widely in the industry to value debt securities by relying on their relationship to other benchmark quoted securities when quoted prices for specific securities are not readily available.
Loans and leases: For variable-rate loans and leases that re-price frequently with no significant change in credit risk or interest rate spread, fair values are based on carrying values. Fair values for other loans and
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
leases are estimated by discounting projected cash flows at interest rates being offered at each reporting date for loans and leases with similar terms, to borrowers of comparable creditworthiness.
Loans held for sale: Since loans designated by the Company as available-for-sale are typically sold shortly after making the decision to sell them, realized gains or losses are usually recognized within the same period and fluctuations in fair values are thus not relevant for reporting purposes. If available-for-sale loans stay on our books for an extended period of time, the fair value of those loans is determined using quoted secondary-market prices.
Cash surrender value of life insurance policies: The fair values are based on current cash surrender values at each reporting date provided by the insurers.
Investment in limited partnerships: The fair values of our investments in limited partnerships are estimated using quarterly indications of value provided by the general partner. The fair values of undisbursed capital commitments are assumed to be the same as their book values.
Other investments: Included in other assets are certain long-term investments carried at cost, which approximates estimated fair value, unless an impairment analysis indicates the need for adjustments.
Deposits: Fair values for non-maturity deposits are equal to the amount payable on demand at the reporting date, which is the carrying amount. Fair values for fixed-rate certificates of deposit are estimated using a cash flow analysis, discounted at interest rates being offered at each reporting date by the Bank for certificates with similar remaining maturities.
Short-term borrowings: The carrying amounts approximate fair values for federal funds purchased, overnight FHLB advances, borrowings under repurchase agreements, and other short-term borrowings maturing within ninety days of the reporting dates. Fair values of other short-term borrowings are estimated by discounting projected cash flows at the Company’s current incremental borrowing rates for similar types of borrowing arrangements.
Long-term borrowings: The fair values of the Company’s long-term borrowings are estimated using projected cash flows discounted at the Company’s current incremental borrowing rates for similar types of borrowing arrangements.
Subordinated debentures: The fair values of subordinated debentures are determined based on the current market value for like instruments of a similar maturity and structure.
Commitments to extend credit and letters of credit: If funded, the carrying amounts for currently unused commitments would approximate fair values for the newly created financial assets at the funding date. However, because of the high degree of uncertainty with regard to whether or not those commitments will ultimately be funded, fair values for loan commitments and letters of credit in their current undisbursed state cannot reasonably be estimated, and only notional values are disclosed in the table below.
SIERRA BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
Carrying amount and estimated fair values of financial instruments were as follows (dollars in thousands):
SIERRA BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
Carrying amount and estimated fair values of financial instruments were as follows (dollars in thousands):
SIERRA BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
21.
BUSINESS COMBINATIONS
On October 1, 2017, the Company acquired 100% of the outstanding common shares of Ojai Community Bancorp (OCB) in exchange for $809,000 in cash and 1,376,431 shares of stock. OCB results of operations were included in the Company’s results beginning October 1, 2017. Acquisition related costs of $2,169,000 and $0 are included in other operating expense in the Company’s income statement for the years ended December 31, 2017 and 2016.
In accordance with GAAP, the Company recorded $18,464,000 of goodwill and $3,453,000 of core deposit intangibles. Goodwill represents the excess of the consideration transferred (cash) at the acquisition date over the fair values of the identifiable net assets acquired. The core deposit intangible is being amortized using a straight line basis over eight years. For tax purposes goodwill and core deposit intangibles are both non-deductible.
The acquisition has provided the Company an opportunity to expand its market presence further in Ventura County andinto Santa Barbara. Synergies and cost savings resulting from the combined operations along with the introduction of the Company’s existing products and services into the new region have provided growth opportunities and the potential to increase profitability.
The following table summarizes the consideration paid for OCB and the amounts of the assets acquired and liabilities assumed recognized at the acquisition date (dollars in thousands):
SIERRA BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
On November 3, 2017, the Company acquired certain deposits of the Woodlake branch of Citizen’s Business Bank (CBB). Results of operations were included in the Company’s results beginning November 3, 2017. Acquisition related costs of $47,000 and $0 are included in other operating expense in the Company’s income statement for the years ended December 31, 2017 and 2016.
In accordance with GAAP, the Company recorded $625,000 of goodwill and $486,000 of core deposit intangibles. Goodwill represents the excess of the consideration transferred (cash) at the acquisition date over the fair values of the identifiable net assets acquired. The core deposit intangible is being amortized using a straight line basis over eight years. For tax purposes goodwill and core deposit intangibles are both non-deductible.
The acquisition has provided the Company an opportunity to expand its market presence in Tulare County. Synergies and cost savings resulting from the combined operations along with the introduction of the Company’s existing products and services into the new region have provided growth opportunities and the potential to increase profitability.
The following table summarizes the amounts of the assets acquired and liabilities assumed recognized at the acquisition date (dollars in thousands):
SIERRA BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
On July 8, 2016, the Company acquired 100% of the outstanding common shares of Coast National Bancorp (CNB) in exchange for $3,280,000 in cash and 599,226 shares of stock. CNB results of operations were included in the Company’s results beginning July 9, 2016. Acquisition related costs of $9,000 and $2,411,000 are included in other operating expense in the Company’s income statement for the years ended December 31, 2017 and 2016.
In accordance with GAAP, the Company recorded $1,360,000 of goodwill and $1,827,000 of core deposit intangibles. Goodwill represents the excess of the consideration transferred (cash) at the acquisition date over the fair values of the identifiable net assets acquired. The core deposit intangible is being amortized using a straight line basis over eight years. For tax purposes goodwill and core deposit intangibles are both non-deductible.
The acquisition has provided the Company an opportunity to expand its market presence further west into the Central California Coast. Synergies and cost savings resulting from the combined operations along with the introduction of the Company’s existing products and services into the new region have provided growth opportunities and the potential to increase profitability.
The following table summarizes the consideration paid for CNB and the amounts of the assets acquired and liabilities assumed recognized at the acquisition date (dollars in thousands):
.
.
SIERRA BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
In many cases, the fair values of assets acquired and liabilities assumed were determined by estimating the cash flows expected to result from those assets and liabilities and discounting them at appropriate market rates. The most significant category of assets for which this procedure was used was that of acquired loans. The excess of expected cash flows above the fair value of the majority of loans will be accreted to interest income over the remaining lives of the loans in accordance with FASB Accounting Standards Codification (ASC) 310-20 (formerly SFAS 91). The Company believes that all contractual cash flows related to these loans will be collected. As such, these loans were not considered impaired at the acquisition date and were not subject to the guidance relating to purchased credit impaired loans, which have shown evidence of credit deterioration since origination. Loans acquired from CNB that were not subject to these requirements had a fair value and gross contractual amounts receivable of $91,429,000 and $94,242,097 as of the date of acquisition. Loans acquired from OCB that were not subject to these requirements had a fair value and gross contractual amounts receivable of $217,800,000 and $223,036,000, as of the date of acquisition.
Certain loans, for which specific credit-related deterioration, since origination, was identified, are recorded at fair value, reflecting the present value of the amounts expected to be collected. Income recognition on these “purchased credit-impaired” loans is based on a reasonable expectation about the timing and amount of cash flows to be collected. Acquired loans deemed impaired and considered collateral dependent, with the timing of the sale of loan collateral indeterminate, remain on non-accrual status and have no accretable yield. These loans are discussed in further detail in Note 4 Purchased Credit Impaired Loans.
In accordance with GAAP, there was no carryover of the allowance for loan losses that had been previously recorded by CNB or OCB.
The Company recorded a deferred income tax asset of $219,000 for CNB and $741,000 for OCB. These deferred income tax assets were related to net operating loss carry-forwards, as well as other tax attributes of CNB and OCB, along with the effects of fair value adjustments resulting from applying the acquisition method of accounting.
The fair value of savings and transaction deposit accounts acquired from CNB and OCB were assumed to approximate their carry value, as these accounts have no stated maturity and are payable on demand.
The operating results of the Company for the twelve months ending December 31, 2017, 2016 and 2015 include the operating results of CNB and OCB since their respective acquisition dates. The following table presents the net interest and other income, basic earnings per share and diluted earnings per share as if the acquisition with CNB and OCB were effective as of January 1, 2017, 2016 and 2015 for the respective year in which each acquisition was closed. The unaudited pro forma information in the following table is intended for informational purposes only and is not necessarily indicative of our future operating results for operating results that would have occurred had the mergers been completed at the beginning of each respective year. No assumptions have been applied to the pro forma results of operations regarding possible revenue enhancements, expense efficiencies or asset dispositions.
Unaudited pro forma net interest income, net income and earnings per share presented below (dollars in thousands, except per share data):
SIERRA BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
22.
QUALIFIED AFFORDABLE HOUSING PROJECT INVESTMENTS
The Company invests in qualified affordable housing projects. At December 31, 2017 and 2016, the balance of the investment for qualified affordable housing projects totaled $8,440,000 and $6,811,000, respectively. These balances are reflected in the other assets line on the consolidated balance sheet. Unfunded commitments related to these investments in qualified affordable housing projects totaled $3,321,000 and $1,868,000 at December 31, 2017 and 2016, respectively.
During the year ended December 31, 2017 and 2016, the Company recognized amortization expense on these investments of $961,000 and $944,000, respectively which was included within pretax income on the consolidated statements of income.
Additionally, during the years ended December 31, 2017 and 2016, the Company recognized tax credits and other benefits from its investment in affordable housing tax credits of $711,000 and $685,000, respectively. The Company had no impairment losses during the years ended December 31, 2017 and 2016.
SIERRA BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
23.
PARENT ONLY CONDENSED FINANCIAL STATEMENTS
BALANCE SHEETS
Years Ended December 31, 2017 and 2016
(dollars in thousands)
SIERRA BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
STATEMENTS OF INCOME
Years Ended December 31, 2017, 2016 and 2015
(dollars in thousands)
SIERRA BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
STATEMENTS OF CASH FLOWS
Years Ended December 31, 2017, 2016 and 2015
(dollars in thousands)
SIERRA BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
24.
CONDENSED QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
The following table sets forth the Company’s unaudited results of operations for the four quarters of 2017 and 2016. In management’s opinion, the results of operations reflect all adjustments (which include only recurring adjustments) necessary to present fairly the condensed results for such periods (dollars in thousands, except per share data).
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting And Financial Disclosure
Not applicable.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
The Company’s Chief Executive Officer and its Chief Financial Officer, after evaluating the effectiveness of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13(a)-15(e) as of the end of the period covered by this report (the “Evaluation Date”) have concluded that as of the Evaluation Date, the Company’s disclosure controls and procedures were adequate and effective to ensure that material information relating to the Company and its consolidated subsidiaries would be made known to them by others within those entities, particularly during the period in which this annual report was being prepared.
Disclosure controls and procedures are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our Management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure, and that such information is recorded, processed, summarized, and reported within the time periods specified by the SEC.
Management’s Report on Internal Control over Financial Reporting
Management of the Company is responsible for the preparation, integrity, and reliability of the consolidated financial statements and related financial information contained in this annual report. The consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America and, as such, include some amounts that are based on judgments and estimates of Management.
Management has established and is responsible for maintaining effective internal control over financial reporting. The Company’s internal control over financial reporting includes those policies and procedures that:
(i)
pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company;
(ii)
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
(iii)
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.
There are inherent limitations in the effectiveness of any internal control, including the possibility of human error and the circumvention or overriding of controls. Accordingly, even effective internal control can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of internal control may vary over time. The system contains monitoring mechanisms, and actions are taken to correct deficiencies identified.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2017. This assessment was based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. This assessment included controls over the preparation of regulatory financial statements in accordance with the Federal Financial Institutions Examination Council’s Instructions for Preparation of Consolidated Reports of Condition and Income, and in accordance with the Board of Governors of the Federal Reserve System’s Instructions for Preparation of Financial Statements for Bank Holding Companies (Consolidated and Parent Company Only). Based on this assessment,
Management believes that the Company maintained effective internal control over financial reporting as of December 31, 2017.
Management is responsible for compliance with the federal and state laws and regulations concerning dividend restrictions and federal laws and regulations concerning loans to insiders designated by the FDIC as safety and soundness laws and regulations. Management assessed compliance by the Company’s insured financial institution, Bank of the Sierra, with the designated laws and regulations relating to safety and soundness. Based on this assessment, Management believes that Bank of the Sierra complied, in all significant respects, with the designated laws and regulations related to safety and soundness for the year ended December 31, 2017.
Our assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2017 has been audited by Vavrinek, Trine, Day & Co., LLP, an independent registered public accounting firm, as stated in their report appearing above in Item 8, Financial Statements and Supplementary Data.
Changes in Internal Control
There were no significant changes in the Company’s internal control over financial reporting or in other factors in the fourth quarter of 2017 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION.
None.
PART III
Item 10.
Item 10. Directors, Executive Officers AND CORPORATE GOVERNANCE
The information required to be furnished pursuant to this item with respect to Directors and Executive Officers of the Company will be set forth under the caption “Election of Directors” in the Company’s proxy statement for the 2018 Annual Meeting of Shareholders (the “Proxy Statement”), which the Company will file with the SEC within 120 days after the close of the Company’s 2017 fiscal year in accordance with SEC Regulation 14A under the Securities Exchange Act of 1934. Such information is hereby incorporated by reference.
The information required to be furnished pursuant to this item with respect to compliance with Section 16(a) of the Exchange Act will be set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement, and is incorporated herein by reference.
The information required to be furnished pursuant to this item with respect to the Company’s Code of Ethics and corporate governance matters will be set forth under the caption “Corporate Governance” in the Proxy Statement, and is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation
The information required to be furnished pursuant to this item will be set forth under the captions “Executive Officer and Director Compensation” and “Compensation Discussion and Analysis” in the Proxy Statement, and is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management AND RELATED SHAREHOLDER MATTERS
Securities Authorized for Issuance under Equity Compensation Plans
The information required by Item 12 with respect to securities authorized for issuance under equity compensation plans is set forth under “Item 5 - Market for Registrant’s Common Equity and Issuer Repurchases of Equity Securities” above.
Other Information Concerning Security Ownership of Certain Beneficial Owners and Management
The remainder of the information required by Item 12 will be set forth under the captions “Security Ownership of Certain Beneficial Owners and Management” and “Election of Directors” in the Proxy Statement, and is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions AND DIRECTOR INDEPENDENCE
The information required to be furnished pursuant to this item will be set forth under the captions “Related Party Transactions” and “Corporate Governance - Director Independence” in the Proxy Statement, and is incorporated herein by reference.
Item 14.
Item 14. PRINCIPAL ACCOUNTING FEES and SERVICES
The information required to be furnished pursuant to this item will be set forth under the caption “Ratification of Appointment of Independent Registered Public Accounting Firm - Fees” in the Proxy Statement, and is incorporated herein by reference.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a) Exhibits
Exhibit #
Description
2.1
Agreement and Plan of Consolidation by and among Sierra Bancorp, Bank of the Sierra and Santa Clara Valley Bank, N.A., dated as of July 17, 2014 (1)
2.2
Agreement and Plan of Reorganization and Merger, dated January 4, 2016 by and between Sierra Bancorp and Coast Bancorp (2)
2.3
Agreement and Plan of Reorganization and Merger, dated as of April 24, 2017 by and between Sierra Bancorp and OCB Bancorp, as amended by Amendment No. 1 thereto dated May 4, 2017 and Amendment No. 2 thereto dated June 6, 2017 (3)
3.1
Restated Articles of Incorporation of Sierra Bancorp (4)
3.2
Amended and Restated By-laws of the Company (5)
10.1
Salary Continuation Agreement for Kenneth R. Taylor (6)
10.2
Salary Continuation Agreement and Split Dollar Agreement for James F. Gardunio (7)
10.3
Split Dollar Agreement for Kenneth R. Taylor (8)
10.4
Director Retirement Agreement and Split dollar Agreement for Robert Fields (8)
10.5
Director Retirement Agreement and Split dollar Agreement for Gordon Woods (8)
10.6
Director Retirement Agreement and Split dollar Agreement for Morris Tharp (8)
10.7
Director Retirement Agreement and Split dollar Agreement for Albert Berra (8)
10.8
401 Plus Non-Qualified Deferred Compensation Plan (8)
10.9
Indenture dated as of March 17, 2004 between U.S. Bank N.A., as Trustee, and Sierra Bancorp, as Issuer (9)
10.10
Amended and Restated Declaration of Trust of Sierra Statutory Trust II, dated as of March 17, 2004 (9)
10.11
Indenture dated as of June 15, 2006 between Wilmington Trust Co., as Trustee, and Sierra Bancorp, as Issuer (10)
10.12
Amended and Restated Declaration of Trust of Sierra Capital Trust III, dated as of June 15, 2006 (10)
10.13
2007 Stock Incentive Plan (11)
10.14
Sample Retirement Agreement Entered into with Each Non-Employee Director Effective January 1, 2007 (12)
10.15
Salary Continuation Agreement for Kevin J. McPhaill (12)
10.16
First Amendment to the Salary Continuation Agreement for Kenneth R. Taylor (12)
10.17
Second Amendment to the Salary Continuation Agreement for Kenneth R. Taylor (13)
10.18
First Amendment to the Salary Continuation Agreement for Kevin J. McPhaill (14)
10.19
Indenture dated as of September 20, 2007 between Wilmington Trust Co., as Trustee, and Coast Bancorp, as Issuer (15)
10.20
Amended and Restated Declaration of Trust of Coast Bancorp Statutory Trust II, dated as of September 20, 2007 (15)
10.21
First Supplemental Indenture dated as of July 8, 2016, between Wilmington Trust Co. as Trustee, Sierra Bancorp as the “Successor Company”, and Coast Bancorp (15)
10.22
2017 Stock Incentive Plan (16)
Statement of Computation of Per Share Earnings (17)
Subsidiaries of Sierra Bancorp
Consent of Vavrinek, Trine, Day & Co., LLP
31.1
Certification of Chief Executive Officer (Section 302 Certification)
31.2
Certification of Chief Financial Officer (Section 302 Certification)
Certification of Periodic Financial Report (Section 906 Certification)
101.INS
XBRL Instance Document
101.SCH
XBRL Taxonomy Extension Schema Document
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document
101.LAB
XBRL Taxonomy Extension Label Linkbase Document
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document
(1)
Filed as an Exhibit to the Form 8-K filed with the SEC on July 18, 2014 and incorporated herein by reference.
(2)
Filed as an Exhibit to the Form 8-K filed with the SEC on January 5, 2016 and incorporated herein by reference.
(3)
Original agreement filed as an exhibit to the Form 8-K filed with the SEC on April 25, 2017 and incorporated herein by reference, and amendments thereto filed as appendices to the proxy statement/prospectus included in the Form S-4/A filed with the SEC on July 24, 2017 and incorporated herein by reference.
(4)
Filed as Exhibit 3.1 to the Form 10-Q filed with the SEC on August 7, 2009 and incorporated herein by reference.
(5)
Filed as an Exhibit to the Form 8-K filed with the SEC on February 21, 2007 and incorporated herein by reference.
(6)
Filed as Exhibit 10.5 to the Form 10-Q filed with the SEC on May 15, 2003 and incorporated herein by reference.
(7)
Filed as an Exhibit to the Form 8-K filed with the SEC on August 11, 2005 and incorporated herein by reference.
(8)
Filed as Exhibits 10.10, 10.17 through 10.20, and 10.22 to the Form 10-K filed with the SEC on March 15, 2006 and incorporated herein by reference.
(9)
Filed as Exhibits 10.9 and 10.10 to the Form 10-Q filed with the SEC on May 14, 2004 and incorporated herein by reference.
(10)
Filed as Exhibits 10.26 and 10.27 to the Form 10-Q filed with the SEC on August 9, 2006 and incorporated herein by reference.
(11)
Filed as Exhibit 10.20 to the Form 10-K filed with the SEC on March 15, 2007 and incorporated herein by reference.
(12)
Filed as Exhibits 10.1 through 10.3 to the Form 8-K filed with the SEC on January 8, 2007 and incorporated herein by reference.
(13)
Filed as Exhibit 10.23 to the Form 10-K filed with the SEC on March 13, 2014 and incorporated herein by reference.
(14)
Filed as Exhibit 10.24 to the Form 10-Q filed with the SEC on May 7, 2015 and incorporated herein by reference.
(15)
Filed as Exhibits 10.1 through 10.3 to the Form 8-K filed with the SEC on July 11, 2016 and incorporated herein by reference.
(16)
Filed as Exhibit 10.1 to the Form 8-K filed with the SEC on March 17, 2017 and incorporated herein by reference.
(17)
Computation of earnings per share is incorporated by reference to Note 6 to the Financial Statements included herein.
(b) Financial Statement Schedules
Schedules to the financial statements are omitted because the required information is not applicable or because the required information is presented in the Company’s Consolidated Financial Statements or related notes.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature
Title
Date
/s/ Albert L. Berra
Director
March 13, 2018
Albert L. Berra
/s/ Vonn R. Christenson
Director
March 13, 2018
Vonn R. Christenson
/s/ Laurence S. Dutto, PhD
Director
March 13, 2018
Laurence S. Dutto, PhD
/s/ Robb Evans
Director
March 13, 2018
Robb Evans
/s/ James C. Holly
Vice Chairman of the Board
March 13, 2018
James C. Holly
/s/ Kevin J. McPhaill
President, Chief Executive
March 13, 2018
Kevin J. McPhaill
Officer & Director
(Principal Executive Officer)
/s/ Lynda B. Scearcy
Director
March 13, 2018
Lynda B. Scearcy
/s/ Morris A. Tharp
Chairman of the Board
March 13, 2018
Morris A. Tharp
/s/ Gordon T. Woods
Director
March 13, 2018
Gordon T. Woods
/s/ Kenneth R. Taylor
Executive Vice President &
March 13, 2018
Kenneth R. Taylor
Chief Financial Officer
(Principal Financial and
Principal Accounting Officer)