ITEM 1 - BUSINESS
Discussions of certain matters in this Report on Form 10-K may constitute forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and as such, may involve risks and uncertainties. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies, and expectations, are generally identifiable by the use of words such as "believe", "expect", "intend", "anticipate", "estimate", "project", "assume," "plan," "predict," "forecast" or similar expressions. These forward-looking statements relate to, among other things, expectations of the business environment in which the Company operates, projections of future performance, potential future performance, potential future credit experience, perceived opportunities in the market, and statements regarding the Company's mission and vision. The Company's actual results, performance, and achievements may differ materially from the results, performance, and achievements expressed or implied in such forward-looking statements due to a wide range of factors. The factors include, but are not limited to changes in interest rates, reducing interest margins or increasing interest rate risk, general economic conditions nationally or in the State of California, legislative and regulatory changes adversely affecting the business in which the Company operates, monetary and fiscal policies of the US Government, real estate valuations, the availability of sources of liquidity at a reasonable cost, competition in the financial services industry, the occurrence of events such as the terrorist acts of September 11, 2001, and other risks. All of the Company's operations and most of its customers are located in California. In addition, acts and threats of terrorism or the impact of military conflicts have increased the uncertainty related to the national and California economic outlook and could have an effect on the future operations of the Company or its customers, including borrowers. The Company does not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.
GENERAL
Heritage Commerce Corp (the "Company") is registered with the Board of Governors of the Federal Reserve System ("FRB") as a Bank Holding Company under the Bank Holding Company Act ("BHCA"). The Company was organized in 1997 to be the holding company for Heritage Bank of Commerce ("HBC"). In 1998 the Company also became the holding company for Heritage Bank East Bay ("HBEB"); in January 2000 the Company became the holding company for Heritage Bank South Valley ("HBSV"); and in October 2000 the Company became the holding company for Bank of Los Altos ("BLA"). On January 1, 2003, HBEB, HBSV, and BLA were merged into HBC. The former HBEB, HBSV, and BLA now operate as branch offices of HBC and continue to serve their local markets.
The Internet address of the Company's website is "http://www.heritagecommercecorp.com." In 1998 the Company began making available free of charge through the Company's website, the Company's annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to these reports. The Company makes these reports available on its website on the same day they appear on the SEC's website.
On February 19, 2004, HBC opened a new Small Business Administration (SBA) loan production office in Irvine. The Irvine office is HBC's ninth SBA loan production office.
General Banking Services
The Company's customer base consists primarily of small to medium-sized businesses and their owners, managers, and employees residing in Santa Clara, Alameda, and Contra Costa counties. Businesses served include manufacturers, distributors, contractors, professional corporations/partnerships, and service businesses. The Company had approximately 15,000 deposit accounts at December 31, 2004.
The Company offers a range of loans, primarily commercial, including real estate, construction, Small Business Administration (SBA), inventory and accounts receivable, and equipment loans and leases. The Company also accepts checking, savings, and time deposits; NOW and money market deposit accounts; and provides travelers' checks, safe deposit, and other customary non-deposit banking services. The Company does not have a trust department.
The main and executive offices of the Company and the offices of HBC, are located at 150 Almaden Boulevard in San Jose, California 95113, with branch offices located at 15575 Los Gatos Boulevard in Los Gatos, California 95032, 3077 Stevenson Boulevard in Fremont, California 94538, 310 Hartz Road in Danville, California 94526, 18625 Sutter Boulevard in Morgan Hill, California 95037, 737 First Street in Gilroy, California 95020, 4546 El Camino Real in Los Altos, California 94022, 369 South San Antonio Road in Los Altos, California 94022, and at 175 East El Camino Real in Mountain View, California 94040. See Item 2
ITEM 2 - PROPERTIES
The main and executive offices of the Company and HBC are located at 150 Almaden Boulevard in San Jose, California 95113, with branch offices located at 15575 Los Gatos Boulevard in Los Gatos, California 95032, at 3077 Stevenson Boulevard in Fremont, California 94538, at 310 Hartz Road in Danville, California 94526, at 18625 Sutter Boulevard in Morgan Hill, California 95037, at 737 First Street in Gilroy, California 95020, at 4546 El Camino Real in Los Altos, California 94022, at 369 S. San Antonio Road in Los Altos, California 94022, and at 175 E. El Camino Real in Mountain View, California 94040.
Bank Branchs
The main offices of Heritage Bank of Commerce are located at 150 Almaden Boulevard in San Jose, California in a fifteen-story Class-A type office building. The primary operating area, which consists of approximately 13,511 square feet, was subleased from a non-affiliated third party under a non-cancelable operating lease dated February 12, 1996. The current monthly rent payment for this space is $25,535 and is subject to change in 2006 based on fair rental value at that time. The sublease expires on February 28, 2010; however, the Company has reserved the right to terminate the sublease in 2006, subject to the terms and conditions established for early termination.
In January of 1997, the Company leased approximately 1,255 square feet of office space (referred to as the "Kiosk") located next to the primary operating area at 150 Almaden Boulevard in San Jose, California to be used for meetings, staff training and marketing events. The current monthly rent payment for this space is $3,328 and is subject to annual increases of 3% until the lease expires on February 28, 2010.
In August of 1997, the Company subleased approximately 2,175 square feet of office space located on the second floor at 150 Almaden Boulevard in San Jose, California. The current monthly rent payment for this space is $4,785 and is subject to change in 2006 based on fair rental value at that time. The sublease expires on February 28, 2010; however, the Company has reserved the right to terminate the sublease in 2006, subject to the terms and conditions established for early termination.
In April of 2000, the Company leased approximately 12,824 square feet of office space located on the third floor at 150 Almaden Boulevard in San Jose, California. The current monthly rent payment for this space is $47,630 and is subject to annual increases of 3% until the lease expires on February 28, 2010.
In May of 2002, the Company subleased approximately 6,731 square feet of office space located on the second floor at 150 Almaden Boulevard in San Jose, California. The current monthly rent payment for this space is $14,808 and is subject to change in 2006 based fair rental value at that time. The sublease expires on February 28, 2010; however, the Company has reserved the right to terminate the sublease in 2006, subject to the terms and conditions established for early termination.
In December of 2003, the Company leased approximately 1,920 square feet of office space located at 15575 Los Gatos Boulevard in Los Gatos, California. The currently monthly rent payment for this space is $4,647 and is subject to annual increases of 3% until the lease expires on November 30, 2008.
In November of 1997, the Company leased approximately 6,590 square feet of space for a branch office in a stand alone office building located at 3077 Stevenson Boulevard in Fremont, California. The current monthly rent payment for this space is $17,002 and is subject to annual increases of 4% until the lease expires on January 31, 2008. The Company has reserved the right to extend the term of the lease for (2) two additional periods of (5) five years each.
In September of 1999, the Company subleased an additional 2,700 square feet of space for a branch office in a one-story multi-tenant building located at 310 Hartz Avenue in Danville, California. The current monthly rent payment for this space is $8,547 and is subject to annual increases of 4% until the lease expires on December 31, 2007.
In March of 1999, the Company leased approximately 7,260 square feet of space for a branch office in a one-story multi-tenant office building located at 18625 Sutter Boulevard in Morgan Hill, California. The current monthly rent payment for this space is $11,676 and is subject to adjustment every 36 months, based on the Consumer Price Index of the Labor of Statistics as defined in the lease agreement, until the lease expires on October 31, 2014.
In January of 2001, the Company leased an additional 2,200 square feet of space for a branch office in a one-story multi-tenant shopping center located at 737 First Street in Gilroy, California. The current monthly rent payment for this space is $3,406 and is subject to change annually based on the Consumer Price Index of the Bureau of Labor Statistics as defined in the lease agreement. The lease expires on February 28, 2006; however, the Company has reserved the right to extend the term of the lease for (1) one additional period of (5) five years.
In February of 1995, the Company leased approximately 7,889 square feet of space for a branch office in a two-story multi-tenant shopping center located at 4546 El Camino Real in Los Altos, California. In October of 2001, the lease was amended to return 795 square feet to the Landlord, leaving 7,094 square feet remaining under the lease. The current monthly rent payment for this space is $14,290 and is subject to annual increases, based on the Consumer Price Index of the Bureau of Labor Statistics as defined in the lease agreement, until the lease expires on April 30, 2005.
In January of 1998, the Company leased an additional 4,840 square feet of space for a branch office in a multi-tenant shopping center located at 175 E. El Camino Real in Mountain View, California. The current monthly rent payment for this space is $12,774 and is subject to annual increases based on the Consumer Price Index of the Bureau of Labor Statistics as defined in the lease agreement. The lease expires on May 30, 2008; however, the Company has reserved the right to extend the term of the lease for (2) two additional periods of (5) five years each.
In September of 1998, the Company leased an additional 3,471 square feet of space for a branch office in a one-story stand-alone office building located at 369 S. San Antonio Road in Los Altos, California. The current monthly rent payment for this space is $15,371 and is subject to annual increases of 4% until the lease expires on September 30, 2008. The Company has reserved the right to extend the term of the lease for (2) two additional periods of (5) five years each.
Loan Production Offices
In August of 2000, the Company leased space for a loan production office located at 740 Front Street in Santa Cruz, California 95060. The lease covers approximately 2,176 square feet of office space and expires on July 31, 2005. The current monthly rent payment for this space is $4,538 and is subject to annual increases based on the Consumer Price Index of the Bureau of Labor Statistics as defined in the lease agreement.
In February of 2004, the Company leased space for a loan production office located at 19200 Von Karman Avenue, in Irvine, California 92612. The lease covers approximately 144 square feet of office space and expires on January 31, 2006. The current monthly rent payment for this space is $875.
In March of 2004, the Company renewed its lease for a loan production office located at 23 E. Beach Street in Watsonville, California 95076. The lease covers approximately 287 square feet of office space and expires on March 31, 2005. The current monthly rent payment for this space is $330.
In March of 2004, the Company leased space for a loan production office located at 264 Clovis Avenue in Clovis, California 93612. The lease covers approximately 140 square feet of office space and expires on March 31, 2005. The current monthly rent payment for this space is $500.
In June of 2004, the Company leased space for a loan production office located at 3120 Cohasset Road in Chico, California 95973. The lease covers approximately 220 square feet of office space and expires on May 31, 2005. The current monthly rent payment for this space is $169. The Company has reserved the right to extend the term of the lease for (2) two additional periods of (1) one year each.
In July of 2004, the Company renewed its leases for (2) loan production offices located at 450 North Brand Boulevard in Glendale, California 91203. Each office is leased under a separate lease agreement, each consisting of approximately 132 square feet of office space. Both leases expire on June 30, 2005; however, the Company has reserved the right to extend each lease for multiple additional periods of (1) one year each. The current monthly rent payment for each office is $1,563.
In December of 2004, the Company renewed its lease for a loan production office located at 8788 Elk Grove Boulevard in Elk Grove, California 95624. The lease consists of approximately 224 square feet of office space and expires on December 1, 2005; however, the Company has reserved the right to extend the term of the lease for a single additional period of (1) one year. The current monthly rent payment for this space is $612.
For additional information on operating leases and rent expense, refer to Note 10 to the Consolidated Financial Statements following "Item 15 - Exhibits and Financial Statement Schedules".
ITEM 3
ITEM 3 - LEGAL PROCEEDINGS
The Company is involved in certain legal actions arising from normal business activities. Management, based upon the advice of legal counsel, believes the ultimate resolution of all pending legal actions will not have a material effect on the financial statements of the Company.
ITEM 4
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There was no submission of matters to a vote of security holders during the fourth quarter of the year ended December 31, 2004.
PART II
ITEM 5
ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
In June 2004, the Company's Board of Director authorized the purchase of up to $10 million of its common stock, which represents approximately 700,000 share, or 6%, of its outstanding shares at current market price. The share repurchase authorization is valid through June 1, 2005.
The Company intends to finance the purchase using its available cash. Shares may be repurchased by the Company in open market purchases or in privately negotiated transactions as permitted under applicable rules and regulations. The repurchase program may be modified, suspended or terminated by the Board of Directors at any time without notice. The extent to which the Company repurchases its shares and the timing of such repurchases will depend upon market conditions and other corporate considerations.
As of December 31, 2004, the Company has repurchased 263,728 shares at an average price of $15.98. Shares were purchased on the open market using available cash.
Repurchases of equity securities during the three months period ended December 31, 2004 are presented in the table below:
Total Number of Approximate Dollar Total Number Shares Purchased Value of Shares That of Shares Price Paid as Part of Publicly May Yet Be Purchased Settlement Date Purchased Per Shares Announced Plans Under the Plans ------------------------------- ---------- --------- ---------------- ------------------ November 8, 2004................ 1,900 $ 17.66 1,900 $ 7,385,717 November 9, 2004................ 2,900 $ 17.80 2,900 $ 7,334,097 November 10, 2004............... 1,900 $ 17.70 1,900 $ 7,300,467 November 15, 2004............... 2,900 $ 17.70 2,900 $ 7,249,137 November 16, 2004............... 1,500 $ 17.71 1,500 $ 7,222,572 November 16, 2004............... 1,000 $ 17.75 1,000 $ 7,204,822 November 17, 2004............... 2,800 $ 17.98 2,800 $ 7,154,478 November 18, 2004............... 1,000 $ 17.87 1,000 $ 7,136,608 November 19, 2004............... 1,000 $ 17.90 1,000 $ 7,118,708 November 22, 2004............... 3,300 $ 18.07 3,300 $ 7,059,077 November 23, 2004............... 3,800 $ 18.41 3,800 $ 6,989,119 November 24, 2004............... 1,000 $ 18.49 1,000 $ 6,970,629 November 26, 2004............... 3,000 $ 18.83 3,000 $ 6,914,139 November 29, 2004............... 4,200 $ 18.90 4,200 $ 6,834,759 December 2, 2004................ 11,700 $ 19.17 11,700 $ 6,610,470 December 3, 2004................ 4,200 $ 19.37 4,200 $ 6,529,116 December 6, 2004................ 4,300 $ 19.51 4,300 $ 6,445,223 December 7, 2004................ 4,500 $ 19.44 4,500 $ 6,357,743 December 8, 2004................ 4,700 $ 19.48 4,700 $ 6,266,187 December 10, 2004............... 4,800 $ 19.00 4,800 $ 6,174,987 December 13, 2004............... 4,700 $ 18.65 4,700 $ 6,087,332 December 14, 2004............... 4,800 $ 18.55 4,800 $ 5,998,292 December 15, 2004............... 2,000 $ 18.83 2,000 $ 5,960,632 December 16, 2004............... 4,800 $ 18.78 4,800 $ 5,870,488 December 17, 2004............... 4,500 $ 18.78 4,500 $ 5,785,978 ---------- ---------------- Total........................... 87,200 87,200 ========== ================
The Company's Common Stock is listed on the Nasdaq National Market under the symbol "HTBK." BrokerageAmerica, LLC, Citigroup Global Markets Holdings Inc., FIG Partners, LLC, FTN Midwest Research Securities Corp., Hill Thompson Magid, L.P., Hoefer & Arnett Incorporated, Keefe, Bruyette & Woods, Inc., Knight Equity Markets, L.P., Merrill Lynch, Pierce, Fenner & Smith, Inc., Morgan Stanley & Company, Inc., RBC Dain Rauscher Inc., Sandler O'Neill & Partners, LP, Schwab Capital Markets L.P., Shemano Group, Inc. and Susquehanna Capital Group have acted as market makers for the Common Stock. These market makers have committed to make a market for the Company's Common Stock, although they may discontinue making a market at any time. No assurance can be given that an active trading market will be sustained for the Common Stock at any time in the future.
The information in the following table for 2004 and 2003 indicates the high and low closing prices for the Common Stock, based upon information provided by the Nasdaq Stock Market.
Quarter
High
Low
Year ended December 31, 2004:
Fourth quarter
$ 19.56
$ 16.20
Third quarter
$ 16.50
$ 14.27
Second quarter
$ 15.00
$ 12.74
First quarter
$ 13.00
$ 12.12
Year ended December 31, 2003:
Fourth quarter
$ 12.63
$ 11.21
Third quarter
$ 12.53
$ 10.51
Second quarter
$ 12.05
$ 9.11
First quarter
$ 9.30
$ 8.56
As of March 16, 2005, there were approximately 1,200 holders of record of Common Stock. There are no other classes of common equity outstanding.
DIVIDENDS
Under California law, the holders of common stock of a bank are entitled to receive dividends when and as declared by the Board of Directors, out of funds legally available therefor. The California Banking Law provides that a state-licensed bank may not make a cash distribution to its shareholders in excess of the lesser of the following: (i) the bank's retained earnings, or (ii) the bank's net income for its last three fiscal years, less the amount of any distributions made by the bank to its shareholders during such period. However, a bank, with the prior approval of the Department may make a distribution to its shareholders of an amount not to exceed the greater of (i) a bank's retained earnings, (ii) its net income for its last fiscal year, or (iii) its net income for the current fiscal year. In the event that the Department determines that the shareholders' equity of a bank is inadequate or that the making of a distribution by a bank would be unsafe or unsound, the Department may order a bank to refrain from making such a proposed distribution.
The FDIC and the Department have authority to prohibit a bank from engaging in business practices that are considered to be unsafe or unsound. Depending upon the financial condition of a bank and upon other factors, the FDIC or the Department could assert that payments of dividends or other payments by a bank might be such an unsafe or unsound practice. The FRB has similar authority with respect to a bank holding company.
For regulatory restrictions on payment of dividends by the Company, see Item 1 - "BUSINESS - Regulation and Supervision - Limitations on Dividends."
To date, the Company has not paid cash dividends. It is the current policy of the Company to retain earnings to increase its capital to support growth. Payment of cash dividends in the future will depend upon the Company's earnings and financial condition and other factors deemed relevant by management. Accordingly, it is likely that no cash dividends from the Company will be paid in the foreseeable future.
MANDATORILY REDEEMABLE CUMULATIVE TRUST PREFERRED SECURITIES OF SUBSIDIARY GRANTOR TRUST
To enhance regulatory capital and to provide liquidity the Company, through unconsolidated subsidiary grantor trusts, issued the following mandatorily redeemable cumulative trust preferred securities of subsidiary grantor trusts: In the first quarter of 2000, the Company issued $7,000,000 aggregate principal amount of 10.875% subordinated debentures due on March 8, 2030 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2000, the Company issued $7,000,000 aggregate principal amount of 10.60% subordinated debentures due on September 7, 2030 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2001, the Company issued $5,000,000 aggregate principal amount of Floating Rate Junior Subordinated Deferrable Interest Debentures due on July 31, 2031 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2002, the Company issued $4,000,000 aggregate principal amount of Floating Rate Junior Subordinated Deferrable Interest Debentures due on September 26, 2032 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. Under applicable regulatory guidelines, the Trust Preferred securities currently qualify as Tier I capital. These subsidiary trusts are not consolidated in the Company's consolidated financial statements and the subordinated debt payable to subsidiary grantor trusts is recorded as debt of the Company to the related trusts. See "Footnote 7 to the Consolidated Financial Statements following "Item 15 - Exhibits and Financial Statement Schedules".
In January 2003, the FASB issued FIN 46, Consolidation of Variable Interest Entities. The purpose of this interpretation is to provide guidance on how to identify a variable interest entity (VIE) and to determine when the assets, liabilities, noncontrolling interests, and results of operations of a VIE need to be included in a company's consolidated financial statements. A company that holds variable interests in an entity will need to consolidate that entity if the company's interest in the VIE is such that the company will absorb a majority of the VIE's expected losses and/or receive a majority of the VIE's expected residual returns, if they occur. New disclosure requirements are also prescribed by FIN 46. In December 2003, the FASB issued FIN 46R, a revision of FIN 46. FIN 46R was effective for all VIE's created after January 31, 2003 in the reporting period ending after March 15, 2004, and became effective for VIE's that existed before February 1, 2003 for the first period ending after December 15, 2003. Under FIN 46R, the Company's subsidiaries, which issued mandatorily redeemable trust preferred securities, were required to be deconsolidated. The Company applied the provisions of FIN 46R to the VIE and deconsolidated its assets and liabilities. Deconsolidation of these entities resulted in total assets and total liabilities increasing by $702,000 and did not have any impact on the Company's results of operations. The adoption of FIN 46R did not have any other material impact on the Company's financial position or result of operations.
ITEM 6
ITEM 6 - SELECTED FINANCIAL DATA
The following table presents a summary of selected financial information that should be read in conjunction with the Company's consolidated financial statements and notes thereto included under Item 8 - "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA."
SELECTED FINANCIAL DATA
AT AND FOR YEAR ENDED DECEMBER 31, --------------------------------------------------------------- As Restated (7) (Dollars in thousands, except per share -------------------------------------------------- amounts and ratios) 2004 2003 2002 2001 2000 ------------------------------------------------------ ----------- ----------- ----------- ----------- ----------- INCOME STATEMENT DATA: Interest income..................................... $ 52,417 $ 48,096 $ 52,756 $ 65,005 $ 67,921 Interest expense.................................... 9,648 10,003 15,237 24,366 25,101 ----------- ----------- ----------- ----------- ----------- Net interest income before provision for probable loan losses......................... 42,769 38,093 37,519 40,639 42,820 Provision for probable loan losses.................. 666 2,900 2,663 1,910 3,159 ----------- ----------- ----------- ----------- ----------- Net interest income after provision for probable loan losses......................... 42,103 35,193 34,856 38,729 39,661 Noninterest income.................................. 10,234 10,429 9,030 6,297 2,877 Noninterest expenses................................ 40,660 34,350 33,248 33,435 34,417 ----------- ----------- ----------- ----------- ----------- Income before income taxes.......................... 11,677 11,272 10,638 11,591 8,121 Provision for income taxes.......................... 3,199 3,496 3,484 4,374 2,899 ----------- ----------- ----------- ----------- ----------- Net income.......................................... $ 8,478 $ 7,776 $ 7,154 $ 7,217 $ 5,222 =========== =========== =========== =========== =========== PER SHARE DATA: Basic net income(1)................................. $ 0.73 $ 0.69 $ 0.65 $ 0.66 $ 0.49 Diluted net income(2)............................... $ 0.71 $ 0.67 $ 0.63 $ 0.64 $ 0.47 Book value(3)....................................... $ 8.45 $ 7.86 $ 7.30 $ 6.60 $ 5.98 Weighted average number of shares outstanding - basic.............................. 11,559,155 11,221,232 11,063,965 10,960,157 10,607,584 Weighted average number of shares outstanding - diluted............................ 11,986,856 11,572,588 11,324,650 11,257,721 11,108,329 Shares outstanding at period end.................... 11,669,837 11,381,037 11,214,414 11,114,967 10,939,124
BALANCE SHEET DATA: Investment securities............................... $ 232,809 $ 153,473 $ 126,443 $ 106,810 $ 110,802 Net loans........................................... $ 713,033 $ 648,706 $ 660,680 $ 621,763 $ 601,130 Allowance for probable loan losses.................. $ 12,497 $ 13,451 $ 13,227 $ 11,154 $ 9,651 Total assets........................................ $ 1,108,173 $ 1,005,982 $ 960,066 $ 912,362 $ 846,072 Total deposits...................................... $ 918,535 $ 835,410 $ 841,936 $ 807,908 $ 738,186 Other borrowed funds................................ $ 47,800 $ 43,600 $ -- $ -- $ 18,000 Notes payable to subsidiary grantor trusts.......... $ 23,702 $ 23,702 $ 23,000 $ 19,000 $ 14,000 Total shareholders' equity.......................... $ 98,579 $ 89,485 $ 81,862 $ 73,341 $ 65,450
SELECTED PERFORMANCE RATIOS: Return on average assets(4)......................... 0.80 % 0.81 % 0.77 % 0.83 % 0.67 % Return on average equity............................ 9.04 % 9.04 % 9.15 % 10.20 % 8.74 % Net interest margin................................. 4.40 % 4.34 % 4.39 % 5.00 % 5.95 % Efficiency.......................................... 76.71 % 70.79 % 71.34 % 71.24 % 75.32 % Average net loans as a percentage of average deposits.............................. 77.11 % 77.21 % 76.49 % 76.88 % 71.24 % Average total shareholders' equity as a percentage of average total assets............... 8.80 % 8.95 % 8.41 % 8.15 % 7.67 %
SELECTED ASSET QUALITY RATIOS(5): Net loan charge-offs (recoveries)to average loans... (0.29)% 0.41 % 0.09 % 0.07 % -- % Allowance for loan losses to total loans............ 1.72 % 2.03 % 1.96 % 1.76 % 1.58 %
CAPITAL RATIOS(6): Tier 1 risk-based................................... 13.0 % 13.3 % 12.1 % 11.7 % 10.4 % Total risk-based.................................... 14.3 % 14.5 % 13.3 % 13.0 % 11.7 % Leverage............................................ 10.9 % 11.1 % 10.7 % 10.2 % 9.3 %
Notes:
Represents net income divided by the average number of shares of common stock outstanding for the respective period.
Represents net income divided by the average number of shares of common stock and common stock-equivalents outstanding for the respective period.
Represents shareholders' equity divided by the number of shares of common stock outstanding at the end of the period indicated.
Average balances used in this table and throughout this Annual Report are based on daily averages.
Nonperforming assets consist of nonaccrual loans, loans past due 90 days or more and still accruing, restructured loans, foreclosed assets, and other real estate owned (OREO). As of December 31, 2004, the Company had $1,330,000 in nonperforming assets. As of December 31, 2003, the Company had $4,580,000 in nonperforming assets. As of December 31, 2002, the Company had $4,571,000 in nonperforming assets. As of December 31, 2001 and 2000, the Company had no nonperforming assets.
The Risk-Based and Leverage Capital ratios are defined in Item 1 - "BUSINESS - Supervision And Regulation - Capital Adequacy Guidelines."
See Note 2 to the consolidated financial statements for description of the restatements.
ITEM 7
ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following management discussion and analysis gives effect to the restatement in Note 2 to the consolidated financial statements.
Executive Summary
This summary is intended to identify the most important matters on which management focuses when it evaluates the financial condition and performance of the Company. When evaluating financial condition and performance, management looks at certain key metrics and measures. The Company's evaluation includes an analysis including comparisons with peer group financial institutions and with its own performance objectives established in the internal planning process.
The primary activity of the Company is commercial banking. The Company's operations are located entirely in the southern and eastern regions of the general San Francisco Bay area of California. The largest city in this area is San Jose and the Company's market includes the headquarters of a number of technology based companies in the region known commonly as Silicon Valley. The Company's customers are primarily closely held businesses and professionals.
Lending
Loan growth is a key metric used by management to measure market share. Over the previous five years ending December 31, 2004, the Company has continued its growth trend in commercial loans. This growth reflects the Company's focus on closely held businesses and success in penetrating this market even in a period of economic stress. Construction lending has declined since 2000, but with evidence of some improvement in market conditions in 2004. Given the slowdown in construction activity, the Company increased its commercial real estate mortgage activity by focusing on financing properties for customers with whom we already had a primary banking relationship. The majority of the Company's commercial real estate mortgages are located in its primary service area and properties financed are often owner occupied.
Deposits
Growth in deposits is another important metric management uses to measure market share. The Company's depositors are primarily located in its primary market area. Depending on loan demand and other funding requirements, the Company will occasionally obtain deposits from wholesale sources including deposit brokers. During 2002, the Company began to reduce its reliance on brokered deposits from $68 million on December 31, 2001 to $20 million at December 31, 2004. The Company also seeks deposits from title insurance companies and real estate exchange facilitators. The Company has a policy to monitor all deposits that may be sensitive to interest rate changes to assure that liquidity risk does not become excessive due to concentrations.
Net Interest Income
The management of interest income and interest expense is fundamental to the performance of the Company. Net interest income, the difference between interest income and interest expense, is the largest component of the Company's total revenue. Management closely monitors both total net interest income and the net interest margin (net interest income divided by average earning assets). Net interest income for the Company has been significantly impacted by market rates of interest. Although assets have grown from $846 million at December 31, 2000 to $1.108 billion at December 31, 2004, net interest income for the years ended December 31, 2000 and December 31, 2004 are virtually the same. This reflects a significant decline in the Company's net interest margin. Approximately 85% of the Company's loan portfolio is indexed to the prime rate. As the Federal Open Market Committee (FOMC) reduced short term interest rates from 2000 to 2003, the prime rate dropped sharply from 9.50% at December 31, 2000 to 4.00% in June 2003. The FOMC began to increase short term rates in July 2004 and the prime rate at December 31, 2004 was 5.25%. The improvement in net interest margin in 2004 is attributable to the FOMC action in the last two quarters of 2004. Because of its focus on commercial lending to closely held businesses, the Company will continue to have a high percentage of floating rate loans and other assets. Management believes that the Company's assets will tend to reprice faster than liabilities when market rates of interest change. This characteristic makes the Company "asset sensitive." Asset sensitive balance sheets tend to perform better, i.e., generate higher net interest income and have higher net interest margins, in a rising rate environment. In a falling rate environment an asset sensitive balance sheet does not tend to perform as well.
The Company, through its asset and liability policies and practices, seeks to maximize net interest income without exposing the Company to an excessive level of interest rate risk. Interest rate risk is managed by monitoring the pricing, maturity and repricing options of all classes of interest bearing assets and liabilities. This is discussed in more detail in Item 7 - Liquidity and Asset/Liability Management.
Management of Credit Risk
Because of its focus on business banking, loans to single borrowing entities are often larger than would be found in a more consumer oriented bank with many smaller, more homogenous loans. The average size of its relationships makes the Company more susceptible to larger losses. As a result of this concentration of larger risks, the Company has maintained an allowance for loan and lease losses which is substantially higher than would be indicated by its actual historic loss experience. A complete discussion of the management of credit risk appears in Item 7 - Provision for Loan and Lease Losses and Allowance for Loan and Lease Losses.
The significantly lower provision for loan and lease losses in 2004 was primarily attributable to commercial loan recoveries of $1.562 million.
Noninterest Income
While net interest income remains the largest single component of total revenues, noninterest income has become a growing component. A significant percentage of the Company's noninterest income is associated with its SBA lending activity, either as gains on the sale of loans sold in the secondary market or servicing income related to loans sold in the secondary market on which the Company retains servicing.
Noninterest income associated with SBA activity has increased each year from 2003 through 2004. Risks associated with the continuation of this level of noninterest income from SBA lending include the possibility that the federal government will eliminate or change SBA programs in a manner that becomes less attractive to the Company or to SBA borrowers. Further, change in the secondary market for SBA loans could reduce gains on sale. Higher than expected prepayments of SBA loans on which the Company has retained servicing could reduce the carrying value of the associated servicing asset and interest only strip. Loan servicing is discussed in Item 7 - Critical Accounting Policies and in the Notes to Consolidated Financial Statements.
In mid-2004, the Company closed its residential mortgage department because of concerns about its long term profitability in changing market conditions. As a result of the closure, mortgage brokerage fees dropped significantly in 2004 and are not expected to be significant in future periods. The closure of the mortgage brokerage department also eliminated costs, including salary and commissions, related to that activity.
During 2003 and 2004, the Company recognized $1.195 million and $871,000, respectively, in income related to the short term leasing of electronic test equipment. In the fourth quarter of 2004, the Company significantly reduced the carrying value of the electronic test equipment through a charge to operating expenses. The Company does not expect to recognize any significant income from this activity in the future.
Noninterest expense
Management considers the control of operating expenses to be a critical element of the Company's performance. Beginning in the second quarter of 2004, the Company undertook several initiatives to reduce its noninterest expense and improve its efficiency. These initiatives included a reduction in staff and the consolidation of its operations under a common brand, Heritage Bank of Commerce. Prior to the third quarter of 2004, the Company had operated with four different bank identities. The implementation of these changes created one time, non-recurring expenses in 2004 totaling approximately $1.283 million which are included in the Company's noninterest expenses for the year.
In addition to the nonrecurring expenses the Company reduced the carrying value of electronic test equipment which is subject to or available for short term leases. The reduction in carrying value resulted in a charge of $2.236 million to operating expenses during 2004.
Key Performance Measures
Through its asset and liability management process, the Company monitors a number of ratios to analyze the Company's performance over time and also to compare the Company against similarly sized and situated companies in the banking industry. Management considers the following ratios to be important benchmarks for the Company's performance and financial conditions:
Return on average assets: Net income as a percentage of average assets. Measures the earning power of the balance sheet.
Return on average equity: Net income as a percentage of average shareholders' equity. Measures the return on invested capital.
Net interest margin: Net interest income as a percentage of average interest earning assets. Measures the earning power of interest earning assets funded by interest bearing liabilities.
Efficiency ratio: Net interest income plus noninterest income divided by non-interest expense. Measures the cost of producing revenue as a percentage of total revenue.
There is no single ratio or metric that summarizes the performance of the Company. The ratios above each take an element of the Company's performance and quantify it so that it can be compared over time and benchmarked against other peer companies. Management uses these and other ratios and metrics in assessing and planning the Company's performance.
The Company believes that the initiatives it undertook in 2004, coupled with increases in short term interest rates including the target federal funds rate and the prime rate, will cause its performance to more closely match the performance of peer banks in the future..
Capital Management and Share Repurchases
Heritage Commerce Corp and Heritage Bank of Commerce meet the regulatory definition of "well capitalized." As part of its asset and liability process, the Company continually assesses its capital position to take into consideration growth, expected earnings, risk profile and potential corporate activities that it may chose to pursue. As a part of this process, the Company determined in the second quarter of 2004 that its capital levels were higher than necessary. To adjust capital to levels consistent with its view of current market conditions, the Company commenced a stock repurchase plan in June 2004.
Critical Accounting Policies
General
HCC's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our consolidated financial statements is, to a significant extent, based on approximate measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. In certain instances, we use a discount factor and prepayment assumptions to determine the present value of assets and liabilities. A change in the discount factor or prepayment spreads could increase or decrease the values of those assets and liabilities which would result in either a beneficial or adverse impact to our financial results. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. The Company applies Accounting Principles Board ("APB") No. 25, "Accounting for Stock Issued to Employees" and related interpretations to account for its stock option plan awards. Other estimates that we use are related to the expected useful lives of our depreciable assets. In addition GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.
Allowance for Probable Loan Losses
The allowance for probable loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting. (1) Statement of Financial Accounting Standards (SFAS) No. 5 "Accounting for Contingencies", which requires that losses be accrued when they are probable of occurring and estimable and (2) SFAS No. 114, "Accounting by Creditors for Impairment of a Loan", which requires that losses be accrued based on the differences between that value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.
The Company's allowance for probable loan losses has three basic components: the formula allowance, the specific allowance and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses an historical loss view as an indicator of future losses and, as a result formula losses could differ from the loss incurred in the future. The specific allowance uses various techniques to arrive at an estimate of loss. Historical loss information and fair market value of collateral are used to estimate those losses. The use of these values is inherently subjective and our actual losses could differ from the estimates. The unallocated allowance captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized in either the formula or specific allowances. For further information regarding our allowance for credit losses, see Allowance for Probable Loan Losses on page 43.
Loan Sales and Servicing
The amounts of gains recorded on sales of loans and the initial recording of servicing assets and interest only strips is based on the estimated fair values of the respective components. In recording the initial value of the servicing assets and the fair value of the I/O strips receivable, the Company uses estimates which are made based on management's expectations of future prepayment and discount rates. In evaluating the servicing assets, management used discounted cash flow modeling techniques, which require estimates regarding the amount and times of future cash flows, including assumptions about loan repayment rates, costs to service, as well as interest rate assumptions that contemplate the risks involved. For the year ended December 31, 2004, management's estimate of constant prepayment rate ("CPR") was 14% and the weighted average discount rate assumption was 9%. These prepayment and discount rates were based on current market conditions and historical performance of the various pools. If actual prepayments with respect to sold loans occur more quickly than projected the carrying value of the servicing assets may have to be adjusted through a charge to earnings. A corresponding decrease in the value of the I/O strip receivable would also be expected.
Stock Based Compensation
Under APB No. 25, compensation cost for stock options is measured as the excess, if any, of the fair market value of the Company's stock at the date of the grant over the amount required to be paid to the Company by the optionee upon exercising the option. Because the Company's stock option plan provides for the issuance of options at a price of no less than the fair market value at the date of the grant, no compensation cost is required to be recognized for the stock option plan on the date of grant. For further information see Note 1 to the Consolidated Financial Statements .
RESULTS OF OPERATIONS
OVERVIEW
In 2004, consolidated net income was $8,478,000, or $0.71 per diluted share, compared to $7,776,000, or $0.67 per diluted share in 2003, and $7,154,000, or $0.63 per diluted share, in 2002. The increase in 2004 from 2003 was primarily due to the increase in average earning assets and increases in key market interest rates in 2004. The increase in 2003 from 2002 was primarily due to the increase in the level of average earning assets, the continuing impact of the decreasing interest rate environment on interest bearing liabilities, and the change in mix of the deposit liabilities with a slight decrease in average interest bearing deposits and an increase in average noninterest bearing deposits. Also contributing to the increase in net income in 2003 was the growth in noninterest income that outpaced the growth in noninterest expenses.
Average interest earning assets increased 11% in 2004 from 2003 and increased 3% in 2003 from 2002. The increase in 2004 was primarily attributable to growth in average loans and investments. The average rate on interest earning assets decreased to 5.39% in 2004 from 5.47% in 2003, and 6.17% in 2002 reflective of the continuing low interest rate environment during the first half of 2004. Average interest bearing liabilities increased 9% in 2004 from 2003, with the increase primarily attributable to growth in interest bearing demand deposits, savings and money-market accounts and other borrowing offset by a decrease in time deposits and brokered deposits. Over the same period average noninterest bearing demand deposits increased 15%. Average interest bearing liabilities decreased 1% for 2003 from 2002. Average time and brokered deposits decreased 33% in 2003 from 2002 more than offsetting the 19% increase in interest bearing demand deposits and the 16% increase in average savings and money-market accounts. Over the same period average noninterest bearing demand deposits increased 13%. The Company's average rate paid on interest bearing liabilities decreased to 1.42% in 2004 from 1.61% in 2003 and 2.43% in 2002, reflective of the continuing low interest rate environment in 2004 and 2003. As a result, the net interest margin increased 6 basis points to 4.40% in 2004 from 4.34% in 2003. In 2003, the net interest margin decreased 5 basis points from 4.39% in 2002.
Net interest income increased $4,676,000, or 12%, for 2004 to $42,769,000 from $38,093,000 for 2003 primarily due to the increase in interest rates. Net interest income increased $574,000, or 2%, to $38,093,000 for 2003 from $37,519,000 for 2002 as the increase in average earning assets and the decrease in average interest bearing liabilities offset the effect of the decline in market interest rates.
Total noninterest income was $10,234,000 in 2004, compared to $10,429,000 in 2003 and $9,030,000 in 2002. Noninterest income in 2004 included $3,052,000 in gains on sales of SBA loans, an increase of $824,000, or 37%, from 2003, and $2,325,000 in servicing income, an increase of $506,000, or 28%, from 2003. Partially offsetting these increases in noninterst income was a decrease in mortgage brokerage fees of $844,000 resulting from the close of the Company's residential mortgage department in June 2004. The primary components of noninterest income in 2003 included $2,228,000 in gain on sales of SBA loans, $1,819,000 in servicing income, $1,810,000 in service charges and other fees, $1,151,000 in appreciation of Corporate Owned Life Insurance, $1,012,000 in brokered fees, and $735,000 in gain on sales of securities. The increase in other income from 2002 to 2003 was primarily due to an increase in rental income from electronic test equipment subject to operating leases of $1,092,000. The primary components of noninterest income in 2002 included $2,262,000 in gains on sales of SBA loans, $1,036,000 in gain on sales of securities, $1,113,000 in appreciation of Corporate Owned Life Insurance, $1,317,000 in servicing income, $1,085,000 in brokered fees, and $1,425,000 in service charges and other fees.
Total noninterest expense was $40,660,000 in 2004, an increase from $34,350,000 in 2003, and $33,248,000 in 2002. Salaries and employee benefits, the single largest component of operating expenses, were $18,754,000 in 2004, an increase from $17,975,000 in 2003, and $18,067,000 in 2002. The increase in noninterest expenses for 2004 was primarily due to a write down in the carrying value of electronic test equipment subject to operating leases of $2,200,000 and increases in retirement plan expense of $1,000,000 primarily related to the resignation of two executive officers, professional fees of $1,108,000 and data processing expense of $635,000 which included costs of outsourcing core data processing operations.
Total assets as of December 31, 2004 were $1,108,173,000, an increase of $102,191,000, or 10%, from $1,005,982,000 as of December 31, 2003. Total deposits as of December 31, 2004 were $918,535,000, an increase of $83,125,000, or 10%, from $835,410,000 as of December 31, 2003.
Total loans at December 31, 2004 were $725,530,000, an increase of $63,373,000, or 10%, compared to $662,157,000 for 2003. The Company's allowance for probable loan losses was $12,497,000, or 1.72%, of total loans for 2004, compared to $13,451,000, or 2.03%, of total loans for 2003.
Nonperforming assets include nonaccrual loans, loans past due 90 days or more and still accruing, restructured loans foreclosed assets and other real estate owned (OREO). Nonperforming assets for 2004 were $1,330,000, compared to $4,580,000 for 2003 and $4,571,000 for 2002.
The Company's shareholders' equity at December 31, 2004 was $98,579,000 compared with $89,485,000 as of December 31, 2003, a 10% increase, which reflects net earnings of $8,478,000 in 2004, the proceeds from exercise of stock options, the change in unallocated ESOP shares, and the effect of the unrealized losses on securities available-for-sale and on a projected benefit obligation. Book value per share increased 8% to $8.45 as of December 31, 2004, compared to $7.86 as of December 31, 2003 and $7.30 as of December 31, 2002. The Company's leverage capital ratio was 10.8% at December 31, 2004, compared to 11.2% at December 31, 2003 and 10.7% at December 31, 2002.
Return on average equity for 2004 was 9.04%, compared to 9.04% for 2003 and 9.15% for 2002. Return on average assets for 2004 was 0.80%, compared to 0.81% for 2003 and 0.77% for 2002.
NET INTEREST INCOME AND NET INTEREST MARGIN
Net interest income is the largest component of the Company's total revenue. Net interest income is the difference between the interest and fees earned on loans and investments and the interest paid on deposits and other liabilities. Net interest income depends on two factors: (1) the volume or balance of earning assets compared to the volume or balance of interest bearing deposits and liabilities, and (2) the interest rate earned on those interest earning assets compared with the interest rate paid on those interest bearing assets and liabilities. Net interest margin is net interest income expressed as a percentage of average earning assets. To maintain its net interest margin, the Company must manage the relationship between interest earned and paid.
The following table presents the average amounts outstanding for the major categories of the Company's balance sheet, the average interest rates earned or paid thereon, and the resulting net yield on average interest earning assets for the periods indicated. Average balances are based on daily averages.
Year Ended December 31, ---------------------------------------------------------------------------------------------------- 2004 2003 2002 -------------------------------- -------------------------------- -------------------------------- Interest Average Interest Average Interest Average Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/ (Dollars in thousands) Balance Expense Rate Balance Expense Rate Balance Expense Rate --------------------------------------------------- ---------- --------- --------- ---------- --------- --------- ---------- --------- --------- ASSETS: Loans, gross(1).................................... $ 725,921 $ 45,325 6.24% $ 681,174 $ 42,934 6.30% $ 675,295 $ 46,609 6.90% Investment securities(2)........................... 216,012 6,715 3.11% 143,529 4,609 3.21% 111,428 5,076 4.56% Interest bearing deposits in other institutions.... 1,336 14 1.05% 5,207 44 0.85% 6,758 88 1.30% Federal funds sold................................. 28,964 363 1.25% 48,604 509 1.05% 61,191 983 1.61% ---------- --------- ---------- --------- ---------- --------- Total interest earning assets................... 972,233 52,417 5.39% 878,514 48,096 5.47% 854,672 52,756 6.17% --------- --------- --------- Cash and due from banks............................ 47,911 40,233 37,522 Premises and equipment, net........................ 3,728 4,846 5,596 Other assets....................................... 41,923 36,894 31,739 ---------- ---------- ---------- Total assets.................................... $1,065,795 $ 960,487 $ 929,529 ========== ========== ========== LIABILITIES AND SHAREHOLDERS' EQUITY: Deposits: Demand, interest bearing........................... $ 112,439 $ 536 0.48% $ 96,772 $ 496 0.51% $ 81,011 $ 719 0.89% Savings and money-market........................... 350,922 3,658 1.04% 318,774 3,705 1.16% 275,217 4,778 1.74% Time deposits, under $100.......................... 38,717 575 1.49% 43,060 798 1.85% 56,097 1,762 3.14% Time deposits, $100 and over....................... 100,309 1,556 1.55% 101,406 1,812 1.79% 129,702 3,572 2.75% Brokered deposits.................................. 11,460 473 4.13% 24,559 995 4.05% 65,183 2,522 3.87% Other borrowings................................... 66,842 2,850 4.26% 38,387 2,197 5.72% 20,784 1,884 9.06% ---------- --------- ---------- --------- ---------- --------- Total interest bearing liabilities................................... 680,689 9,648 1.42% 622,958 10,003 1.61% 627,994 15,237 2.43% --------- --------- --------- Demand deposits, noninterest bearing............... 275,192 238,467 211,195 Other liabilities.................................. 16,139 13,058 12,164 ---------- ---------- ---------- Total liabilities............................... 972,020 874,483 851,353 Shareholders' equity............................... 93,775 86,004 78,176 ---------- ---------- ---------- Total liabilities and shareholders' equity......................... $1,065,795 $ 960,487 $ 929,529 ========== ========== ========== Net interest income / margin....................... $ 42,769 4.40% $ 38,093 4.34% $ 37,519 4.39% ========= ========= =========
(1) Yields and amounts earned on loans include loan fees of $4,057,000, $4,036,000, and $4,544,000 for the years ended December 31, 2004, 2003, and 2002. Nonaccrual loans of $1,028,000, $3,972,000, and $4,571,000 for the years ended December 31, 2004, 2003, and 2002 are included in the average balance calculations above.
(2) Interest income is reflected on an actual basis, not a fully taxable equivalent basis and does not include a fair value adjustment.
Net interest income for 2004 increased 12% from 2003. Net interest income for 2003 increased 2% from 2002. The increase in 2004 was due to the increase in average earning assets and increases in key market interest rates in 2004. The increase in average interest earnings assets was primarily attributable to growth in average loans and investments. Average earning assets increased by $93,719,000 in 2004 from 2003. Average loans outstanding, including loans held for sale, increased $44,747,000 during 2004 over the average during 2003. Average securities in 2004 increased $72,483,000 from 2003. The change in the average loans outstanding in 2004 was primarily due to the increase in the commercial and real estate mortgage loan portfolios and real estate land and construction loan portfolio. The increase in net interest income in 2003 from 2002 was primarily due to an increase in the level of the average earning assets, partially affected by the continuing impact of the decreasing interest rate environment on interest bearing liabilities, and the change in mix of the deposit liabilities with a slight decrease in average interest bearing liabilities.
In 2004, changes in volume of earning assets contributed $3,780,000 to net interest income while the effect of the changes in rates contributed $896,000 resulting in the overall increase from 2003 of $4,676,000. The Company's average interest earning assets increased $93,719,000, or 11%, for 2004 to $972,233,000 from $878,514,000 for 2003. The yield on interest earning assets in 2004 was 5.39%, compared to 5.47% in 2003, and 6.17% in 2002. The Company's average interest bearing liabilities increased $57,731,000, or 9%, in 2004 to $680,689,000, compared to $622,958,000 for 2003. The rate paid on interest bearing liabilities in 2004 was 1.42%, compared to 1.61% in 2003, and 2.43% in 2002.
The following tables show the changes in interest income resulting from changes in the volume of interest earning assets and interest-bearing liabilities and changes in the average rates earned and paid. The total change is shown in the column designated "Net Change" and is allocated in the columns to the left, for the portions attributable to volume changes and rate changes that occurred during the period indicated. Changes due to both volume and rate have been allocated to the change in volume.
Years Ended December 31, ------------------------------------------------------------------ 2004 versus 2003 2003 versus 2002 -------------------------------- -------------------------------- Increase (Decrease) Due Increase (Decrease) Due to Change In: to Change In: -------------------------------- -------------------------------- Average Average Net Average Average Net (Dollars in thousands) Volume Rate Change Volume Rate Change --------------------------------------------------- ---------- --------- --------- ---------- --------- --------- INTEREST EARNING ASSETS: Loans, gross..................................... $ 2,820 $ (429) $ 2,391 $ 371 $ (4,046) $ (3,675) Investment securities............................ 2,251 (145) 2,106 1,031 (1,498) (467) Interest bearing deposits in other institutions.. (41) 11 (30) (13) (31) (44) Federal funds sold............................... (245) 99 (146) (132) (342) (474) ---------- --------- --------- ---------- --------- --------- Total interest earning assets...................... $ 4,785 $ (464) $ 4,321 $ 1,257 $ (5,917) $ (4,660) ---------- --------- --------- ---------- --------- --------- INTEREST BEARING LIABILITIES: Demand, interest bearing......................... $ 71 $ (31) $ 40 $ 81 $ (304) $ (223) Savings and money-market......................... 343 (390) (47) 506 (1,579) (1,073) Time deposits, under $100........................ (67) (156) (223) (242) (722) (964) Time deposits, $100 and over..................... (16) (240) (256) (506) (1,254) (1,760) Brokered deposits................................ (541) 19 (522) (1,646) 119 (1,527) Other borrowings................................. 1,215 (562) 653 1,008 (695) 313 ---------- --------- --------- ---------- --------- --------- Total interest bearing liabilities................. $ 1,005 $ (1,360) $ (355) $ (799) $ (4,435) $ (5,234) ---------- --------- --------- ---------- --------- --------- Net interest income................................ $ 3,780 $ 896 $ 4,676 $ 2,056 $ (1,482) $ 574 ========== ========= ========= ========== ========= =========
PROVISION FOR PROBABLE LOAN LOSSES
The provision for probable loan losses represents the current period expense associated with maintaining an appropriate allowance for credit losses. The loan loss provision and level of allowance for each period is dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management's assessment of the quality of the loan portfolio, the valuation of problem loans and the general economic conditions in the Company's market area. Periodic fluctuations in the provision for loan losses result from management's assessment of the adequacy of the allowance for probable loan losses; however, actual loan losses may vary from current estimates.
For 2004, the provision for probable loan losses was $666,000, compared to $2,900,000 for 2003 and $2,663,000 for 2002. The allowance for probable loan losses represented 1.72%, 2.03%, and 1.96% of total loans at December 31, 2004, 2003, and 2002, respectively. See "Allowance for Probable Loan Losses" on page 43 for additional information.
NONINTEREST INCOME
The following table sets forth the various components of the Company's noninterest income:
Increase (Decrease) -------------------------------------------- Years Ended December 31, 2004 versus 2003 2003 versus 2002 -------------------------------- --------------------- --------------------- (Dollars in thousands) 2004 2003 2002 Amount Percent Amount Percent --------------------------------------------------- ---------- --------- --------- ---------- --------- --------- ---------- Gain on sale of loans.............................. $ 3,052 $ 2,228 $ 2,262 $ 824 37 %$ (34) (2)% Servicing income................................... 2,325 1,819 1,317 506 28 % 502 38 % Service charges and other fees on deposit accounts.............................. 1,799 1,810 1,425 (11) (1)% 385 27 % Appreciation of company owned life insurance............................. 1,031 1,151 1,113 (120) (10)% 38 3 % Equipment leasing.................................... 871 1,195 103 (324) (27)% 1,092 1,060 % Gain on sale of securities available-for-sale............................... 476 735 1,036 (259) (35)% (301) (29)% Mortgage brokerage fees............................ 168 1,012 1,085 (844) (83)% (73) (7)% Other.............................................. 512 479 689 33 7 % (210) (30)% ---------- --------- --------- ---------- --------- Total.............................................. $ 10,234 $ 10,429 $ 9,030 $ (195) (2)%$ 1,399 15 % ========== ========= ========= ========== =========
Noninterest income for 2004 was $10,234,000, compared to $10,429,000 for 2003 and $9,030,000 for 2002. In 2004, gain on sale of Small Business Administration (SBA) loans increased 37%, and loan-servicing income increased 28%. The Company has an ongoing program of originating SBA loans and selling the government guaranteed portion in the secondary market, while retaining the servicing of the whole loans. The increased noninterest income from SBA lending in 2004 was offset by a decrease in mortgage brokerage fees resulting from the close of the Company's residential mortgage department in June 2004, and declines in equipment leasing income. The decline in the appreciation of company owned life insurance was primarily the result of a lower interest rate environment in early 2004 compared to 2003. The decline in gain on sales of securities in 2004 was related to market conditions.
The increase in noninterest income in 2003 compared to the same period in 2002 was primarily due to increased servicing income, service charges and other fees, and rental income from electronic test equipment subject to operating leases. The overall increase in servicing income was primarily the result of expansion of the SBA lending operation and the overall increase in the level of loans serviced. The increase in service charges and other fees was primarily from an increase in demand deposit accounts resulting in customers paying additional fees for services. The above increases were offset by the decrease in gain on sale of securities available-for-sale of $301,000 due to market conditions and the decrease on sale of the credit card portfolio of $172,000 sold in 2002.
NONINTEREST EXPENSES
The following table sets forth the various components of the Company's noninterest expenses:
Increase (Decrease) -------------------------------------------- Years Ended December 31, 2004 versus 2003 2003 versus 2002 -------------------------------- --------------------- --------------------- (Dollars in thousands) 2004 2003 2002 Amount Percent Amount Percent --------------------------------------------------- ---------- --------- --------- ---------- --------- --------- ---------- Salaries and employee benefits..................... $ 18,754 $ 17,975 $ 18,067 $ 779 4 %$ (92) (1)% Occupancy.......................................... 3,670 3,541 3,207 129 4 % 334 10 % Professional fees.................................. 2,656 1,548 1,563 1,108 72 % (15) (1)% Operational Losses................................. 2,219 (1) 88 2,220 222,000 % (89) (101)% Retirement plan expense ........................... 1,741 741 897 1,000 135 % (156) (17)% Loan origination costs............................. 1,628 1,439 1,277 189 13 % 162 13 % Advertising and promotion.......................... 1,090 747 737 343 46 % 10 1 % Client services.................................... 1,044 1,018 1,100 26 3 % (82) (7)% Amortization of leased equipment................... 1,016 985 83 31 3 % 902 1,087 % Furniture and equipment............................ 921 1,588 1,503 (667) (42)% 85 6 % Amortization of low income housing projects ....... 878 398 341 480 121 % 57 17 % Data processing expense............................ 722 87 86 635 730 % 1 1 % Other.............................................. 4,321 4,284 4,299 37 1 % (15) 0 % ---------- --------- --------- ---------- --------- Total.............................................. $ 40,660 $ 34,350 $ 33,248 $ 6,310 18 %$ 1,102 3 % ========== ========= ========= ========== =========
The following table indicates the percentage of noninterest expenses in each category:
Years Ended December 31, ------------------------------------------------------------------ 2004 2003 2002 --------------------- --------------------- -------------------- % of % of % of (Dollars in thousands) Amount Total Amount Total Amount Total --------------------------------------------------- ---------- --------- --------- ---------- --------- --------- Salaries and employee benefits..................... $ 18,754 46% $ 17,975 52% $ 18,067 54% Occupancy.......................................... 3,670 9% 3,541 10% 3,207 10% Professional fees.................................. 2,656 7% 1,548 5% 1,563 5% Operational Losses................................. 2,219 5% (1) 0% 88 0% Retirement plan expense ........................... 1,741 4% 741 2% 897 3% Loan origination costs............................. 1,628 4% 1,439 4% 1,277 4% Advertising and promotion.......................... 1,090 3% 747 2% 737 2% Client services.................................... 1,044 3% 1,018 3% 1,100 3% Amortization of leased equipment................... 1,016 2% 985 3% 83 0% Furniture and equipment............................ 921 2% 1,588 5% 1,503 5% Amortization of low income housing projects ....... 878 2% 398 1% 341 1% Data processing expense.............................. 722 2% 87 0% 86 0% Other.............................................. 4,321 11% 4,284 13% 4,299 13% ---------- --------- --------- ---------- --------- --------- Total.............................................. $ 40,660 100% $ 34,350 100% $ 33,248 100% ========== ========= ========= ========== ========= =========
Noninterest expenses for 2004 increased $6,310,000, or 18%, from 2003. In 2003 noninterest expense increased $1,102,000, or 3%, from 2002. The efficiency ratio was 76.71% for 2004, compared to 70.79% and 71.34%, respectively, for 2003 and 2002.
Salaries and employee benefits, the single largest component of noninterest expenses increased $779,000 in 2004 from 2003. In 2003, salaries and employee benefits decreased $92,000 from 2002. The increase in 2004 was primarily related to severance payments of $1,283,000 incurred as the result of the elimination of certain full time positions and $521,000 associated with the resignation of the former CEO, partially offset by a decrease of $428,000 in loan officer commissions related to closure of the residential mortgage brokerage department. Salaries and employee benefit, as a percentage of total noninterest expenses decreased to 46% in 2004 from 52% in 2003 and 54% in 2002, respectively. Salaries and employee benefits in 2005 will reflect the addition of a new Chief Executive Officer hired in March 2005.
Occupancy increased by $129,000, or 4%, for 2004 compared to 2003. Occupancy costs increased 10% in 2003 from 2002. The increase in 2004 from 2003 was primarily attributable to increased rental costs related to the opening of a new branch office in Los Gatos in December 2003, depreciation on leasehold improvements and write-offs associated with the outsourcing of the data processing function. Occupancy cost as a percentage of total noninterest expenses decreased to 9% for 2004 from 10% for 2003 and 2002.
Professional fees increased $1,108,000, or 72%, in 2004, compared to 2003. Professional fees decreased 1% in 2003 from 2002. The increase in 2004 from 2003 was primarily due to increased audit and consulting expenses related to compliance with Sarbanes-Oxley, legal expenses related to the proxy solicitation for the 2004 annual meeting and other corporate governance matters. Professional fees as a percentage of total noninterest expenses increased to 7% for 2004 from 5% for 2003 and 2002.
Operational losses increased $2,220,000 in 2004, compared to 2003. Operational losses decreased $89,000 in 2003 from 2002. The increase in 2004 from 2003 was primarily due to the write-off of electronic test equipment subject to operating leases.
Retirement plan expense increased $1,000,000, or 135%, for 2004, compared to 2003. Retirement plan expense decreased 17% in 2003 from 2002. The increase in 2004 from 2003 was primarily due to the elimination of certain full time positions and the resignation of the former CEO. Retirement plan expense as a percentage of total noninterest expenses increased to 4% for 2004 from 2% in 2003 and 3% in 2002.
Loan origination costs increased $189,000, or 13%, for 2004, compared to 2003. Loan origination costs increased 13% from 2002. The increase in 2004 from 2003 was primarily due to continued growth in the loan portfolio. Loan origination costs as a percentage of total noninterest expenses remained fairly constant for 2004, 2003 and 2002.
Advertising and promotion costs increased $343,000, or 46%, for 2004, compared to 2003. Advertising and promotion increased 1% from 2002. The increase in 2004 from 2003 was primarily due to several new promotions and sponsorships in 2004 as well as expenses associated with the consolidation of the Company's operations under the common brand Heritage Bank of Commerce during 2004. Prior to the third quarter of 2004, the Company had operated under 4 different trade names; Heritage Bank of Commerce, Heritage Bank East Bay, Heritage Bank South Valley, and Bank of Los Altos. Advertising and promotion as a percentage of total expenses increased to 3% for 2004 from 2% for 2003 and 2002.
Furniture and equipment decreased $667,000, or 42%, for 2004, compared to 2003. Furniture and equipment increased 6% from 2002 to 2003. The decrease in 2004 from 2003 was primarily due to the decrease in the level of purchase of small equipment, fewer equipment repairs, and lower depreciation on furniture and equipment in 2004. Furniture and equipment as a percentage of total noninterest expenses decrease to 2% for 2004 from 5% for 2003 and 2002.
Data processing expense increased $635,000, or 730%, for 2004, compared to 2003 and 2002. The increase in 2004 from 2003 was primarily due to outsourcing of the core data and item processing functions in the first quarter of 2004. As a result of the outsourcing arrangement, contracted data processing costs are shown as data processing expenses in 2004. When the data processing function was internal, prior to the first quarter of 2004, staffing and depreciation costs, the two major expenses associated with this function, were included in salaries and employee benefits and furniture and equipment expense, respectively. The Company estimates that the outsourcing of core data and item processing has reduced costs by an approximately $50,000 pre-tax per quarter, beginning with the second quarter of 2004.
Other noninterest expenses increased $37,000, or 1%, for 2004, compared to 2003. Other noninterest expenses in remained fairly constant for 2003 and 2002. Other noninterest expenses as a percentage of total noninterest expenses decreased to 11% for 2004 from 13% for 2003 and 2002.
PROVISION FOR INCOME TAXES
The Company files consolidated federal and combined state income tax returns. Amounts provided for income tax expense are based on income reported for financial statement purposes and do not necessarily represent amounts currently payable under tax laws.
The provision for income taxes was $3,199,000 for 2004 and $3,496,000 for 2003 and $3,484,000 for 2002. The Company's effective tax rates were 27.4%, 31.0%, and 32.8% for 2004, 2003, and 2002, respectively. The difference in the effective tax rate compared to the statutory tax rate of 42% is primarily the result of the Company's investment in life insurance policies whose earnings are not subject to taxes, tax credits related to investments in low income housing, jobs creation in an enterprise zone, and investments in tax-free municipal securities.
FINANCIAL CONDITION
As of December 31, 2004, total assets were $1,108,173,000, an increase of 10% from $1,005,982,000 for 2003. Total securities available-for-sale was $232,809,000, an increase of 52% from $153,473,000 for 2003. The total loan portfolio was $725,530,000, an increase of 10% from $662,157,000 for 2003. Total deposits were $918,535,000, an increase of 10% from $835,410,000 for 2003. Other borrowings increased $4,200,000, or 10%, to $47,800,000 for 2004, from $43,600,000 for 2003.
SECURITIES PORTFOLIO
A major component of the Company's earning asset base is its securities portfolio. The following table sets forth the carrying value of investment securities at the dates indicated:
Years Ended December 31, ------------------------------- (Dollars in thousands) 2004 2003 2002 --------- --------- --------- Securities available-for-sale (at fair value) U.S. Treasury................................... $ 5,942 $ 7,015 $ 4,740 U.S. Government Agencies........................ 90,308 36,115 48,029 Municipals - Tax Exempt......................... 9,206 15,704 12,134 Mortgage-Backed Securities...................... 107,735 79,615 44,774 CMOs.............................................. 19,618 15,024 14,134 Corporate Bonds................................... -- -- 2,632 --------- --------- --------- Total securities available-for-sale.......... $ 232,809 $ 153,473 $ 126,443 ========= ========= =========
The following table summarizes the amounts and distribution of the Company's investment securities and the weighted average yields as of December 31, 2004:
December 31, 2004 -------------------------------------------------------------------------------------------- Maturity -------------------------------------------------------------------------------------------- After One Year After Five Years and Within and Within Within One Year Five Years Ten Years After Ten Years Total ---------------- ---------------- ---------------- ---------------- ---------------- (Dollars in thousands) Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield ------------------------------- -------- ------- -------- ------- -------- ------- -------- ------- -------- ------- Securities available-for-sale: U.S. Treasury................. $ 4,956 1.67 % $ 986 1.64 % $ -- -- % $ -- -- % $ 5,942 1.67 % U.S. Government Agencies...... 19,961 2.09 % 70,347 2.37 % -- -- % -- -- % 90,308 2.31 % Municipals - tax exempt....... 709 4.61 % 8,497 2.24 % -- -- % -- -- % 9,206 2.42 % Mortgage-Backed Securities.... -- -- % 212 5.05 % 11,400 3.88 % 96,123 4.04 % 107,735 4.03 % CMOs.......................... -- -- % -- -- % -- -- % 19,618 3.03 % 19,618 3.03 % -------- -------- -------- -------- -------- Total available-for-sale.... $ 25,626 2.06 % $ 80,042 2.35 % $ 11,400 3.88 % $115,741 3.87 % $232,809 3.15 % ======== ======== ======== ======== ========
Note: Yields on tax exempt municipal securities are not presented on a fully tax equivalent basis.
Securities that are classified as available of sale are carried at their fair value. This means that the carrying amount of same securities will increase or decrease based on changes in interest rates and very rarely to changes in their credit quality. In 2002, the Company recognized that the flexibility to sell any of its securities prior to maturity in order to manage interest rate risk or to provide liquidity was more desirable than the avoidance of the balance sheet volatility and consequently reclassified all of its securities as available for sale. The amortized cost of the transferred securities was $12,778,000 and the related unrealized holding gain was $841,000.
As of December 31, 2004, the only securities held by the Company where the aggregate book value of the Company's investment in securities of a single issuer exceeded 10% of the Company's shareholders' equity were direct obligations of the U.S. government or U.S. government agencies.
The securities portfolio of the Company is also used as collateral to meet requirements imposed as a condition of deposit by some depositors and other contractual obligations, such as political subdivisions (public funds) or of other funds such as bankruptcy trustee deposits. Securities with amortized cost of $85,883,000 and $49,474,000 as of December 31, 2004 and 2003 were pledged to secure public and certain other deposits as required by law or contract. A portion of these deposits can only be secured by U.S. treasury. The Company has not used interest rate swaps or other derivative instruments to hedge fixed rate loans or to otherwise mitigate interest rate risk.
LOANS
Total loans (exclusive of loans held for sale) were $725,530,000 at December 31, 2004, an increase of 10% from $662,157,000 at December 31, 2003, and an increase of 8% from $673,907,000 at December 31, 2002. The Company's allowance for loan losses was $12,497,000, or 1.72% of total loans, for 2004, as compared to $13,451,000, or 2.02% of total loans, for 2003, and $13,227,000, or 1.96% of total loans, for 2002. As of December 31, 2004, 2003, and 2002, the Company had $1,330,000, $4,580,000, and $4,571,000, respectively, in nonperforming assets.
The loan portfolio is primarily composed of commercial loans to companies principally engaged in manufacturing, wholesale and service businesses and real estate lending, with the balance in direct finance leases and consumer loans.
The following table presents the Company's loans outstanding at year-end by loan type:
December 31, --------------------------------------------------------------------------------------------- % of % of % of % of % of (Dollars in thousands) 2004 Total 2003 Total 2002 Total 2001 Total 2000 Total ----------------------------- --------- ------- --------- ------- --------- ------- --------- ------- --------- ------- Commercial................... $ 300,452 41% $ 281,561 43% $ 263,144 39% $ 208,713 33% $ 200,846 33% Real estate - mortgage....... 303,154 42% 276,908 42% 259,974 38% 246,119 39% 230,468 38% Real estate - land and construction................ 118,290 16% 101,082 15% 147,822 22% 174,077 27% 171,325 28% Consumer..................... 2,908 1% 1,743 0% 2,850 1% 3,833 1% 8,172 1% --------- ------- --------- ------- --------- ------- --------- ------- --------- ------- Total loans.................. 724,804 100% 661,294 100% 673,790 100% 632,742 100% 610,811 100% Deferred loan costs (fees)... 726 863 117 175 (30) Allowance for loan losses.... (12,497) (13,451) (13,227) (11,154) (9,651) --------- --------- --------- --------- --------- Loans, net................... $ 713,033 $ 648,706 $ 660,680 $ 621,763 $ 601,130 ========= ========= ========= ========= =========
The change in the Company's loan portfolio is primarily due to the increase in the commercial and real estate mortgage loan portfolios and real estate land and construction loan portfolio. The increase in the commercial loans, commercial real estate mortgages and land and construction loans is due to the Company's continued expansion and focus on originating these types of loans.
The Company's commercial loans are made for working capital, financing the purchase of equipment or for other business purposes. Such loans include loans with maturities ranging from thirty days to one year and "term loans," with maturities normally ranging from one to five years. Short-term business loans are generally intended to finance current transactions and typically provide for periodic principal payments, with interest payable monthly. Term loans normally provide for floating interest rates, with monthly payments of both principal and interest.
The Company is an active participant in the Small Business Administration (SBA) and California guaranteed lending programs, and has been approved by the SBA as a lender under the Preferred Lender Program. The Company regularly makes SBA-guaranteed loans and considers such loans to be investment loans; however, the guaranteed portion of these loans may be sold in the secondary market depending on market conditions and, once it is determined they will be sold, are classified as held for sale and carried at the lower of cost or market. In the event of the sale of the guaranteed portion of an SBA loan, the Company retains the servicing rights for the sold portion. As of December 31, 2004, 2003, and 2002, $146.1 million, $117.8 million and $83.0 million, respectively, in SBA loans were serviced by the Company for others.
As of December 31, 2004, real estate mortgage loans consists of adjustable and fixed rate loans secured by commercial property of $248,736,000, loans secured by first mortgages on 1-4 family residential properties of $2,249,000, and home equity lines of credit secured by junior deeds of trust on 1-4 family residential properties of $52,170,000. Properties securing the real estate mortgage loans are primarily located in the Company's trade area. While no specific industry concentration is considered significant, the Company's lending operations are located in the Company's market areas that are dependent on the technology and real estate industries and their supporting companies. Real estate values in portions of Santa Clara County and neighboring San Mateo County are among the highest in the country at present. The Company's borrowers could be adversely impacted by a downturn in these sectors of the economy, which could reduce the demand for loans and adversely impact the borrowers' abilities to repay their loans.
The Company's real estate term loans consist primarily of loans made based on the borrower's cash flow and are secured by deeds of trust on commercial and residential property to provide a secondary source of repayment. It is the Company's policy to restrict real estate term loans to no more than 80% of the lower of the property's appraised value or the purchase price of the property, depending on the type of property and its utilization. The Company offers both fixed and floating rate loans. Maturities on such loans are generally restricted to between five and ten years (on an amortization ranging from fifteen to twenty-five years with a balloon payment due at maturity); however, SBA and certain other real estate loans easily sold in the secondary market may be granted for longer maturities.
The Company's real estate land and construction loans are primarily interim loans made by the Company to finance the construction of commercial and single family residential properties. These loans are typically short term. The Company utilizes underwriting guidelines to assess the likelihood of repayment from sources such as sale of the property or permanent mortgage financing prior to making the construction loan.
The Company makes consumer loans for the purpose of financing automobiles, various types of consumer goods, and other personal purposes. Additionally, the Company makes equity lines of credit and equity loans available to its clientele. Consumer loans generally provide for the monthly payment of principal and interest. Most of the Company's consumer loans are secured by the personal property being purchased, or, in the instances of equity loans or lines, real property.
With certain exceptions, state chartered banks are permitted to make extensions of its credit to any one borrowing entity up to 15% of the banks' capital and reserves for unsecured loans and up to 25% of the banks' capital and reserves for secured loans. For HBC these lending limits were $19.0 million and $31.7 million at December 31, 2004.
The Company does not have any concentrations by industry or group of industries in its loan portfolio, however, 59% and 58% of its net loans were secured by real property as of December 31, 2004 and 2003. While no specific industry concentration is considered significant, the Company's lending operations are located in the Company's market areas that are dependent on the technology and real estate industries and their supporting companies.
The following table presents the maturity distribution of the Company's loans as of December 31, 2004. The table shows the distribution of such loans between those loans with predetermined (fixed) interest rates and those with variable (floating) interest rates. Floating rates generally fluctuate with changes in the prime rate as reflected in the western edition of The Wall Street Journal. As of December 31, 2004, approximately 84% of the Company's loan portfolio consisted of floating interest rate loans.
Over One Due in Year But One Year Less Than Over (Dollars in thousands) or Less Five Years Five Years Total --------------------------------------------- --------- --------- --------- --------- Commercial................................... $ 282,355 $ 11,412 $ 6,685 $ 300,452 Real estate - mortgage....................... 197,020 58,282 47,852 303,154 Real estate - land and construction.......... 118,241 49 -- 118,290 Consumer..................................... 2,703 205 -- 2,908 --------- --------- --------- --------- Total loans............................. 600,319 69,948 54,537 724,804 ========= ========= ========= =========
Loans with variable interest rates........... 582,330 25,284 17 607,631 Loans with fixed interest rates.............. 17,989 44,664 54,520 117,173 --------- --------- --------- --------- Total loans............................. $ 600,319 $ 69,948 $ 54,537 $ 724,804 ========= ========= ========= =========
In the normal course of business, HBC is a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk, in excess of the amounts recognized in the balance sheet.
HBC uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Credit risk is the possibility that a loss may occur because a party to a transaction failed to perform according to the terms of the contract. HBC controls the credit risk of these transactions through credit approvals, limits, and monitoring procedures. The Company established an allowance for credit losses on off-balance sheet exposures of $281,000 as of December 31, 2004. Management does not anticipate any significant losses as a result of these transactions.
Commitments to extend credit as of December 31, were as follows:
(Dollars in thousands) 2004 2003 ---------------------------------------- --------- --------- Commitments to extend credit............ $ 313,036 $ 269,504 Standby letters of credit............... 5,256 4,449 --------- --------- $ 318,292 $ 273,953 ========= =========
Commitments to extend credit are agreements to lend to a client as long as there is no violation of conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses. Since some of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. HBC evaluates each client's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by HBC upon extension of credit, is based on management's evaluation of the borrower. Collateral held varies but may include cash, marketable securities, accounts receivable, inventory, property, plant and equipment, income-producing commercial properties, and/or residential properties.
Standby letters of credit are written conditional commitments issued by HBC to guaranty the performance of a client to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to clients.
NONPERFORMING ASSETS
Nonperforming assets consist of nonaccrual loans, loans past due 90 days and still accruing, troubled debt restructurings and other real estate owned. Management generally places loans on nonaccrual status when they become 90 days past due, unless they are well secured and in the process of collection. When a loan is placed on nonaccrual status, the accrual of interest is discontinued, and any accrued and unpaid interest is reversed, and the amortization of the deferred loan fees and costs is discontinued. Any interest or principal payments received on the nonaccrual loans are applied to principal. Loans are charged off when management determines that collection has become unlikely. Restructured loans are those where HBC has granted a concession on the interest paid or original repayment terms due to financial difficulties of the borrower. Other real estate owned ("OREO") consists of real property acquired through foreclosure on the related underlying defaulted loans. The following table shows nonperforming assets at the dates indicated:
December 31, ------------------------------------------------------- (Dollars in thousands) 2004 2003 2002 2001 2000 --------- --------- --------- --------- --------- Nonaccrual loans............................. $ 1,028 $ 3,972 $ 4,571 $ -- $ -- Loans 90 days past due and still accruing.... 302 608 -- -- -- Restructured loans........................... -- -- -- -- -- --------- --------- --------- --------- --------- Total nonperforming loans................. 1,330 4,580 4,571 -- -- Other real estate owned...................... -- -- -- -- -- --------- --------- --------- --------- --------- Total nonperforming assets................ $ 1,330 $ 4,580 $ 4,571 $ -- $ -- ========= ========= ========= ========= ========= Nonperforming assets as a percentage of period end loans plus foreclosed assets.. 0.18% 0.69% 0.68% -- --
As of December 31, 2004, the Company had $1,028,000 in loans on nonaccrual status, which were considered impaired loans. The impaired loans had a related valuation allowance of $250,000 as of December 31, 2004. The Company had $302,000 in loans past due 90 days or more and still accruing interest and no restructured loans as of December 31, 2004. As of December 31, 2003, the Company had $3,972,000 in loans on nonaccrual status, which were considered impaired loans. The impaired loans had a related valuation allowance of $464,000 as of December 31, 2003. The Company had $608,000 in loans past due 90 days or more and still accruing interest and no restructured loans as of December 31, 2003. As of December 31, 2002, the Company had $4,571,000 in loans on nonaccrual status, which were considered impaired loans. The impaired loans had a related valuation allowance of $356,000 as of December 31, 2002. The Company had no loans past due 90 days or more and still accruing interest and no restructured loans as of December 31, 2002.
ALLOWANCE FOR PROBABLE LOAN LOSSES
The Company assigns to all of its loans a risk grade consistent with the system recommended by regulatory agencies. Grades range from "Pass" to "Loss" depending on credit quality, with "Pass" representing loans that involve an acceptable degree of risk. Management conducts a critical evaluation of the loan portfolio monthly. This evaluation includes periodic loan by loan review for certain loans to evaluate the level of impairment as well as detailed reviews of other loans (either individually or in pools) based on an assessment of the following factors: past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, collateral value, loan volumes and concentrations, size and complexity of the loans, recent loss experience in particular segments of the portfolio, bank regulatory examination results, and current economic conditions in the Company's marketplace, in particular the state of the technology industry and the real estate market.
This process attempts to assess the risk of loss inherent in the portfolio by segregating loans into four components for purposes of determining an appropriate level of the allowance: "watch," "special mention," "substandard" and "doubtful." Additionally, the Company maintains a program for regularly scheduled reviews of certain new and renewed loans by an outside loan review consultant. Any loans identified during an external review process that expose the Company to increased risk are appropriately downgraded and an increase in the allowance for loan losses is established for such loans. Further, the Company is examined periodically by the FDIC, FRB, and the Department, at which time a further review of loan quality is conducted.
Loans that demonstrate a weakness, for which there is a possibility of loss if the weakness is not corrected, are categorized as "classified." Classified loans include all loans considered as substandard, doubtful, and loss and may result from problems specific to a borrower's business or from economic downturns that affect the borrower's ability to repay or that cause a decline in the value of the underlying collateral (particularly real estate).
At December 31, 2004, the principal balance of classified loans, which include all loans internally graded as substandard, doubtful, and loss, was $35,646,000. These loans constituted 5% of total loans and 32% of capital and reserves at that date. As of December 31, 2003, the principal balance of classified loans was $48,257,000. These loans constituted 7% of total loans and 47% of capital and reserves as of that date. As of December 31, 2002, the principal balance of classified loans was $27,915,000. These loans constituted 4% of total loans and 29% of capital and reserves as of that date. During the first quarter of 2004, the Company identified a $4,000,000 unsecured commercial line of credit with risks identified that create doubt about the full repayment under the original terms of the agreement. The loan was placed on nonaccrual a specific reserve was established. Subsequent to placement on nonaccrual, the Company was advised that the borrower had filed for bankruptcy protection and $2,000,000 was charged-off in the first quarter of 2004. The Company continued to negotiate with the borrower within the framework of the bankruptcy and the remaining $2,000,000 of the loan was paid during the second quarter of 2004. An additional $250,000 of the $2,000,000 loss was recovered in the fourth quarter of 2004. Other than this loan and the loans already classified at December 31, 2004, the Company has not identified any potential problem loans. The decrease in the allowance related to the charged-offs in 2004.
It is the policy of management to maintain the allowance for probable loan losses at a level adequate for risks inherent in the loan portfolio. Based on information currently available to analyze loan loss delinquency and a history of actual charge-offs, management believes that the loan loss allowance is adequate. However, the loan portfolio can be adversely affected if California economic conditions and the real estate market in the Company's market area were to weaken. Also any weakness of a prolonged nature in the technology industry would have a negative impact on the local market. The effect of such events although uncertain at this time, could result in an increase in the level of nonperforming loans and increased loan losses, which could adversely affect the Company's future growth and profitability. No assurance of the ultimate level of credit losses can be given with any certainty. Loans are charged against the allowance when management believes that the collectibility of the principal is unlikely. See "Provision for probable loan losses" on page 35.
The following table summarizes the Company's loan loss experience as well as provisions and charges to the allowance for loan losses and certain pertinent ratios for the periods indicated:
(Dollars in thousands) 2004 2003 2002 2001 2000 --------------------------------------------- --------- --------- --------- --------- --------- Balance, beginning of period................. $ 13,451 $ 13,227 $ 11,154 $ 9,651 $ 6,511 Charge-offs: Commercial.......................... (2,901) (2,906) (936) (708) (52) Real estate - mortgage.............. -- -- -- -- -- Real estate - land and construction. -- -- -- -- -- Direct financing lease.............. -- -- -- -- -- Consumer............................ -- -- -- (1) -- --------- --------- --------- --------- --------- Total charge-offs............................ (2,901) (2,906) (936) (709) (52) Recoveries: Commercial.......................... 1,562 230 346 301 33 Real estate - mortgage.............. -- -- -- -- -- Real estate - land and construction. -- -- -- -- -- Direct financing lease.............. -- -- -- -- -- Consumer............................ -- -- -- 1 -- --------- --------- --------- --------- --------- Total recoveries............................. 1,562 230 346 302 33 --------- --------- --------- --------- --------- Net charge-offs.............................. (1,339) (2,676) (590) (407) (19) Provision for loan losses.................... 666 2,900 2,663 1,910 3,159 Reclassification to other liabilities.......... (281)(1) -- -- -- -- --------- --------- --------- --------- --------- Balance, end of period....................... $ 12,497 $ 13,451 $ 13,227 $ 11,154 $ 9,651 ========= ========= ========= ========= =========
RATIOS: Net charge-offs to average loans outstanding................................ 0.19 % 0.41 % 0.09 % 0.07 % -- % Allowance for loan losses to average loans. 1.80 % 2.07 % 2.07 % 1.84 % 1.80 % Allowance for loan losses to total loans at end of period..................... 1.72 % 2.03 % 1.96 % 1.76 % 1.58 % Allowance for loan losses to nonperforming loans........................ 940 % 294 % 289 % -- % -- %
(1) The Company reclassified the allowance for probable loan losses on unused commitments of $281,000 to other liabilities as of December 31, 2004.
Charge-offs reflect the realization of losses in the portfolio that were recognized previously though provisions for loan losses. The net charge-offs in 2004 were $1,339,000, compared to $2,676,000 in 2003, $590,000 in 2002, $407,000 in 2001, and $19,000 in 2000. The decrease in net charge-offs in 2004 was primarily due to a $1.56 million in the recovery of commercial loans which had been previously charge-off.
The increase in net charge-offs in 2003 was primarily a result of a $2,000,000 write-off taken in third quarter of 2003 related to a single commercial loan. Historical net charge-offs are not necessarily indicative of the amount of net charge-offs that the Company will realize in the future.
The following table summarizes the allocation of the allowance for loan losses (ALL) by loan type and the allocation as a percent of loans outstanding in each loan category at the dates indicated:
December 31, ------------------------------------------------------------------------------------------------------ 2004 2003 2002 2001 2000 ------------------ ------------------ ------------------ ------------------ ------------------ Percent Percent Percent Percent Percent of ALL of ALL of ALL of ALL of ALL in each in each in each in each in each category category category category category to total to total to total to total to total (Dollars in thousands) Allowance loans Allowance loans Allowance loans Allowance loans Allowance loans -------------------------- --------- -------- --------- -------- --------- -------- --------- -------- --------- -------- Commercial................ $ 8,691 2.89 % $ 9,667 3.42 % $ 6,349 2.41 % $ 5,489 2.63 % $ 4,244 2.11 % Real estate - mortgage.... 1,671 0.55 % 2,003 0.72 % 2,411 0.93 % 1,420 0.58 % 1,509 0.65 % Real estate - land and construction............. 1,711 1.45 % 1,714 1.70 % 3,574 2.42 % 3,066 1.76 % 2,084 1.22 % Consumer.................. 38 1.31 % 37 2.12 % 47 1.63 % 102 2.66 % 158 1.93 % Unallocated............... 386 -- % 30 -- % 846 -- % 1,077 -- % 1,656 -- % --------- --------- --------- --------- --------- Total..................... $ 12,497 1.72 % $ 13,451 2.03 % $ 13,227 1.96 % $ 11,154 1.76 % $ 9,651 1.58 % ========= ========= ========= ========= =========
Loans are charged against the allowance when management believes that the collectibility of the principal is doubtful. The Company's methodology for assessing the appropriateness of the allowance consists of several key elements, which include specific allowances, the formula allowance and the unallocated allowance.
Specific allowances are established in cases where management has identified significant conditions or circumstances related to a credit that management believes indicate the probability that a loss may be incurred in excess of the amount determined by the application of the formula allowance. As of December 31, 2004, 2003 and 2002, nonperforming loans had a related specific valuation allowance of $270,000, 474,000 and $356,000, respectively.
The formula allowance is calculated by applying loss factors to outstanding loans. Loss factors are based on management's experience and may be adjusted for significant factors that, in management's judgment, may affect the collectibility of the portfolio as of the evaluation date. Due to the Company's limited historical loss experience, management also considers peer bank loan loss experience to determine the loss factor for each loan category. The formula allowance on December 31, 2004 was $11,841,000, compared to $12,947,000 on December 31, 2003.
The unallocated allowance is based upon management's evaluation of various conditions that are not directly measured in the determination of the formula and specific allowances. The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they are not identified with specific problem credits or portfolio segments. As of December 31, 2004, the Company's unallocated allowance was $386,000, compared to $30,000 on December 31, 2003. In evaluating the appropriateness of the unallocated allowance, management considered the following factors:
Bank's Lending Policies and Procedures - Changes in lending policies and procedures, including underwriting standards and collection, charge-off, and recovery practices.
Economic Conditions - Changes in national and local economic and business conditions, trends, and developments, including the condition of various market segments.
Changes in the Bank's Lending Management and Staff - Changes in the experience, ability and depth of lending management and other relevant staff.
Changes in Trend and Volume of Past Due and Classified Loans - Changes in the trend of the volume and severity of past due and classified loans; and trends in the volume of nonaccrual loans, troubled debt restructurings and other loan modifications.
Quality of the Bank's Loan Review System - Changes in the quality of the Bank's loan review system and the degree of oversight by the Bank's Board of Directors.
Credit Concentrations - The existence and effect of any concentrations of credit and changes in the level of such concentrations.
There can be no assurance that the adverse impact of any of these conditions on the Bank will not be in excess of the current level of unallocated reserves. The current business, economic, and real estate markets along with the seasoning of the portfolio and the nature and duration of the current business cycle will affect the amount of unallocated reserve.
In an effort to improve its analysis of risk factors associated with its loan portfolio, the Company continues to monitor and to make appropriate changes to its internal loan policies. These efforts better enable the Company to assess risk factors prior to granting new loans and to assess the sufficiency of the allowance for loan losses.
Management believes that it has adequately provided an allowance for estimated probable losses in the credit portfolio. Significant deterioration in Northern California real property values or economic downturns could impact future operating results, liquidity or capital resources and require additional provisions to the allowance or cause losses in excess of the allowance.
DEPOSITS
Total deposits were $918,535,000 at December 31, 2004, an increase of $83,125,000, or 10%, compared to $835,410,000 at December 31, 2003. Demand, savings, and money market deposits increased $66,090,000, or 10%, to $755,659,000 at December 31, 2004 from $689,569,000 at December 31, 2003. During 2004, time deposits increased $17,035,000, or 12%, from $145,841,000 in 2003 to $162,876,000. The overall change in the deposit portfolio had a positive impact on the net interest margin as the average cost of interest bearing liabilities was reduced.
The following table summarizes the distribution of average deposits and the average rates paid for the periods indicated:
Years ended December 31, ----------------------------------------------------------- 2004 2003 2002 ----------------- ------------------ ------------------ Average Average Average Average Rate Average Rate Average Rate (Dollars in thousands) Balance Paid Balance Paid Balance Paid -------------------------------------- --------- ------- --------- -------- --------- -------- Demand, noninterest bearing........... $ 275,192 -- % $ 238,467 -- % $ 211,195 -- % Demand, interest bearing.............. 112,439 0.48 % 96,772 0.51 % 81,011 0.89 % Savings and money market.............. 350,922 1.04 % 318,774 1.16 % 275,217 1.74 % Time deposits, under $100............. 38,717 1.49 % 43,060 1.85 % 56,097 3.14 % Time deposits, $100 and over.......... 100,309 1.55 % 101,406 1.79 % 129,702 2.75 % Time deposits, brokered deposits...... 11,460 4.13 % 24,559 4.05 % 65,183 3.87 % --------- --------- --------- Total average deposits................ $ 889,039 0.76 % $ 823,038 0.95 % $ 818,405 1.63 % ========= ========= =========
As of December 31, 2004, the Company had a deposit mix of 39% in savings and money market accounts, 18% in time deposits, 13% in interest bearing demand accounts, and 30% in noninterest bearing demand deposits. On December 31, 2004, approximately $6,568,000, or less than 1%, of deposits were from public sources, and approximately $70,743,000, or 8%, of deposits were from title and escrow companies. As of December 31, 2003, the Company had a deposit mix of 41% in savings and money market accounts, 17% in time deposits, 13% in interest bearing demand accounts, and 29% in noninterest bearing demand deposits. On December 31, 2003, approximately $5,006,000, or less than 1%, of deposits were from public sources, and approximately $69,640,000, or 8%, of deposits were from title and escrow companies.
The Company obtains deposits from a cross-section of the communities it serves. The Company's business is not seasonal in nature. The Company had brokered deposits totaling approximately $19,862,000 and $11,970,000 at December 31, 2004 and 2003, respectively. These brokered deposits generally mature within one to three years. The Company is not dependent upon funds from sources outside the United States.
The following table indicates the maturity schedule of the Company's time deposits of $100,000 or more as of December 31, 2004:
% of (Dollars in thousands) Balance Total --------- ------- Three months or less.................. $ 46,082 37 % Over three months through six months.. 19,017 15 % Over six months through twelve months. 32,192 26 % Over twelve months.................... 27,290 22 % --------- ------- Total....................... $ 124,581 100 % ========= =======
The Company focuses primarily on providing and servicing business deposit accounts that are frequently over $100,000 in average balance per account. As a result certain types of business clients whom the Company caters to and serves typically carry average deposits in excess of $100,000. The account activity for some account types and client types necessitates appropriate liquidity management practices by the Company to ensure its ability to fund deposit withdrawals.
OFF-BALANCE SHEET ARRANGEMENTS AND AGGREGATE CONTRACTUAL OBLIGATIONS AND COMMITMENTS
The contractual obligations of the Company, summarized by type of obligation and contractual maturity, at December 31, 2004, are as follows:
Less Than One to Four to After (Dollars in thousands) One Year Three Years Five Years Five Years Total ----------------------------------------------- -------- ---------- ---------- -------- -------- Long-term borrowings....................... $ 15,100 $ 21,800 $ 10,900 $ -- $ 47,800 Notes payable to subsidiary grantor trusts.... -- -- -- 23,702 23,702 Operating leases........................... 2,186 4,211 3,064 910 10,371 Time deposits.............................. 130,080 24,881 7,915 -- 162,876 -------- ---------- ---------- -------- -------- Total debt and operating leases............ $147,366 $ 50,892 $ 21,879 $ 24,612 $244,749 ======== ========== ========== ======== ========
In addition to those obligations listed above, in the normal course of business, the Company will make cash distributions for the payment of interest on interest bearing deposit accounts and debt obligations, payments for quarterly tax estimates and contributions to certain employee benefit plans.
The following table presents the Company's commitments to fund as of December 31, 2004 and 2003.
(Dollars in thousands) 2004 2003 ---------------------------------------- --------- --------- Commitments to extend credit............ $ 313,036 $ 269,504 Standby letters of credit............... 5,256 4,449 --------- --------- $ 318,292 $ 273,953 ========= =========
LIQUIDITY AND ASSET/LIABILITY MANAGEMENT
To meet liquidity needs, the Company maintains a portion of its funds in cash deposits in other banks, in Federal funds sold and in investment securities. As of December 31, 2004, the Company's primary liquidity ratio was 16.35%, comprised of $105,700,000 in investment securities available-for-sale of maturities (or probable calls) of up to five years, less $15,800,000 of securities that were pledged to secure public and certain other deposits as required by law and contract, Federal funds sold of $24,100,000, and $33,600,000 in cash and due from banks, as a percentage of total unsecured deposits of $902,735,000. As of December 31, 2003, the Company's primary liquidity ratio was 18.51%, comprised of $53,200,000 in investment securities available-for-sale of maturities (or probable calls) of up to five years, less $15,900,000 million securities that were pledged to secure public and certain other deposits as required by law and contract, Federal funds sold of $72,200,000, and $42,000,000 in cash and due from banks, as a percentage of total unsecured deposits of $819,510,000. As of December 31, 2002, the Company's primary liquidity ratio was 16.47%, comprised of $64,600,000 in investment securities available-for-sale of maturities (or probable calls) of up to five years, less $15,000,000 of securities that were pledged to secure public and certain other deposits as required by law and contract, Federal funds sold of $44,000,000, and $42,600,000 in cash and due from banks, as a percentage of total unsecured deposits of $827,000,000.
The following table summarizes the Company's borrowings under its Federal funds purchased, security repurchase arrangements and lines of credit for the periods indicated:
(Dollars in thousands) 2004 2003 ------------------------------------------- ------------ ------------ Average balance during the year............ $ 43,109 $ 15,387 Average interest rate during the year...... 2.07% 1.71% Maximum month-end balance during the year.. $ 48,600 $ 43,600 Average rate at December 31................ 2.21% 1.68%
The Company has Federal funds purchase lines and lines of credit of totaling $56,000,000 from correspondent banks. As of December 31, 2004, the Company had borrowing capacity of approximately $105,000,000 under a borrowing line with the Federal Home Loan Bank secured by certain loans and investment securities.
CAPITAL RESOURCES
The following table summarizes risk-based capital, risk-weighted assets, and risk-based capital ratios of the Company:
December 31, ---------------------------------- (Dollars in thousands) 2004 2003 2002 ------------------------------ ---------- ---------- ---------- Capital components: Tier 1 Capital............. $ 121,096 $ 110,891 $ 101,966 Tier 2 Capital............. 11,623 10,403 10,563 ---------- ---------- ---------- Total risk-based capital... $ 132,719 $ 121,294 $ 112,529 ========== ========== ==========
Risk-weighted assets.......... $ 929,241 $ 830,537 $ 842,399 Quarterly average assets...... $1,112,526 $ 992,608 $ 950,091 MINIMUM REGULATORY REQUIREMENTS ----------- Capital ratios: Total risk-based capital...... 14.3% 14.6% 13.4% 8.0% Tier 1 risk-based capital..... 13.0% 13.4% 12.1% 4.0% Leverage ratio(1)............. 10.9% 11.2% 10.7% 4.0%
(1) Tier 1 capital divided by average assets (excluding goodwill).
The table above presents the capital ratios of the Company computed in accordance with applicable regulatory guidelines and compared to the standards for minimum capital adequacy requirements under the FDIC's prompt corrective action authority as of December 31, 2004. The risk-based and leverage capital ratios are defined in Item 1 - "Business - Supervision and Regulation - Capital Adequacy Guidelines" on page 9.
At December 31, 2004, 2003 and 2002, the Company's capital met all minimum regulatory requirements. As of December 31, 2004, 2003 and 2002, management believes that HBC, and its former subsidiary banks, were considered "well capitalized" under the regulatory framework for prompt corrective action.
To enhance regulatory capital and to provide liquidity the Company, through unconsolidated subsidiary grantor trusts, issued the following mandatorily redeemable cumulative trust preferred securities of subsidiary grantor trusts: In the first quarter of 2000, the Company issued $7,000,000 aggregate principal amount of 10.875% subordinated debentures due on March 8, 2030 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2000, the Company issued $7,000,000 aggregate principal amount of 10.60% subordinated debentures due on September 7, 2030 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2001, the Company issued $5,000,000 aggregate principal amount of Floating Rate Junior Subordinated Deferrable Interest Debentures due on July 31, 2031 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2002, the Company issued $4,000,000 aggregate principal amount of Floating Rate Junior Subordinated Deferrable Interest Debentures due on September 26, 2032 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. Under applicable regulatory guidelines, the Trust Preferred securities currently qualify as Tier I capital. No assurance can be given that the banking regulators will continue Tier 1 capital treatment for trust preferred securities in light of the recent accounting change. The subsidiary trusts are not consolidated in the Company's consolidated financial statements and the subordinated debt payable to the subsidiary grantor trusts is recorded as debt of the Company to the related trusts.
MARKET RISK
Market risk is the risk of loss to future earnings, to fair values, or to future cash flows that may result from changes in the price of a financial instrument. The value of a financial instrument may change as a result of changes in interest rates, foreign currency exchange rates, commodity prices, equity prices and other market changes that affect market risk sensitive instruments. Market risk is attributed to all market risk sensitive financial instruments, including securities, loans, deposits, borrowings, its trading activities for its own account, and its role as a financial intermediary in customer-related transactions. The objective of market risk management is to avoid excessive exposure of the Company's earnings and equity to loss and to reduce the volatility inherent in certain financial instruments.
INTEREST RATE SENSITIVITY
The planning of asset and liability maturities is an integral part of the management of an institution's net yield. To the extent maturities of assets and liabilities do not match in a changing interest rate environment, net yields may change over time. Even with perfectly matched repricing of assets and liabilities, risks remain in the form of prepayment of loans or investments or in the form of delays in the adjustment of rates of interest applying to either earning assets with floating rates or to interest bearing liabilities. The Company has generally been able to control its exposure to changing interest rates by maintaining primarily floating interest rate loans and a majority of its time certificates with relatively short maturities.
The table below sets forth the interest rate sensitivity of the Company's interest earning assets and interest bearing liabilities as of December 31, 2004, using the rate sensitivity GAP ratio. For purposes of the following table, an asset or liability is considered rate-sensitive within a specified period when it can be repriced or when it is scheduled to mature within the specified time frame:
Due Due in Due Within Three After One Three to Twelve to Five Due After Not Rate- (Dollars in thousands) Months Months Years Five Years Sensitive Total -------------------------------------------------- ---------- ---------- ---------- ---------- ---------- ---------- INTEREST EARNING ASSETS: Federal funds sold............................... $ 24,100 $ -- $ -- $ -- $ -- $ 24,100 Interest bearing deposits in other institutions.. 2,210 -- -- -- -- 2,210 Securities....................................... 140 25,486 80,042 127,141 -- 232,809 Total loans, including loans held-for-sale, net of deferred costs.......... 558,683 79,540 69,948 54,537 -- 762,708 ---------- ---------- ---------- ---------- ---------- ---------- Total interest earning assets..................... 585,133 105,026 149,990 181,678 -- 1,021,827
Cash and due from banks........................... -- -- -- -- 31,436 31,436 Other assets...................................... -- 26,303 -- -- 28,607 54,910 ---------- ---------- ---------- ---------- ---------- ---------- Total assets...................................... $ 585,133 $ 131,329 $ 149,990 $ 181,678 $ 60,043 $1,108,173 ========== ========== ========== ========== ========== ==========
INTEREST BEARING LIABILITIES: Demand, interest bearing......................... $ 120,890 $ -- $ -- $ -- $ -- $ 120,890 Savings and money market......................... 357,318 -- -- -- -- 357,318 Time deposits.................................... 61,407 68,674 32,795 -- -- 162,876 Other borrowings................................. -- 15,100 32,700 -- -- 47,800 Notes payable to subsidiary grantor trusts....... 9,279 -- -- 14,423 -- 23,702 ---------- ---------- ---------- ---------- ---------- ---------- Total interest bearing liabilities................ 548,894 83,774 65,495 14,423 -- 712,586
Demand noninterest bearing........................ 70,743 -- -- -- 206,708 277,451 Accrued interest payable and other liabilities........................... -- -- -- -- 19,557 19,557 Shareholders' equity.............................. -- -- -- -- 98,579 98,579 ---------- ---------- ---------- ---------- ---------- ---------- Total liabilities and shareholders' equity.......................................... $ 619,637 $ 83,774 $ 65,495 $ 14,423 $ 324,844 $1,108,173 ========== ========== ========== ========== ========== ==========
Interest rate sensitivity GAP..................... $ (34,504) $ 47,555 $ 84,495 $ 167,255 $ (264,801) $ -- ========== ========== ========== ========== ========== ========== Cumulative interest rate sensitivity GAP................................. $ (34,504) $ 13,051 $ 97,546 $ 264,801 $ -- $ -- Cumulative interest rate % sensitivity GAP ratio........................... (3.11)% 1.18 % 8.80 % 23.90 % -- % --
Interest rate changes do not affect all categories of assets and liabilities equally or at the same time. Varying interest rate environments can create unexpected changes in prepayment levels of assets and liabilities, which may have a significant effect on the net interest margin and are not reflected in the interest sensitivity analysis table. Because of these factors, an interest sensitivity gap report may not provide a complete assessment of the exposure to changes in interest rates. To supplement traditional GAP analysis, the Company performs simulation modeling to estimate the potential effects of changing interest rate environments.
The process allows the Company to explore the complex relationships within the GAP over time and various interest rate environments. For additional information on the Company's simulation model and the methodology used to estimate the potential effects of changing interest rates, see Item 7A
ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As a financial institution, the Company's primary component of market risk is interest rate volatility. Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on most of the Company's assets and liabilities, and the market value of all interest-earning assets, other than those which have a short term to maturity. Since all of the Company's interest-bearing assets and liabilities are located at HBC, all of the Company's interest rate risk exposure lies at that level, as well. As a result, all interest rate risk management procedures are performed at HBC's level. Based upon the nature of the Company's operations, the Company is not subject to foreign exchange or commodity price risk. The Company has no market risk sensitive instruments held for trading purposes. As of December 31, 2004, the Company does not use interest rate derivatives to hedge its interest rate risk.
The Company's exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee (ALCO). Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximize income. Management realizes certain risks are inherent, and that the goal is to identify and accept the risks. Management uses two methodologies to manage interest rate risk: 1) a standard GAP analysis; and 2) an interest rate shock simulation model.
The detail from the Company's GAP analysis is shown under the caption "Interest Rate Sensitivity", above, and is not discussed here. The Company applies a market value (MV) methodology to gauge its interest rate risk exposure as derived from its simulation model. Generally, MV is the discounted present value of the difference between incoming cash flows on interest earning assets and other investments and outgoing cash flows on interest bearing liabilities and other liabilities. The application of the methodology attempts to quantify interest rate risk as the change in the MV which would result from a theoretical 200 basis point (1 basis point equals 0.01%) change in market interest rates. Both a 200 basis point increase and a 200 basis point decrease in market rates are considered.
At December 31, 2004, it was estimated that the Company's MV would increase 18.09% in the event of a 200 basis point increase in market interest rates. The Company's MV at the same date would decrease 27.73% in the event of a 200 basis point decrease in market interest rates.
Presented below, as of December 31, 2004 and 2003, is an analysis of the Company's interest rate risk as measured by changes in MV for instantaneous and sustained parallel shifts of 200 basis points in market interest rates:
2004 2003 --------------------------------------------- --------------------------------------------- Market Value as a % of Market Value as a % of $ Change % Change Present Value of Assets $ Change % Change Present Value of Assets (Dollars in thousands) in Market in Market ---------------------- in Market in Market ---------------------- Change in rates Value Value MV Ratio Change (bp) Value Value MV Ratio Change (bp) --------------------- ---------- ---------- --------- ----------- ---------- ---------- --------- ----------- + 200 bp............ $ 33,886 18.09 % 20.0 % 306 $ 46,986 30.90 % 19.8 % 467 0 bp............ $ -- -- % 16.9 % -- $ -- -- % 15.1 % -- - 200 bp............ $ (51,939) (27.73)% 12.2 % (469) $ (51,713) (34.02)% 10.0 % (514)
Management believes that the MV methodology overcomes three shortcomings of the typical maturity gap methodology. First, it does not use arbitrary repricing intervals and accounts for all expected future cash flows. Second, because the MV method projects cash flows of each financial instrument under different interest rate environments, it can incorporate the effect of embedded options on an institutions' interest rate risk exposure. Third, it allows interest rates on different instruments to change by varying amounts in response to a change in market interest rates, resulting in more accurate estimates of cash flows.
However, as with any method of gauging interest rate risk, there are certain shortcomings inherent to the MV methodology. The model assumes interest rate changes are instantaneous parallel shifts in the yield curve. In reality, rate changes are rarely instantaneous. The use of the simplifying assumption that short-term and long-term rates change by the same degree may also misstate historic rate patterns, which rarely show parallel yield curve shifts. Further, the model assumes that certain assets and liabilities of similar maturity or period to repricing will react in the same way to changes in rates. In reality, certain types of financial instruments may react in advance of changes in market rates, while the reaction of other types of financial instruments may lag behind the change in general market rates. Additionally, the MV methodology does not reflect the full impact of annual and lifetime restrictions on changes in rates for certain assets, such as adjustable rate loans. When interest rates change, actual loan prepayments and actual early withdrawals from certificates may deviate significantly from the assumptions used in the model. Finally, this methodology does not measure or reflect the impact that higher rates may have on adjustable-rate loan clients' ability to service their debt. All of these factors are considered in monitoring the Company's exposure to interest rate risk.
Liquidity risk represents the potential for loss as a result of limitations on our ability to adjust our future cash flows to meet the needs of depositors and borrowers and to fund operations on a timely and cost-effective basis. The Liquidity Policy approved by the Board requires annual review of the Company's liquidity by the Asset/Liability Committee, which is composed of senior executives, and the Finance and Investment Committee of the Board of Directors.
ITEM 8
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and report of Independent Registered Public Accounting Firm are set forth on pages 62 through 91, which follows Item 15 - "Exhibits and Financial Statement Schedules"
The following table discloses the Company's selected unaudited quarterly financial data. See Note 2 to the consolidated financial statements for description of the restatements.
For the Quarter Ended ----------------------------------------------------------------------------------------------- As Previously As Previously As Previously Reported As Restated Reported As Restated Reported As Restated 12/31/2004 09/30/2004 09/30/2004 06/30/2004 06/30/2004 03/31/2004 03/31/2004 ------------ ------------- ----------- ------------ ----------- ------------ ------------ Interest income............. $ 14,330 $ 13,633 $ 13,563 $ 12,690 $ 12,617 $ 11,984 $ 11,907 Interest expense............ 2,677 2,484 2,484 2,298 2,298 2,189 2,189 ------------ ------------- ----------- ------------ ----------- ------------ ------------ Net interest income......... 11,653 11,149 11,079 10,392 10,319 9,795 9,718 (Reversal of)Provision for loan losses........... (726) 600 254 600 575 600 563 ------------ ------------- ----------- ------------ ----------- ------------ ------------ Net interest income after (Reversal of) provision for loan losses............ 12,379 10,549 10,825 9,792 9,744 9,195 9,155 Noninterest income.......... 2,358 2,363 2,608 2,304 2,549 2,474 2,719 Noninterest expense......... 11,401 8,889 9,131 10,916 11,158 8,712 8,970 ------------ ------------- ----------- ------------ ----------- ------------ ------------ Net income before taxes..... 3,336 4,023 4,302 1,180 1,135 2,957 2,904 Provision for income taxes..................... 690 1,135 1,210 380 366 950 933 ------------ ------------- ----------- ------------ ----------- ------------ ------------ Net income.................. $ 2,646 $ 2,888 $ 3,092 $ 800 $ 769 $ 2,007 $ 1,971 ============ ============= =========== ============ =========== ============ ============ Net income per share basic..................... $ 0.23 $ 0.25 $ 0.26 $ 0.07 $ 0.07 $ 0.18 $ 0.17 Net income per share diluted................... $ 0.23 $ 0.24 $ 0.26 $ 0.07 $ 0.06 $ 0.17 $ 0.16
For the Quarter Ended ----------------------------------------------------------------------------------------------------------- As Previously As Previously As Previously As Previously Reported As Restated Reported As Restated Reported As Restated Reported As Restated 12/31/2003 12/31/2003 09/30/2003 09/30/2003 06/30/2003 06/30/2003 03/31/2003 03/31/2003 ------------ ------------- ----------- ------------ ----------- ------------ ------------ ---------- Interest income............. $ 12,219 $ 12,219 $ 11,556 $ 11,556 $ 11,873 $ 11,873 $ 12,448 $ 12,448 Interest expense............ 2,309 2,309 2,369 2,369 2,552 2,552 2,773 2,773 ------------ ------------- ----------- ------------ ----------- ------------ ------------ ---------- Net interest income......... 9,910 9,910 9,187 9,187 9,321 9,321 9,675 9,675 (Reversal of)Provision for loan losses........... 400 400 600 600 600 600 1,300 1,300 ------------ ------------- ----------- ------------ ----------- ------------ ------------ ---------- Net interest income after (Reversal of) provision for loan losses............ 9,510 9,510 8,587 8,587 8,721 8,721 8,375 8,375 Noninterest income.......... 2,486 2,486 2,463 2,463 2,516 2,516 2,964 2,964 Noninterest expense......... 9,044 9,047 8,310 8,313 8,486 8,488 8,500 8,502 ------------ ------------- ----------- ------------ ----------- ------------ ------------ ---------- Net income before taxes..... 2,952 2,949 2,740 2,737 2,751 2,749 2,839 2,837 Provision for income taxes..................... 910 909 800 799 880 879 910 909 ------------ ------------- ----------- ------------ ----------- ------------ ------------ ---------- Net income.................. $ 2,042 $ 2,040 $ 1,940 $ 1,938 $ 1,871 $ 1,870 $ 1,929 $ 1,928 ============ ============= =========== ============ =========== ============ ============ ========== Net income per share basic..................... $ 0.18 $ 0.18 $ 0.17 $ 0.17 $ 0.17 $ 0.17 $ 0.17 $ 0.17 Net income per share diluted................... $ 0.17 $ 0.17 $ 0.17 $ 0.17 $ 0.16 $ 0.16 $ 0.17 $ 0.17
ITEM 9
ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A
ITEM 9A - CONTROLS AND PROCEDURES
Disclosure Control and Procedures
The Company has carried out an evaluation, under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures as of December 31, 2004. As defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), disclosure controls and procedures are controls and procedures designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act are recorded, processed, summarized and reported on a timely basis. Based upon that evaluation and as result of the material weakness described below, the Chief Executive Officer and Chief Financial Officer have concluded that the Company's disclosure controls and procedures were not effective as of December 31, 2004.
Material Weakness in Internal Control Over Financial Reporting
Management has concluded that, as of December 31, 2004, the Company did not design and implement controls over the selection and application of accounting policies for complex, non-routine transactions. This is a material weakness that caused the restatement of previously issued financial statements. It is considered a material weakness due to the actual misstatements identified, the potential for additional misstatements, and the lack of other mitigating controls to detect the misstatements.
Management has determined that this control deficiency constituted a material weakness in the Company's internal control over financial reporting as of December 31, 2004. A material weakness is a control deficiency, or combination of control deficiencies, that results in a more than remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.
This material weakness resulted in restatements of the Company's financial statements for the years ended December 31, 2002 and 2003, and the first three quarters in 2004. The material weakness resulted in accounting errors related to an asset subject to a lease, delayed equity contributions to low income housing partnerships, and leased facilities.
Remediation of Material Weakness
The Company is in the process of creating a formal process related to the design and implementation of control over the selection and application of accounting policies for complex, non-routine transactions. This process will include the early identification of complex, non-routine transactions. These transactions will be initially documented by the Company's internal accounting staff. A regular meeting with accounting staff and executive level officers involved and familiar with accounting issues related to complex, non-routine transactions, will be held to review the initial documentation of complex, non-routine transactions. As required, outside legal or accounting advice will be obtained.
Through these steps, the Company believes it is addressing the deficiencies that affected its internal control over financial reporting as of December 31, 2004. However, the effectiveness of any system of internal controls is subject to inherent limitations and there can be no assurance that the Company's internal control over financial reporting will prevent or detect all errors. The Company intends to continue to evaluate and strengthen its internal control over financial reporting system.
Reports of Management and Independent Registered Public Accounting Firm
Management has assessed of the effectiveness of the Company's internal control over financial reporting as of December 31, 2004 and their report is at page 59.
Deloitte & Touche LLP, independent registered public accounting firm has audited the consolidated financial statements of the Company for the year ended December 31, 2004 and has issued their reports on the financial statements and management's assessment of the effectiveness of the Company's internal control over financial reporting.
Changes in Internal Control over Financial Reporting
During the quarter ended December 31, 2004, there were no changes in our internal controls over financial reporting that materially affected, or are reasonably likely to affect, our internal controls over financial reporting. However, the Company is in the process of creating a formal process related to the design and implementation of controls over the selection and application of accounting policies for complex, non-routine transactions as noted above. The Company believes that this change in internal controls over financial reporting will improve its financial reporting system but there is no assurance that this change will materially affect the Company's internal control over financial reporting.
ITEM 9B
ITEM 9B - OTHER INFORMATION
None
PART III
ITEM 10
ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Reference is made to the Company's Proxy Statement for the May 26, 2005 Annual Meeting of Shareholders for incorporation of information concerning directors and persons nominated to become directors of the Company. Information concerning executive officers of the Company also included in the Company's Proxy Statement.
ITEM 11
ITEM 11 - EXECUTIVE COMPENSATION
Information concerning executive compensation is incorporated by reference from the text under the caption "Executive Compensation" in the Proxy Statement for the May 26, 2005 Annual Meeting of Shareholders.
ITEM 12
ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Information concerning ownership of the equity stock of the Company by certain beneficial owners and management is incorporated by reference from the text under the caption "Security Ownership of Certain Beneficial Owners and Management" in the Proxy Statement for the May 26, 2005 Annual Meeting of Shareholders.
Information concerning the Company's stock option plans is incorporated by reference from the text under the caption "Equity Compensation Plan Information" in the Proxy Statement for the May 26, 2005 Annual Meeting of Shareholders.
ITEM 13
ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information concerning certain relationships and related transactions with officers, directors, and the Company, and equity compensation plan information, is incorporated by reference from the text under the caption "Transactions with Management and Others" in the Proxy Statement for the May 26, 2005 Annual Meeting of Shareholders.
ITEM 14
ITEM 14 - PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information concerning principal accounting fees and services is incorporated by reference from the text under the caption "Principal Accounting Firm Fees" in the Proxy Statement for the May 26, 2005 Annual Meeting of Shareholders.
PART IV
ITEM 15
ITEM 15 - EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a)(1) FINANCIAL STATEMENTS
The Financial Statements of the Company and the independent auditors' report are set forth on pages 62 through 91.
(a)(2) FINANCIAL STATEMENT SCHEDULES
All schedules to the Financial Statements are omitted because of the absence of the conditions under which they are required or because the required information is included in the Financial Statements or accompanying notes.
(a)(3) EXHIBITS
The exhibit list required by this Item is incorporated by reference to the Exhibit Index included in this report.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report on Form 10-K to be signed on its behalf by the undersigned thereunto duly authorized.
Heritage Commerce Corp
DATE: March 31, 2005
BY: /s/ William Del Biaggio, Jr.
William Del Biaggio, Jr.
Interim Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report on Form 10-K has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated:
Signature
Title
Date
/s/ FRANK BISCEGLIA
Frank Bisceglia
Director
March 31, 2005
/s/ JAMES BLAIR
James Blair
Director
March 31, 2005
/s/ JACK CONNER
Jack Conner
Director
March 31, 2005
/s/ WILLIAM DEL BIAGGIO, JR.
William Del Biaggio, Jr.
Director and Chairman of the Board and Interim Chief Executive Officer
March 31, 2005
/s/ LAWRENCE D. MCGOVERN
Lawrence D. McGovern
Executive Vice President and Chief Financial Officer, Principal Financial and Accounting Officer
March 31, 2005
/s/ ROBERT MOLES
Robert Moles
Director
March 31, 2005
/s/ LON NORMANDIN
Lon Normandin
Director
March 31, 2005
/s/ JACK PECKHAM
Jack Peckham
Director
March 31, 2005
/s/ HUMPHREY POLANEN
Humphrey Polanen
Director
March 31, 2005
/s/ CHARLES TOENISKOETTER
Charles Toeniskoetter
Director
March 31, 2005
/s/ RANSON WEBSTER
Ranson Webster
Director
March 31, 2005
HERITAGE COMMERCE CORP
DECEMBER 31, 2004
Page
Management's Annual Report on Internal Control over Financial Reporting
Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of December 31, 2004 and
Consolidated Income Statements for the years ended December 31, 2004, 2003 and 2002
Consolidated Statements of Changes in Shareholders' Equity as of December 31, 2004, 2003 and 2002
Consolidated Statements of Cash Flows as of December 31, 2004, 2003 and 2002
Notes to Consolidated Financial Statements
Management's Annual Report on Internal Control over Financial Reporting
Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. As defined in Rule 13a-15(f) under the Exchange Act, internal control over financial reporting is a process designed by, or under the supervision of, a company's principal executive and principal financial officers and effected by a company's board of directors, management and other personnel, 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. It includes those policies and procedures that:
Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of a company;
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 a company are being made only in accordance with authorizations of management and the board of directors of the company; and
Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of a company's assets that could have a material effect on its financial statements.
Because of the 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.
Management is also responsible for ensuring compliance with federal laws and regulations relating to safety and soundness.
The Company's management has used the Committee of Sponsoring Organizations of the Treadway Commission (COSO) framework to evaluate the effectiveness of the Company's internal control over financial reporting. Management has selected the COSO framework for its evaluation as it is a control framework recognized by the SEC and the Public Company Accounting Oversight Board, that is free from bias, permits reasonably consistent qualitative and quantitative measurement of the Company's internal controls, is sufficiently complete so that relevant controls are not omitted and is relevant to an evaluation of internal controls over financial reporting.
Management of the Company assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2004, and identified a material weakness in the design of its internal controls. The Company did not design and implement controls over the selection and application of accounting policies for complex, non-routine transactions.
Because of this material weakness, management has concluded that the Company did not maintain effective internal control over financial reporting as of December 31, 2004, based on the criteria described in the COSO Internal Control - Integrated Framework.
The Company's independent registered public accounting firm has issued an attestation report on the management's assessment of the Company's internal controls over financial reporting.
Date: March 30, 2005
/s/ William Del Biaggio, Jr.
William Del Biaggio, Jr.
Interim Chief Executive Officer
/s/ Lawrence D. McGovern
Lawrence D. McGovern
Chief Financial Officer
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
Heritage Commerce Corp:
We have audited management's assessment, included in the accompanying Management's Annual Report on Internal Control over Financial Reporting, that Heritage Commerce Corp and subsidiary (the "Company") did not maintain effective internal control over financial reporting as of December 31, 2004, because of the effect of the material weakness identified in management's assessment based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Because management's assessment and our audit were conducted to meet the reporting requirements of Section 112 of the Federal Deposit Insurance Corporation Improvement Act (FDICIA), management's assessment and our audit of the Company's internal control over financial reporting included controls over the preparation of the schedules equivalent to the basic financial statements in accordance with the instructions for the Consolidated Financial Statements for Bank Holding Companies (Form FR Y-9C). The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel 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 the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
A material weakness is a significant deficiency, or combination of significant deficiencies, that result in a more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weakness has been identified and included in management's assessment: The Company did not design and implement controls over the selection and application of accounting policies for complex, non-routine transactions. This material weakness resulted in restatements of the Company's previously issued interim and annual consolidated financial statements as described in Note 2 to the consolidated financial statements. Additionally, certain audit adjustments to the 2004 consolidated financial statements, which were not material individually, but which affected various financial statement line items, were necessary to present the financial statements in accordance with generally accepted accounting principles. This deficiency was concluded to be a material weakness due to the actual misstatements identified, the potential for additional misstatements, and the lack of other mitigating controls to detect the misstatements. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the December 31, 2004 consolidated financial statements and this report does not affect our report on such consolidated financial statements.
In our opinion, management's assessment that the Company did not maintain effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, the Company has not maintained effective internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have not examined and, accordingly, we do not express an opinion or any other form of assurance on management's statement referring to compliance with laws and regulations.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2004 of the Company and our report dated March 30, 2005 expressed an unqualified opinion on those financial statements.
/s/ Deloitte & Touche LLP
San Francisco, California
March 30, 2005
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
Heritage Commerce Corp:
We have audited the accompanying consolidated balance sheets of Heritage Commerce Corp and subsidiary (the "Company") as of December 31, 2004 and 2003, and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2004. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Heritage Commerce Corp and subsidiary as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company's internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 30, 2005 expressed an unqualified opinion on management's assessment of the effectiveness of the Company's internal control over financial reporting and an adverse opinion on the effectiveness of the Company's internal control over financial reporting because of a material weakness.
/s/ Deloitte & Touche LLP
San Francisco, California
March 30, 2005
HERITAGE COMMERCE CORP
CONSOLIDATED BALANCE SHEETS
December 31, ----------------------- (As Restated (Dollars in thousands) 2004 see Note 2) ------------------------------------------------------------------------ ---------- ----------- ASSETS Cash and due from banks................................................. $ 33,646 $ 42,017 Federal funds sold...................................................... 24,100 72,200 ---------- ----------- Total cash and cash equivalents........................ 57,746 114,217 Securities available-for-sale, at fair value............................ 232,809 153,473 Loans held for sale, at lower of cost or market......................... 37,178 30,638 Loans, net of deferred costs of $726 and $863 for 2004 and 2003......... 725,530 662,157 Allowance for probable loan losses...................................... (12,497) (13,451) ---------- ----------- Loans, net............................................. 713,033 648,706 Premises and equipment, net............................................. 3,183 4,034 Accrued interest receivable and other assets............................ 33,226 27,137 Company owned life insurance ........................................... 26,303 25,273 Other investments....................................................... 4,695 2,504 ---------- ----------- TOTAL................................................... $1,108,173 $ 1,005,982 ========== =========== LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Deposits Demand, noninterest bearing...................................... $ 277,451 $ 238,423 Demand, interest bearing......................................... 120,890 105,260 Savings and money market......................................... 357,318 345,886 Time deposits, under $100........................................ 38,295 39,869 Time deposits, $100 and over..................................... 104,719 94,002 Brokered deposits................................................ 19,862 11,970 ---------- ----------- Total deposits........................................................ 918,535 835,410 Accrued interest payable and other liabilities........................ 19,557 13,785 Other borrowings...................................................... 47,800 43,600 Notes payable to subsidiary grantor trusts............................ 23,702 23,702 ---------- ----------- Total liabilities...................................... 1,009,594 916,497 ---------- ----------- Commitments and contingencies Shareholders' equity: Preferred stock, no par value; 10,000,000 shares authorized: none outstanding........................................................ -- -- Common stock, no par value; 30,000,000 shares authorized; shares outstanding: 11,669,837 in 2004 and 11,381,037 in 2003............. 67,409 65,234 Unallocated ESOP shares............................................... (193) (443) Accumulated other comprehensive income (loss), net of taxes.......... (1,730) 79 Retained earnings..................................................... 33,093 24,615 ---------- ----------- Total shareholders' equity............................. 98,579 89,485 ---------- ----------- TOTAL.................................................. $1,108,173 $ 1,005,982 ========== ===========
See notes to consolidated financial statements.
HERITAGE COMMERCE CORP
CONSOLIDATED INCOME STATEMENTS
Year ended December 31, ---------------------------------------- 2003 2002 (As Restated, (As Restated, (Dollars in thousands, except per share data) 2004 see Note 2) see Note 2) ------------------------------------------------------------------- ----------- ------------ ------------- Interest income: Loans, including fees............................................ $ 45,325 $ 42,934 $ 46,609 Securities, taxable.............................................. 6,418 4,198 4,576 Securities, non-taxable.......................................... 297 411 500 Interest bearing deposits in other financial institutions........ 14 44 88 Federal funds sold............................................... 363 509 983 ----------- ------------ ------------- Total interest income.............................................. 52,417 48,096 52,756 ----------- ------------ ------------- Interest expense: Deposits......................................................... 6,798 7,806 13,353 Subsidiary grantor trusts........................................ 1,958 1,935 1,871 Other............................................................ 892 262 13 ----------- ------------ ------------- Total interest expense............................................. 9,648 10,003 15,237 ----------- ------------ ------------- Net interest income before provision for probable loan losses...... 42,769 38,093 37,519 Provision for probable loan losses................................. 666 2,900 2,663 ----------- ------------ ------------- Net interest income after provision for probable loan losses....... 42,103 35,193 34,856 ----------- ------------ ------------- Noninterest income: Gain on sale of loans............................................ 3,052 2,228 2,262 Servicing income................................................. 2,325 1,819 1,317 Service charges and other fees on deposit accounts............... 1,799 1,810 1,425 Appreciation of company owned life insurance..................... 1,031 1,151 1,113 Equipment leasing................................................ 871 1,195 103 Gain on sales of securities available-for-sale................... 476 735 1,036 Mortgage brokerage fees............................................ 168 1,012 1,085 Other............................................................ 512 479 689 ----------- ------------ ------------- Total noninterest income........................................... 10,234 10,429 9,030 ----------- ------------ ------------- Noninterest expenses: Salaries and employee benefits................................... 18,754 17,975 18,067 Occupancy........................................................ 3,670 3,541 3,207 Professional fees................................................ 2,656 1,548 1,563 Operational losses............................................... 2,219 (1) 88 Retirement plan expense.......................................... 1,741 741 897 Loan origination costs........................................... 1,628 1,439 1,277 Advertising and promotion........................................ 1,090 747 737 Client services.................................................. 1,044 1,018 1,100 Amortization of leased equipment................................. 1,016 985 83 Furniture and equipment.......................................... 921 1,588 1,503 Amortization of low income housing projects...................... 878 398 341 Data processing expense.......................................... 722 87 86 Other............................................................ 4,321 4,284 4,299 ----------- ------------ ------------- Total noninterest expenses......................................... 40,660 34,350 33,248 ----------- ------------ ------------- Income before provision for income taxes........................... 11,677 11,272 10,638 Provision for income taxes......................................... 3,199 3,496 3,484 ----------- ------------ ------------- Net income......................................................... $ 8,478 $ 7,776 $ 7,154 =========== ============ ============= Earnings per share: Basic........................................................... $ 0.73 $ 0.69 $ 0.65 Diluted......................................................... $ 0.71 $ 0.67 $ 0.63
See notes to consolidated financial statements.
HERITAGE COMMERCE CORP
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 2004, 2003, AND 2002
Accumulated Other Common Stock Comprehensive Total ---------------------- Income (Loss) Unallocated Retained Shareholders' Comprehensive (Dollars in thousands) Shares Amount (Net of Taxes) ESOP Shares Earnings Equity Income ----------- --------- ------------- ---------- ----------- ------------ -------------- BALANCES, JANUARY 1, 2002 (1)....... 11,114,967 $ 63,536 $ 1,021 $ (901) $ 9,685 $ 73,341 Net income (1)....................... -- -- -- -- 7,154 7,154 $ 7,154 Net change in unrealized loss on securities available-for-sale, net of reclassification adjustment and taxes............................ -- -- 693 -- -- 693 693 -------------- Total comprehensive income (1).... $ 7,847 ============== Amortization of stock compensation... -- -- -- 250 -- 250 Additional unallocated ESOP shares... -- -- -- (42) -- (42) Additional paid-in-capital in ESOP... -- 45 -- -- -- 45 Stock options exercised.............. 99,447 421 -- -- -- 421 ----------- --------- ------------- ---------- ----------- ------------ BALANCES, DECEMBER 31, 2002 (1)...... 11,214,414 64,002 1,714 (693) 16,839 81,862 Net income (1)....................... -- -- -- -- 7,776 7,776 $ 7,776 Net change in unrealized gain on securities available-for-sale, net of reclassification adjustment and taxes............................ -- -- (1,635) -- -- (1,635) (1,635) -------------- Total comprehensive income (1).... $ 6,141 ============== Amortization of stock compensation... -- -- -- 250 -- 250 Additional paid-in-capital in ESOP... -- 59 -- -- -- 59 Stock options exercised.............. 166,623 1,173 -- -- -- 1,173 ----------- --------- ------------- ---------- ----------- ------------ BALANCES, DECEMBER 31, 2003 (1)...... 11,381,037 65,234 79 (443) 24,615 89,485 Net income........................... -- -- -- -- 8,478 8,478 $ 8,478 Net change in unrealized loss on securities available-for-sale, net of reclassification adjustment and taxes............................ -- -- (684) -- -- (684) (684) Additional minimum liblility, net of taxes...................... -- -- (1,125) -- -- (1,125) (1,125) -------------- Total comprehensive income ....... $ 6,669 ============== Amortization of stock compensation... -- -- -- 250 -- 250 Additional paid-in-capital in ESOP... -- 296 -- -- -- 296 Common stock repurchased............. (263,728) (4,214) -- -- -- (4,214) Stock options exercised.............. 552,528 6,093 -- -- -- 6,093 ----------- --------- ------------- ---------- ----------- ------------ BALANCES, DECEMBER 31, 2004.......... 11,669,837 $ 67,409 $ (1,730) $ (193) $ 33,093 $ 98,579 =========== ========= ============= ========== =========== ============
(1) As restated, see Note 2.
See notes to consolidated financial statements.
HERITAGE COMMERCE CORP
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year ended December 31, --------------------------------------- 2003 2002 (As Restated, (As Restated, (Dollars in thousands) 2004 see Note 2) see Note 2) --------------------------------------------------------------------- ---------- ------------ ------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income........................................................... $ 8,478 $ 7,776 $ 7,154 Adjustments to reconcile net income to net cash provided by operating activities: Net gain / loss on disposals of property and equipment............ (17) (35) (100) Depreciation and amortization..................................... 1,366 1,995 1,828 Provision for probable loan losses................................ 666 2,900 2,663 Gain on sales of securities available-for-sale (AFS).............. (476) (735) (1,036) Provision for deferred income taxes............................... (1,163) (911) (1,466) Non-cash compensation expense related to ESOP plan................ 546 309 253 Amortization / accretion of discounts and premiums on securities.. 1,090 591 230 Gain on sale of loans............................................. (3,052) (2,228) (2,262) Proceeds from sales of loans held for sale........................ 57,647 46,985 52,200 Originations of loans held for sale............................... (74,898) (79,927) (66,108) Maturities of loans held for sale................................. 13,763 32,616 20,547 Appreciation of company owned life insurance...................... (1,031) (1,151) (1,113) Effect of changes in: Accrued interest receivable and other assets................... (3,948) 930 (9,156) Accrued interest payable and other liabilities................. 4,540 1,305 417 ---------- ------------ ------------- Net cash provided by operating activities............................ 3,511 10,420 4,051 ---------- ------------ ------------- CASH FLOWS FROM INVESTING ACTIVITIES: Net decrease (increase) in loans..................................... (64,712) 9,074 (41,581) Purchases of securities available-for-sale (AFS)..................... (127,662) (152,989) (84,260) Maturities/Paydowns/Calls of securities available-for-sale (AFS)..... 23,270 49,834 24,575 Proceeds from sales of securities available-for-sale (AFS)........... 22,641 73,256 40,033 Maturities/Paydowns/Calls of securities held-to-maturity (HTM)....... -- -- 1,776 Purchases of company owned life insurance............................ -- (225) (750) Purchase of premises and equipment................................... (532) (800) (1,452) Redemption (purchase) of other investments........................... (2,191) 768 (528) ---------- ------------ ------------- Net cash used in investing activities................................ (149,186) (21,082) (62,187) ---------- ------------ ------------- CASH FLOWS FROM FINANCING ACTIVITIES: Net (decrease) increase in deposits.................................. 83,125 (6,526) 34,028 Proceeds from issuance of mandatorily redeemable cumulative trust preferred securities of Subsidiary Grantor Trust.............................. -- -- 4,000 Net proceeds from issuance of common stock........................... 6,093 1,173 421 Common stock repurchased............................................. (4,214) -- -- Net change in other borrowings....................................... 4,200 43,600 -- ---------- ------------ ------------- Net cash provided by financing activities............................ 89,204 38,247 38,449 ---------- ------------ ------------- Net increase (decrease) in cash and cash equivalents................. (56,471) 27,585 (19,687) Cash and cash equivalents, beginning of year......................... 114,217 86,632 106,319 ---------- ------------ ------------- Cash and cash equivalents, end of year............................... $ 57,746 $ 114,217 $ 86,632 ========== ============ =============
Supplemental disclosures of cash flow information: Cash paid during the year for: Interest......................................................... $ 9,493 $ 10,914 $ 17,327 Income taxes..................................................... $ 3,080 $ 2,735 $ 4,480 Supplemental schedule of non-cash investing and financing activity: Transfer of investment securities from HTM to AFS.................... $ -- $ -- $ 13,619
See notes to consolidated financial statements.
HERITAGE COMMERCE CORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) SIGNIFICANT ACCOUNTING POLICIES
Description of Business and Basis of Presentation
Heritage Commerce Corp (the "Company") operates as a bank holding company. Effective January 1, 2003, Heritage Bank East Bay ("HBEB"), Heritage Bank South Valley ("HBSV"), and Bank of Los Altos ("BLA") were merged into Heritage Bank of Commerce ("HBC"). HBC is a California state chartered bank which offers a full range of commercial and personal banking services to residents and the business/professional community in Santa Clara and Alameda counties, California. HBC was incorporated on November 23, 1993 and commenced operations on June 8, 1994.
The accounting and reporting policies of the Company and its subsidiary conform to accounting principles generally accepted in the United States of America ("GAAP") and prevailing practices within the banking industry.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Consolidation
The consolidated financial statements include the accounts of the Company and its subsidiary bank. All significant intercompany accounts and transactions have been eliminated.
The Company also has four other subsidiaries, Heritage Capital Trust I, and Heritage Statutory Trust I, formed in 2000, Heritage Statutory Trust II, formed in 2001, and Heritage Statutory Trust III, formed in 2002, which are Delaware statutory business trusts formed for the exclusive purpose of issuing and selling trust preferred securities. Starting on December 31, 2003, these subsidiary trusts are not consolidated in the Company's consolidated financial statements and the subordinated debt payable to subsidiary grantor trusts is recorded as debt of the Company to the related trusts.
Cash and Cash Equivalents
The Company considers all highly liquid debt instruments purchased with remaining terms to maturity of three months or less from the date of acquisition to be cash equivalents. Cash and cash equivalents include cash on hand, amounts due from banks, and Federal funds sold. Generally, Federal funds are sold and purchased for one-day periods.
Securities
The Company classifies its securities into two categories, available-for-sale and held-to-maturity, at the time of purchase and reevaluates such classifications annually. Securities available-for-sale are recorded at fair value with a corresponding recognition of the net unrealized holding gain or loss, net of income taxes, as a net amount within accumulated other comprehensive income (loss), which is a separate component of shareholders' equity, until realized. Securities held-to-maturity are recorded at amortized cost and are based on the Company's positive intent and ability to hold the securities to maturity. As of December 31, 2004 and 2003, all the Company's securities were classified as available-for-sale securities.
A decline in the market value of any available-for-sale or held-to-maturity security below cost that is deemed other than temporary results in a charge to earnings and the corresponding establishment of a new cost basis for the security.
Premiums and discounts are amortized, or accreted, over the life of the related investment security as an adjustment to income using a method that approximates the interest method. Interest income is recognized when earned. Realized gains and losses for securities classified as available-for-sale are included in earnings and are derived using the specific identification method for determining the cost of securities sold.
Loans Held for Sale
The Company holds for sale the guaranteed portion of certain Small Business Administration (SBA) loans. These loans are carried at the lower of cost or market, based on the aggregate value of the portfolio.
Gains or losses on SBA loans held for sale are recognized upon completion of the sale, and are based on the difference between the net sales proceeds and the relative fair value of the guaranteed portion of the loan sold compared to the relative fair value of the unguaranteed portion.
The servicing assets that result from the sale of SBA loans, sold with servicing rights retained, are amortized over the lives of the loans using a method approximating the interest method.
The Company accounts for the transfer and servicing of financial assets based on the financial and servicing assets it controls and liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished. Servicing assets are measured at their fair value and are amortized in proportion to and over the period of net servicing income and are assessed for impairment on an ongoing basis. Impairment is determined by stratifying the servicing rights based on interest rates and terms. Fair value is determined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market-based assumptions. Impairment is recognized through a valuation allowance. Any servicing assets in excess of the contractually specified servicing fees have been reclassified at fair value as an interest-only (I/O) strip receivable and treated like an available for sale security. The servicing asset, net of any required valuation allowance, and I/O strip receivable are included in other assets.
Loans
Loans are stated at the principal amount outstanding net of deferred loan origination fees and costs. The majority of the Company's loans are at variable interest rates. Interest on loans is credited to income using the effective yield interest method.
Generally, if a loan is classified as non-accrual, the accrual of interest is discontinued, any accrued and unpaid interest is reversed, and the amortization of deferred loan fees and costs is discontinued. Loans are classified as non-accrual when the payment of principal or interest is 90 days past due, unless the amount is well secured and in the process of collection. Any interest or principal payments received on nonaccrual loans are applied toward reduction of principal. Nonaccrual loans generally are not returned to performing status until the obligation is brought current, the loan has performed in accordance with the contract terms for a reasonable period of time, and the ultimate collectibility of the total contractual principal and interest is no longer in doubt.
Renegotiated loans are those in which the Company has formally restructured a significant portion of the loan. The remaining portion is charged off, with a concession either in the form of below market rate financing, or debt forgiveness on the charged off portion. Loans that have been renegotiated and have not met specific performance standards for payment are classified as renegotiated loans within the classification of nonperforming assets. Upon payment performance, such loans may be transferred from nonperforming status to accrual status. At December 31, 2004 and 2003 the Company did not have any renegotiated loans outstanding.
Non-refundable loan fees and direct origination costs are deferred and recognized over the expected lives of the related loans using the effective yield interest method.
Allowance for Probable Loan Losses
The Company maintains an allowance for probable loan losses to absorb probable losses inherent in the loan portfolio. The allowance is based on ongoing, monthly assessments of the probable estimated losses. Loans are charged against the allowance when management believes that the collectibility of the principal is doubtful. The allowance is increased by the provision for loan losses, which is charged against current period operating results and decreased by the amount of charge-offs, net of recoveries. The Company's methodology for assessing the appropriateness of the allowance consists of several key elements, which include the formula allowance, specific allowances and the unallocated allowance.
The formula allowance is calculated by applying loss factors to outstanding loans and certain unused commitments. Loss factors are based on the Company's historical loss experience and may be adjusted for significant factors that, in management's judgment, affect the collectibility of the portfolio as of the evaluation date.
Specific allowances are established in cases where management has identified significant conditions or circumstances related to a credit that management believes indicate the probability that a loss has been incurred in excess of the amount determined by the application of the formula allowance. The allowance also incorporates the results of measuring impaired loans. Management considers a loan to be impaired when it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the note agreement. When a loan is considered to be impaired, the amount of impairment is measured based on the present value of expected future cash flows discounted at the note's effective interest rate, or the fair value of the collateral if the loan is collateral dependent.
The unallocated allowance is based upon management's evaluation of various conditions that are not directly measured in the determination of the formula and specific allowances. The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they are not identified with specific problem credits or portfolio segments. The conditions evaluated in connection with the unallocated allowance may include existing general economic and business conditions affecting the key lending areas of the Company, in particular the technology industry and the real estate market, credit quality trends, collateral values, loan volumes and concentrations, seasoning of the loan portfolio, specific industry conditions within portfolio segments, recent loss experience in particular segments of the portfolio, duration of the current business cycle, and bank regulatory examination results.
Premises and Equipment
Premises and equipment are stated at cost. Depreciation and amortization are computed on a straight-line basis over the lesser of the lease terms or estimated useful lives of five to fifteen years, if appropriate. The Company evaluates the recoverability of long-lived assets on an on-going basis.
Other Investments
Other investments consist of FRB and FHLB stock which are carried at cost.
Equipment Under Operating Leases to Others
Equipment under operating leases where the Company is the lessor is carried at cost less accumulated depreciation based on the terms of the leases and is included in other assets. This equipment represents a pool of electronic testing equipment available for short-term rentals purchased in 2002 from a third party, who also services the leases. At December 31, 2004, the Company has $2,807,000 in equipment and $2,085,000 in accumulated depreciation related to these leases. For the year ended December 31, 2004, depreciation expense was $1,016,000 and rental revenue on the lease was $871,000. The Company regularly evaluates this equipment for impairment. In 2004, the Company recorded a write-off on the electronic test equipment of $2,193,000 recorded in operating losses due to an impairment identified.
Termination Benefits
In 2004, the Company recorded certain termination benefits related to the elimination of certain full time positions and the resignation of the former CEO. The Company recorded severance expense of $1,283,000 recognized in salaries and employee benefits and special termination benefit expense of $765,000 recorded in retirement plan expense related to this activity. The Company has a remaining accrual of $431,000 recorded in accrued interest payable and other liabilities at December 31, 2004 related to remaining cash payments to be made under the termination benefits.
Income Taxes
The Company files consolidated federal and combined state income tax returns. Amounts provided for income tax expense are based on income reported for financial statement purposes and do not necessarily represent amounts currently payable under tax laws. Deferred taxes, which arise principally from temporary differences between the period in which certain income and expenses are recognized for financial accounting purposes and the period in which they affect taxable income, are included in the amounts provided for income taxes. Under this method, the computation of the net deferred tax liability or asset gives current recognition to changes in the tax laws.
Earnings Per Share
Basic earnings per share is computed by dividing net income by the weighted average common shares outstanding. Diluted earnings per share reflects potential dilution from outstanding stock options, using the treasury stock method. There were 14,336, 253,805 and 884,474 stock options for 2004, 2003, and 2002 that were considered to be antidilutive and excluded from the computation of diluted earnings per share. For each of the years presented, net income is the same for basic and diluted earnings per share. Reconciliation of weighted average shares used in computing basic and diluted earnings per share is as follows:
Year ended December 31, ------------------------------------- 2004 2003 2002 ----------- ----------- ----------- Weighted average common shares outstanding - used in computing basic earnings per share.................. 11,559,155 11,221,232 11,063,965 Dilutive effect of stock options outstanding, using the treasury stock method........................ 427,701 351,356 260,685 ----------- ----------- ----------- Shares used in computing diluted earnings per share.... 11,986,856 11,572,588 11,324,650 =========== =========== ===========
Stock-Based Compensation
The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. No compensation expense has been recognized in the financial statements for employee stock option arrangements, as the Company's stock option plan provides for the issuance of options at a price of no less than the fair market value at the date of the grant.
Statement of Financial Accounting Standard ("SFAS") No. 123, Accounting for Stock-Based Compensation, requires the disclosure of pro forma net income and earnings per share had the Company adopted the fair value method at the grant date of all stock options. Under SFAS No. 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which differ significantly from the Company's stock option awards. Those models also require subjective assumptions, which greatly affect the calculated values. The Company's calculations were made using the Black-Scholes option pricing model with the following weighted average assumptions: expected life, 84 months; risk-free interest rate, 4.10% for 2004, 3.61% for 2003, and 4.34% for 2002; stock volatility of 22% in 2004, 29% in 2003, and 23% in 2002; and no dividends during the expected term. The Company's calculations are based on a multiple option valuation approach, and forfeitures are recognized as they occur.
Subsequent to the issuance of the 2003 consolidated financial statements, management determined that compensation expense for amortization of fair value of stock awards, net of taxes for 2003 and 2002 had been calculated incorrectly. Accordingly, such pro forma amounts presented in the table below have been restated. The effect was to decrease compensation expense for amortization of fair value of stock awards, net of taxes $160,000 in 2003 and to increase compensation expense for amortization of fair value of stock awards, net of taxes $41,000 in 2002. Pro forma net income per common share increased $0.02 per share basic and $0.02 per share diluted in 2003. Pro forma net income per common share decreased $0.01 per share basic but remained the same per share diluted in 2002. This correction did not impact the Company's consolidated financial position, results of operations, or cash flows for any period presented.
Had compensation expense for the Company's stock option plan been determined under the requirements of SFAS No. 123 the Company's pro forma net income and earnings per common share would have been as follows:
Year ended December 31, --------------------------------- (Dollars in thousands, except per share data) 2004 2003 2002 --------------------------------------------------------- ---------- ---------- --------- Net income As reported.......................................... $ 8,478 $ 7,776 $ 7,154 Less: Compensation expense for amortization of fair value of stock awards, net of taxes......... (445) (521) (719) ---------- ---------- --------- Pro forma............................................ $ 8,033 $ 7,255 $ 6,435 ========== ========== ========= Net income per common share - basic As reported.......................................... $ 0.73 $ 0.69 $ 0.65 Pro forma............................................ $ 0.69 $ 0.65 $ 0.58
Net income per common share - diluted As reported.......................................... $ 0.71 $ 0.67 $ 0.63 Pro forma............................................ $ 0.67 $ 0.63 $ 0.57
Comprehensive Income
Comprehensive income includes net income and other comprehensive income, which represents the changes in its net assets during the period from non-owner sources. The Company's sources of other comprehensive income are unrealized gains and losses on securities available-for-sale, I/O strips, which are treated like available-for-sale securities, and the additional minimum liability related to the Company's supplemented retirement plan. The items in other comprehensive income are presented net of tax. Reclassification adjustments result from gains or losses on investment securities that were realized and included in net income of the current period that also had been included in other comprehensive incomes as unrealized holding gains and losses in the period in which they are excluded from comprehensive income of the current period. The following is a summary of the components of other comprehensive income:
Year ended December 31, ------------------------------------- (Dollars in thousands) 2004 2003 2002 --------------------------------------------------------------- ----------- ----------- ----------- Net income..................................................... $ 8,478 $ 7,776 $ 7,154 ----------- ----------- ----------- Other comprehensive income, net of tax: Net unrealized holding gains (losses) on available-for-sale securities during the year, net of tax of $245, $817, and $(1,006) for 2004, 2003 and 2002............................ (338) (1,128) 1,389 Additional minimum liability, net of tax of $815 for 2004.... (1,125) -- -- Less: reclassification adjustment for net realized gains, net of tax of $130, $228, and $340 for 2004, 2003 and 2002, on available-for-sale securities included in net income during the year................................ (346) (507) (696) ----------- ----------- ----------- Other comprehensive income (loss) ............................. (1,809) (1,635) 693 ----------- ----------- ----------- Comprehensive income........................................... $ 6,669 $ 6,141 $ 7,847 =========== =========== ===========
Segment Reporting
HBC is an independent community business bank with eight branch offices, which offer similar products to customers located in Santa Clara, Alameda, and Contra Costa counties of California. No customer accounts for more than 10 percent of revenue for HBC or the Company. Management evaluates the Company's performance as a whole and does not allocate resources based on the performance of different lending or transaction activities. Accordingly, the Company and its subsidiary bank all operate as one business segment.
Reclassifications
Certain amounts in the 2003 and 2002 financial statements have been reclassified to conform to the 2004 presentation.
Costs Associated with Exit or Disposal Activities
Effective January 1, 2003, the Company adopted SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities", which addresses accounting for restructuring and similar costs for restructuring activities initiated after December 31, 2002. SFAS No. 146 supersedes previous accounting guidance, principally Emerging Issues Task Force Issue No. 94-3. SFAS No. 146 requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. Under Issue No. 94-3, a liability for an exit cost was recognized at the date of the Company's commitment to an exit plan. SFAS No. 146 also establishes that the liability should initially be measured and recorded at fair value. The adoption of SFAS No. 146 did not have a material effect on the Company's financial position, results of operations, or cash flows.
Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." The Statement establishes standards for how the Company should classify and measure certain financial instruments with characteristics of both liabilities and equity. This Statement was effective for financial instruments entered into or modified after May 31, 2003, and to other instruments effective at the beginning of the first interim period beginning after June 15, 2003. Adoption of this Statement did not have a material impact on the Company's financial position or results of operations.
Employers' Disclosures about Pensions and Other Postretirement Benefits
In December 2003, the FASB issued SFAS No. 132R, a revision of SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits, an amendment of FASB Statement No. 87, 88, and 106." The Statement expands the disclosure requirements of SFAS No. 132 to include information describing measurement date(s), plan obligations, cash flows, and components of net periodic benefit costs of defined pension plans and other defined benefit postretirement plans. The Statement was effective for financial statements with fiscal years ending after December 15, 2003, with additional disclosure of expected benefits to be paid in each of the next five years and in the aggregate for the five years thereafter required for fiscal years ending after June 15, 2004. The disclosures required under SFAS No. 132R are contained in Note 11 of these consolidated financial statements.
Accounting for Share-Based Payments
In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment". This Statement requires that compensation costs related to share-based payment transactions be recognized in the financial statements. Measurement of the cost of employee service will be based on the grant-date fair value of the equity or liability instruments issued. That cost will recognized over the period during which an employee is required to provide service in exchange for the award. Additionally, liability awards will be remeasured each reporting period. Statement 123R replaces SFAS No. 123, "Accounting for Stock-Based Compensation" and supercedes APB Opinion No. 25, "Accounting for Stock Issued to Employees". This Statement is effective for interim periods beginning after June 15, 2005 and requires adoption using a modified prospective application or a modified retrospective application. The Company has not yet concluded on the method of adoption allowed by the Statement and is currently evaluating the impact of this accounting guidance on its financial condition and results of operations. Disclosure required under SFAS No. 123 is shown in Note 1 of these consolidated financial statements.
Accounting for Guarantors and Disclosure Requirements for Guarantees
In November 2002, the FASB issued FASB Interpretation No. ("FIN") 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including indirect Guarantees of Indebtedness of Others." FIN 45 expands on the accounting guidance of Statements No. 5, 57, and 107 and incorporates without change the provisions of FIN 34, which is superceded. FIN 45 elaborates on the existing disclosure requirements for most guarantees and requires that guarantors recognize a liability for the fair value of guarantees at inception. The disclosure requirements of FIN 45 were effective for financial statement periods ending after December 15, 2002. The initial recognition and measurement provisions of FIN 45 are applied on a prospective basis to guarantees issued or modified after December 31, 2002. The adoption of the measurement provisions of FIN 45 did not have a material effect on the Company's financial position, results of operations, or cash flows.
Consolidation of Variable Interest Entities
In January 2003, the FASB issued FIN 46, Consolidation of Variable Interest Entities. The purpose of this interpretation is to provide guidance on how to identify a variable interest entity (VIE) and to determine when the assets, liabilities, noncontrolling interests, and results of operations of a VIE need to be included in a company's consolidated financial statements. A company that holds variable interests in an entity will need to consolidate that entity if the company's interest in the VIE is such that the company will absorb a majority of the VIE's expected losses and/or receive a majority of the VIE's expected residual returns, if they occur. New disclosure requirements are also prescribed by FIN 46. In December 2003, the FASB issued FIN 46R, a revision of FIN 46. FIN 46R was effective for all VIE's created after January 31, 2003 in the reporting period ending after March 15, 2004, and became effective for VIE's that existed before February 1, 2003 for the first period ending after December 15, 2003. Under FIN 46R, the Company's subsidiaries, which issued mandatorily redeemable trust preferred securities, were required to be deconsolidated. The Company applied the provisions of FIN 46R to the VIE and deconsolidated its assets and liabilities. Deconsolidation of these entities resulted in total assets and total liabilities increasing by $702,000 and did not have any impact on the Company's results of operations. The adoption of FIN 46R did not have any other material impact on the Company's financial position or result of operations.
(2) RESTATEMENT
Subsequent to the issuance of the Company's consolidated financial statements for the year ended December 31, 2003, management determined that the 2003 and 2002 financial statements should be restated as a result of the following three accounting errors.
An asset which the Company had accounted for as a direct financing lease and classified as a part of the loan portfolio as of December 31, 2003 should have been accounted for as equipment subject to an operating lease and classified as an other asset. The book value of the equipment subject to an operating lease related to this error is approximately $3,931,000 at December 31, 2003.
The Company determined that it needed order to increase other assets and other liabilities $2,515,000 as of December 31, 2003, from the amounts previously reported to record unconditional, legally binding delayed equity contributions to low income housing partnerships in accordance with Emerging Issues Task Force (EITF) Issue No. 94-1, "Accounting for Tax Benefits Resulting From Investments in Affordable Housing Projects".
The Company determined that its previous method of accounting for rent holidays and step-up rents in its facilities lease agreements was not appropriate and that it should have accounted for rent holidays and step-up rents on a straight-line basis. The after-tax income statement effect for years ended December 31, 2003 and 2002 was to reduce income by $6,000 and $23,000, respectively
.
The following is a summary of the significant effects of the restatements on the consolidated balance sheet as of December 31, 2003:
As Previously December 31, 2003 (Dollars in thousands) Reported Adjustments As Restated ------------------------------------------------------------------------ ---------- ----------- ---------- Loans, net of deferred costs of $726 and $863 for 2004 and 2003......... $ 666,088 $ (3,931) $ 662,157 Loans, net.............................................................. $ 652,637 $ (3,931) $ 648,706 Accrued interest receivable and other assets............................ $ 20,425 $ 6,712 $ 27,137 Total assets............................................................ $1,003,201 $ 2,781 $ 1,005,982 Accrued interest payable and other liabilities.......................... $ 10,643 $ 3,142 $ 13,785 Total liabilities....................................................... $ 913,355 $ 3,142 $ 916,497 Retained earnings....................................................... $ 24,976 $ (361) $ 24,615 Total shareholders' equity.............................................. $ 89,846 $ (361) $ 89,485 Total liabilities and shareholders' equity ............................. $1,003,201 $ 2,781 $ 1,005,982
The following is a summary of the effects of the restatements on the consolidated income statements for the fiscal years ended December 31, 2003 and 2002:
As Previously December 31, 2003 (Dollars in thousands) Reported Adjustments As Restated ------------------------------------------------------------------- ------------ ------------ ------------- Occupancy.......................................................... $ 3,531 $ 10 $ 3,541 Total noninterest expenses......................................... $ 34,340 $ 10 $ 34,350 Income before provision for income taxes........................... $ 11,282 $ (10) $ 11,272 Provision for income taxes......................................... $ 3,500 $ (4) $ 3,496 Net income......................................................... $ 7,782 $ (6) $ 7,776
As Previously December 31, 2002 (Dollars in thousands) Reported Adjustments As Restated ------------------------------------------------------------------- ------------ ------------ ------------- Occupancy.......................................................... $ 3,168 $ 39 $ 3,207 Total noninterest expenses......................................... $ 33,209 $ 39 $ 33,248 Income before provision for income taxes........................... $ 10,677 $ (39) $ 10,638 Provision for income taxes......................................... $ 3,500 $ (16) $ 3,484 Net income......................................................... $ 7,177 $ (23) $ 7,154
(3) SECURITIES
The amortized cost and estimated fair value of securities as of December 31, 2004 were as follows:
Gross Gross Estimated Amortized Unrealized Unrealized Fair (Dollars in thousands) Cost Gains Losses Value ------------------------------------------------ ------------- ----------- ----------- ----------- Securities available-for-sale: U.S. Treasury............................... $ 5,998 $ -- $ 56 $ 5,942 U.S. Government Agencies.................... 91,245 2 939 90,308 Municipals - Tax Exempt..................... 9,211 26 31 9,206 FHLMC and FNMA Mortgage-Backed Securities... 108,642 278 1,734 107,186 GNMA Mortgage-Backed Securities............. 520 29 -- 549 CMOs........................................ 19,843 1 226 19,618 ------------- ----------- ----------- ----------- Total securities available-for-sale............. $ 235,459 $ 336 $ 2,986 $ 232,809 ============= =========== =========== ===========
The amortized cost and estimated fair value of securities as of December 31, 2003 were as follows:
Gross Gross Estimated Amortized Unrealized Unrealized Fair (Dollars in thousands) Cost Gains Losses Value ------------------------------------------------ ------------- ----------- ----------- ----------- Securities available-for-sale: U.S. Treasury............................... $ 6,989 $ 26 $ -- $ 7,015 U.S. Government Agencies.................... 36,138 105 128 36,115 Municipals - Tax Exempt..................... 15,247 500 43 15,704 FHLMC and FNMA Mortgage-Backed Securities... 79,996 263 1,490 78,769 GNMA Mortgage-Backed Securities............. 799 47 -- 846 CMOs........................................ 15,154 10 140 15,024 ------------- ----------- ----------- ----------- Total securities available-for-sale............. $ 154,323 $ 951 $ 1,801 $ 153,473 ============= =========== =========== ===========
At the March 17-18, 2004 Emerging Issues Task Force meeting, the Task Force reached a consensus on Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." Issue 03-1 provides guidance for the determination of when an investment is other-than-temporarily impaired. The guidance for evaluating whether an investment is other-than-temporarily impaired should be applied in other-than-temporary impairment evaluations made in reporting periods beginning after June 15, 2004. On September 30, 2004, the FASB deferred the effective date of paragraphs 10 through 20 of EITF Issue No. 03-1. Application of those paragraphs is deferred pending issuance of a final FASB Staff Position. Management is in the process of evaluating the impacts of EITF 03-1 guidance. Other-than-temporary impairment that may need to be recognized upon adoption of Issue 03-1 will be dependant on market conditions and management's intent and ability at the time of the impairment evaluation to hold investments with market values below amortized cost until a forecasted recovery in fair value up to (or beyond) amortized cost.
The following table shows the gross unrealized losses and fair value of the Company's investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2004:
Less Than 12 Months 12 Months or More Total --------------------- -------------------- -------------------- Market Unrealized Market Unrealized Market Unrealized (Dollars in thousands) Value Losses Value Losses Value Losses ---------------------------------------------- --------- --------- --------- --------- --------- --------- U.S. Treasury............................. $ 5,942 $ 56 $ -- $ -- $ 5,942 $ 56 U.S. Government Agencies.................. 84,955 842 $ 2,903 $ 97 87,858 939 Municipals................................ 6,400 31 -- -- 6,400 31 FHLMC and FNMA Mortgage-Backed Securities. 34,455 497 41,430 1,237 75,885 1,734 CMOs...................................... 12,117 226 -- -- 12,117 226 --------- --------- --------- --------- --------- --------- Total securities available-for-sale........... $ 143,869 $ 1,652 $ 44,333 $ 1,334 $ 188,202 $ 2,986 ========= ========= ========= ========= ========= =========
At December 31, 2004, the Company held 101 securities, of which 64 had market values below amortized cost. Six securities have been carried with an unrealized loss for over 12 months. Higher interest rates at December 31, 2004 resulted in lower market values for the period. Other than temporary loss was primarily due to interest rates. There was no security which sustained downgrades in credit ratings. All principal amounts are expected to be paid when securities mature. Because the Company has the ability and intent to hold these securities until a recovery of fair value, which may be maturity, the Company does not consider these securities to be other-than-temporarily impaired at December 31, 2004.
The amortized cost and estimated fair values of securities as of December 31, 2004 by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or pre-pay obligations with or without call or pre-payment penalties.
Available-for-sale ---------------------------- Estimated Amortized Fair (Dollars in thousands) Cost Value ------------------------------------------------ ------------- ----------- Due within one year............................. $ 25,781 $ 25,626 Due after one through five years................ 80,880 80,042 Due after five through ten years................ 11,438 11,400 Due after ten years............................. 117,360 115,741 ------------- ----------- Total........................................... $ 235,459 $ 232,809 ============= ===========
Sales of securities available-for-sale resulted in gross realized gains of $477,000, $816,000, and $1,036,000 during the years ended December 31, 2004, 2003, and 2002, respectively.
Sales of securities available-for-sale resulted in gross realized losses of $1,000, $81,000, and $0 during the years ended December 31, 2004, 2003, and 2002, respectively.
Securities with amortized cost of $85,883,000 and $49,474,000 as of December 31, 2004 and 2003 were pledged to secure public and certain other deposits as required by law or contract.
(4) LOANS
Loans as of December 31, 2004 and 2003 were as follows:
(Dollars in thousands) 2004 2003 ------------------------------------------------ ------------- ----------- Loans held for sale............................. $ 37,178 $ 30,638 ============= =========== Loans held for investment Commercial.................................... $ 300,452 $ 281,561 Real estate - mortgage........................ 303,154 276,908 Real estate - land and construction........... 118,290 101,082 Consumer...................................... 2,908 1,743 ------------- ----------- Total loans..................................... 724,804 661,294 Deferred loan costs............................. 726 863 Allowance for probable loan losses.............. (12,497) (13,451) ------------- ----------- Loans, net...................................... $ 713,033 $ 648,706 ============= ===========
Included in commercial loans at December 31, 2004 and 2003 were overdrafts from various deposit accounts of approximately $1,411,000 and $804,000, respectively.
Changes in the allowance for probable loan losses were as follows:
Year ended December 31, ----------------------------------------- (Dollars in thousands) 2004 2003 2002 ------------------------------------------------ ------------- ----------- ----------- Balance, beginning of year...................... $ 13,451 $ 13,227 $ 11,154 ------------- ----------- ----------- Loans charged-off............................... (2,901) (2,906) (936) Recoveries...................................... 1,562 230 346 ------------- ----------- ----------- Net loans charged-off........................... (1,339) (2,676) (590) Provision for probable loan losses.............. 666 2,900 2,663 Reclassification to other liabilities........... (281)(1) -- -- ------------- ----------- ----------- Balance, end of year............................ $ 12,497 $ 13,451 $ 13,227 ============= =========== ===========
(1) The Company reclassified the allowance for probable loan losses on unused commitments of $281,000 to other liabilities as of December 31, 2004.
As of December 31, 2004, the Company had $1,028,000 in loans on nonaccrual status, which were considered impaired loans. The impaired loans had a related valuation allowance of $250,000 as of December 31, 2004. For the year ended December 31, 2004, the average recorded investment in loans for which impairment has been recognized was approximately $1,111,000. The Company had $302,000 in loans past due 90 days or more and still accruing interest and no restructured loans as of December 31, 2004.
As of December 31, 2003, the Company had $3,972,000 in loans on nonaccrual status, which were considered impaired loans. The impaired loans had a related valuation allowance of $464,000 as of December 31, 2003. For the year ended December 31, 2003, the average recorded investment in loans for which impairment has been recognized was approximately $3,933,000. The Company had $608,000 in loans past due 90 days or more and still accruing interest and no restructured loans as of December 31, 2003.
As of December 31, 2002, the Company had $4,571,000 in loans on nonaccrual status, which were considered impaired loans. The impaired loans had a related valuation allowance of $356,000 as of December 31, 2002. For the year ended December 31, 2002, the average recorded investment in loans for which impairment has been recognized was approximately $2,235,000. The Company had no loans past due 90 days or more and still accruing interest and no restructured loans as of December 31, 2002.
For the year ended December 31, 2004, the Company had $369,000 in foregone interest income on nonaccrual loans and the Company recognized $36,000 in interest income for cash payments received on nonaccrual loans. For the year ended December 31, 2003 the Company had $167,000 in foregone interest income on nonaccrual loans and the Company recognized $3,000 in interest income for cash payments received on nonaccrual loans. For the year ended December 31, 2002 the Company had $70,000 in foregone interest income on nonaccrual loans and the Company recognized $134,000 in interest income for cash payments received on nonaccrual loans.
Concentrations of credit risk arise when a number of clients are engaged in similar business activities, or activities in the same geographic region, or have similar features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic conditions. The Company's loan portfolio is concentrated in commercial (primarily manufacturing, wholesale, and service) and real estate lending, with the balance in consumer loans. While no specific industry concentration is considered significant, the Company's lending operations are located in the Company's market areas that are dependent on the technology and real estate industries and their supporting companies. Thus, the Company's borrowers could be adversely impacted by a downturn in these sectors of the economy which could reduce the demand for loans and adversely impact the borrowers' abilities to repay their loans.
HBC makes loans to executive officers, directors, and their affiliates in the ordinary course of business. These transactions were on substantially the same terms as those prevailing at the time for comparable transactions with unrelated parties and do not involve more than normal risk or unfavorable terms for the Bank.
The following table presents the loans outstanding to related parties, with interest rates at December 31, 2004, ranging from 5.5% to 7.25%, for the years ended December 31, 2004 and 2003:
(Dollars in thousands) 2004 2003 ------------------------------------------------ ------------- ----------- Beginning balance............................... $ 5,250 $ 11,155 Advances on loans during the year............... 1,252 1,817 Repayment on loans during the year.............. (1,873) (7,722) ------------- ----------- Ending balance.................................. $ 4,629 $ 5,250 ============= ===========
Loan Servicing
At December 31, 2004 and 2003, the Company serviced loans guaranteed by the Small Business Administration which it had sold to the secondary market of approximately $146,071,000 and $117,770,000.
At December 31, 2004 and 2003, the balance of the servicing assets was $2,213,000 and $1,876,000, respectively. There was no valuation allowance as of December 31, 2004 and 2003 as the fair market value of the assets was greater than the carrying value. At December 31, 2004 and 2003, the carrying amount of Interest-Only (I/O) strip receivable was $3,954,000, net of an unrealized gain of $1,536,000, and $2,803,000, net of an unrealized gain of $925,000, respectively. These assets represent the servicing spread generated from the sold guaranteed portions of SBA loans. Servicing income from these loans was $2,325,000 and $1,819,000 in 2004 and 2003. Amortization of the related assets for 2004 and 2003 was $1,609,000 and $1,346,000, respectively. In recording the initial value of the servicing assets and the fair value of the I/O strip receivable, the Company uses estimates which are made based on management's expectations of future prepayment and discount rates. Management's estimate of constant prepayment rate ("CPR") was 14% for the year ended December 31, 2004 and 2003. The weighted average discount rate assumption was 9% and 10%, respectively, for the year ended December 31, 2004 and 2003. These prepayment and discount rates were based on current market conditions and historical performance of the various loan pools. If actual prepayments with respect to sold loans occur more quickly than projected the carrying value of the servicing assets may have to be adjusted through a charge to earnings. A corresponding decrease in the value of the I/O strip receivable would also be expected.
At December 31, 2004, key economic assumptions and the sensitivity of the current fair value of residual cash flows on the Interest-Only (I/O) strip to immediate 10 percent and 20 percent adverse changes in those assumptions are as follows:
(Dollars in thousands) ---------------------------------------------------------------------------------- Carrying amount/fair value of interest-only (I/O strip)........................... $ 3,954 Weighted average life (in years).................................................. 4.6 Prepayment speed assumption (annual rate)......................................... 14% Impact on fair value of 10% adverse change in prepayment speed (CPR 15%).......... $ (151) Impact on fair value of 20% adverse change in prepayment speed (CPR 17%).......... $ (426) Residual cash flow discount rate assumption (annual).............................. 9% Impact on fair value of 10% adverse change in discount rate (10% discount rate)... $ (132) Impact on fair value of 20% adverse change in discount rate (11% discount rate)... $ (256)
It is the policy of management to review key economic assumptions used in FAS 140 accounting model to establish the value of the I/O strip on a quarterly basis. The bank has completed a sensitivity analysis to determine the impact on the value of the asset in the event of a 10% and 20% adverse change, independently from any change in another key assumption. This test involved the "Prepayment speed assumption (CPR)" and the "Residual cash flow discount rate". The value of the asset can be adversely impacted by a significant increase in either the "prepayment speed" of the portfolio or a significant increase in the "discount rate".
(5) PREMISES AND EQUIPMENT
Premises and equipment as of December 31, 2004 and 2003 were as follows:
(Dollars in thousands) 2004 2003 ------------------------------------------------ ------------- ----------- Furniture and equipment......................... $ 4,404 $ 4,145 Leasehold improvements.......................... 4,285 4,339 ------------- ----------- 8,689 8,484 Accumulated depreciation and amortization....... (5,506) (4,450) ------------- ----------- Premises and equipment, net..................... $ 3,183 $ 4,034 ============= ===========
Depreciation expense was $1,366,000, $1,995,000, and $1,828,000 for the year ended December 31, 2004, 2003, and 2002, respectively.
(6) DEPOSITS
At December 31, 2004, the Company had $32,796,000 in interest bearing time deposits with a remaining term of greater than one year, of which $27,290,000 exceeded $100,000. Maturity information of all interest bearing time deposits with a remaining term of greater than one year is summarized below.
December 31, (Dollars in thousands) 2004 ------------------------------------------------ ------------- Due after one year through two years............ $ 16,096 Due after two years through three years......... 8,785 Due after three years through four years.......... 7,915 Due after four years through five years........... -- Due after five years.............................. -- ------------- Total time deposits............................. $ 32,796 =============
(7) BORROWING ARRANGEMENTS
FHLB Borrowings & Available Lines of Credit
The Company maintains a collateralized line of credit with the Federal Home Loan Bank (the FHLB) of San Francisco. Under this line, the Company can borrow from the FHLB on a short-term (typically overnight) or long-term (over one year) basis. As of December 31, 2004, the Company had no borrowing outstanding from FHLB. At December 31, 2004, the Company has Federal funds purchase lines and lines of credit available of $56,000,000. The following table represents the Company's total other borrowings for the period indicated:
December 31, ---------------------------- (Dollars in thousands) 2004 2003 ------------------------------------------------ ------------- ----------- FHLB short-term borrowings...................... $ -- $ 15,000 Long-term borrowings............................ 47,800 28,600 ------------- ----------- Total other borrowings.......................... $ 47,800 $ 43,600 ============= ===========
The following table summarizes the Company's borrowings under its Federal funds purchased, security repurchase arrangements and lines of credit for the periods indicated:
(Dollars in thousands) 2004 2003 ------------------------------------------- ------------ ------------ Average balance during the year............ $ 43,109 $ 15,387 Average interest rate during the year...... 2.07% 1.71% Maximum month-end balance during the year.. $ 48,600 $ 43,600 Average rate at December 31................ 2.21% 1.68%
The maturity of the Company's total other borrowings, at December 31, 2004, are as follows:
(Dollars in thousands) 2005 2006 2007 2008 2009 There After Total ----------------------------------------------- -------- ---------- ---------- -------- -------- ---------- --------- Long -term borrowings...................... $ 15,100 $ 10,900 $ 10,900 $ 10,900 $ -- $ -- $ 47,800
Notes Payable to Subsidiary Grantor Trusts
The following is a summary of the notes payable to the Company's subsidiary grantor trusts at December 31:
(Dollars in thousands) 2004 2003 ---------------------------------------------------------------------- --------- ----------- Subordinated debentures due to Heritage Capital Trust I with interest payable semi-anually at 10.875%, redeemable with a premium beginning March 8, 2010 and with no premium beginning March 8, 2020 and due March 8, 2030............................... $ 7,217 $ 7,217 Subordinated debentures due to Heritage Statutory Trust I with interest payable semi-anually at 10.6%, redeemable with a premium beginning September 7, 2010 and with no premium beginning September 7, 2020 and due September 7, 2030....................... 7,206 7,206 Subordinated debentures due to Heritage Statutory Trust II with interest payable semi-anually based on 3-month Libor plus 3.58% (6.13% at December 31, 2004), redeemable with a premium beginning July 31, 2006 and with no premium beginning July 31, 2011 and due July 31, 2031................................................. 5,155 5,155 Subordinated debentures due to Heritage Statutory Trust III with interest payable semi-anually based on 3-month Libor plus 3.40% (5.95% at December 31, 2004), redeemable with a premium beginning September 26, 2007 and with no premium beginning September 26, 2012 and due September 26, 2032................................... 4,124 4,124 --------- ----------- Total................................................................. $ 23,702 $ 23,702 ========= ===========
The Company has guaranteed, on a subordinated basis, distributions and other payments due on the trust preferred securities issued by the subsidiary grantor trusts. The amount of deferred costs at December 31, 2004, 2003 and 2002 was $601,000, $624,000 and $647,000, respectively. Deferred costs amortization for the years ended December 31, 2004, 2003 and 2002 was $23,000, $23,000 and $31,000, respectively.
(8) INCOME TAXES
The provision for income taxes for the years ended December 31, consisted of the following:
December 31, ----------------------------------------- (Dollars in thousands) 2004 2003 2002 ------------------------------------------------ ------------- ----------- ----------- Current: Federal....................................... $ 3,439 $ 3,463 $ 3,890 State......................................... 923 944 1,060 ------------- ----------- ----------- Total current................................... 4,362 4,407 4,950 ------------- ----------- ----------- Deferred: Federal....................................... (844) (658) (1,037) State......................................... (319) (253) (429) ------------- ----------- ----------- Total deferred.................................. (1,163) (911) (1,466) ------------- ----------- ----------- Provision for income taxes...................... $ 3,199 $ 3,496 $ 3,484 ============= =========== ===========
The effective tax rate differs from the federal statutory rate for the years ended December 31, as follows:
December 31, ----------------------------------------- 2004 2003 2002 ------------- ----------- ----------- Statutory federal income tax rate............... 35.0 % 35.0 % 35.0 % State income taxes, net of federal tax benefit.. 7.9 5.2 4.5 Low income housing credits...................... (5.3) (2.6) -- Non-taxable interest income..................... (2.6) (1.2) (1.6) Officers' life insurance........................ (8.8) (3.6) (3.5) Other........................................... 1.2 (1.8) (1.6) ------------- ----------- ----------- Effective tax rate.............................. 27.4 % 31.0 % 32.8 % ============= =========== ===========
Net deferred tax asset as of December 31, consists of the following:
December 31, ---------------------------- (Dollars in thousands) 2004 2003 ------------------------------------------------ ------------- ----------- Deferred tax assets: Allowance for loan losses................... $ 5,255 $ 5,656 Securities available-for-sale............... -- 32 Accrued expenses............................ 4,127 1,978 FHLB stock.................................. -- 602 State income taxes.......................... 323 332 Net operating loss carryforward............. 103 225 Other....................................... 1,408 678 ------------- ----------- Total deferred tax assets....................... 11,216 9,503 ------------- ----------- Deferred tax liabilities: Securities available-for-sale............... (468) -- Leases...................................... (89) (455) Loan fees................................... (989) (112) Other....................................... (278) (207) ------------- ----------- Total deferred tax liabilities.................. (1,824) (774) ------------- ----------- Net deferred tax assets......................... $ 9,392 $ 8,729 ============= ===========
The Company believes that it is more likely than not that it will realize the above deferred tax assets in future periods; therefore, no valuation allowance has been provided against its deferred tax assets.
The Company has net operating loss carryforwards of $295,000 for federal income tax purposes. These losses related to the entity that was the predecessor of the Bank, and are subject to restrictions as a result of the change of control that limits the maximum annual recovery of the net operating loss to $295,000. The net operations losses of approximately $290,000 expire in 2005, $3,000 expire in 2008 and $2,000 expire in 2009. Management has determined that a valuation allowance is not necessary.
(9) STOCK BASED COMPENSATION
The Company has a stock option plan (the Plan) for directors, officers, and key employees. The Plan provides for the grant of incentive and non-qualified stock options. The Plan provides that the option price for both incentive and non-qualified stock options will be determined by the Board of Directors at no less than the fair value at the date of grant. Options granted vest on a schedule determined by the Board of Directors at the time of grant. Generally, options vest over four years. All options expire no later than ten years from the date of grant. As of December 31, 2004, there are 276,500 shares available for future grants under the Plan. Option activity under the Plan is as follows:
Weighted Number Average of Exercise Shares Price ----------- --------- Options Outstanding at January 1, 2002 (1,148,381 exercisable at weighted average exercise price of $7.69).... 1,546,651 $ 8.25 Granted (weighted average fair value of $3.13)......................... 300,500 $ 8.63 Exercised.............................................................. (99,447) $ 2.80 Cancelled.............................................................. (149,692) $ 11.14 ----------- Options Outstanding at December 31, 2002 (1,144,948 exercisable at weighted average exercise price of $8.18).... 1,598,012 $ 8.39 Granted (weighted average fair value of $4.45)......................... 94,438 $ 10.95 Exercised.............................................................. (166,623) $ 5.57 Cancelled.............................................................. (66,989) $ 9.45 ----------- Options Outstanding at December 31, 2003 (1,134,344 exercisable at weighted average exercise price of $8.69).... 1,458,838 $ 8.82 Granted (weighted average fair value of $5.03)......................... 184,500 $ 14.37 Exercised.............................................................. (552,528) $ 7.81 Cancelled.............................................................. (103,835) $ 10.68 ----------- Options Outstanding at December 31, 2004 (723,336 exercisable at weighted average exercise price of $9.52)...... 986,975 $ 10.23 ===========
Additional information regarding options outstanding under the Plan as of December 31, 2004 is as follows:
Weighted Average Weighted Weighted Remaining Average Average Range of Number Contractual Exercise Number Exercise Exercise Prices Outstanding Life (Yrs.) Price Exercisable Price ------------------- ------------- ----------- --------- ------------ --------- $ 1.42 - $4.41... 40,787 1.50 $ 2.62 40,787 $ 2.62 $ 4.42 - $5.32... 34,296 2.43 $ 5.22 34,296 $ 5.22 $ 5.33 - $9.70... 470,505 5.91 $ 8.87 381,265 $ 8.91 $ 9.71 - $16.37.. 417,887 6.73 $ 12.49 266,176 $ 11.98 $16.38 - $19.06... 23,500 9.87 $ 17.94 812 $ 17.68 ------------- ------------ $ 1.42 - $19.06.. 986,975 6.05 $ 10.23 723,336 $ 9.52 ============= ============
As discussed in Note 1, the Company continues to account for its stock-based awards using the intrinsic value method in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related interpretations. Accordingly, no compensation expense has been recognized in the financial statements for employee stock option arrangements.
(10) LEASES
Operating Leases
The Company leases its premises under non-cancelable operating leases with terms, including renewal options, ranging from five to fifteen years. Future minimum payments under the agreements are as follows:
(Dollars in thousands) Year ending December 31, --------------------------------------------------------- 2005.................................................. $ 2,186 2006.................................................. 2,084 2007.................................................. 2,127 2008.................................................. 1,672 2009.................................................. 1,392 Thereafter.............................................. 910 ---------- Total................................................... $ 10,371 ==========
Rent expense under operating leases was $2,610,000, $2,609,000, and $2,506,000, during the years ended December 31, 2004, 2003, and 2002. Rent expense was reduced by deferred rent concessions on one of the Company's locations of $42,000 for the year ended December 31, 2004 and $46,000 for the year ended December 31, 2003 and 2002.
(11) BENEFIT PLANS
The Company offers a 401(k) savings plan. All salaried employees are eligible to contribute up to 20% of their pre-tax compensation (to maximums established by the Internal Revenue Code) to the plan through salary deductions under Section 401(k) of the Internal Revenue Code. The Company has made a discretionary matching contribution of up to $1,500 for each employee's contributions in 2004, 2003 and 2002. Contributions paid were $292,000, $284,000, and $304,000 in 2004, 2003 and 2002.
The Company also sponsors an employee stock ownership plan. The plan allows the Company to purchase shares on the open market and award those shares to certain employees in lieu of paying cash bonuses. To be eligible to receive an award of shares under this plan, an employee must have worked at least 1,000 hours during the year and must be employed by the Company, or its subsidiary, on December 31. Awards under this plan generally vest over four years. During 2004, 2003 and 2002, the Company made contributions of $450,000, $397,000, and $358,000 into the Plan. The amount contributed was recognized as salaries and benefits expense in the Company's financial statements. On September 7, 2001, the ESOP borrowed $1,000,000 from an unaffiliated third party lender in order to fund the purchase of common stock of the Company. This loan is being repaid with annual installments of principal of $250,000 until September 7, 2005, at which time the principal outstanding balance together with accrued interest is due and payable. An annual rate of interest, equal to Prime rate plus 0.50% floating on a daily basis, is due on the first day of each month. The funds for repayment will be primarily coming from the Company's contributions to the ESOP over a similar time period. The loan is collateralized by the 127,000 shares of the Company's common stock held by the ESOP. At December 31, 2004, the ESOP owned approximately 197,900 shares of the Company's stock. At December 31, 2004 and 2003, the unearned compensation related to the ESOP was $193,000 and $443,000. These amounts are shown as a reduction of shareholders equity in the Consolidated Balance Sheets.
The Company also has a nonqualified deferred compensation plan for the directors ("Deferral Plan"). Under the Deferral Plan, a participating director may defer up to 100% of his monthly board fees into the Deferral Plan for up to ten years. Amounts deferred earn interest at the rate of 8% per annum. The director may elect a distribution schedule of up to ten years with interest accruing (at the same 8%) on the declining balance. The Company's deferred compensation obligation of $412,000 and $332,000 as of December 31, 2004 and 2003 is included in "Accrued interest payable and other liabilities".
The Company has purchased life insurance policies on the lives of directors who have agreed to participate in the Deferral Plan. It is expected that the earnings on these policies will offset the cost of the program. In addition, the Company will receive death benefit payments upon the death of the director. The proceeds will permit the Company to "complete" the deferral program as the director originally intended if he dies prior to the completion of the deferral program. The disbursement of deferred fees is accelerated at death and commences one month after the director dies.
In the event of the director's disability prior to attainment of his benefit eligibility date, the director may request that the Board permit him to receive an immediate disability benefit equal to the annualized value of the director's deferral account.
The Company has a supplemental retirement plan covering key executives and directors (Plan). The Plan is a nonqualified defined benefit plan and is unsecured and unfunded and there are no Plan assets. The deferred benefit represents a stated amount for key executives and directors that generally vest over nine years and is reduced for early retirement. The Company has purchased insurance on the lives of the directors and executive officers in the plan and intends to use the cash values of these policies ($26,303,000 and $25,273,000 at December 31, 2004 and 2003, respectively) to pay the retirement and death benefit obligations. If the life insurance contract is terminated by the Company, the Company still has the obligation to pay the retirement and death benefits. The accrued pension obligation was $5,805,000 and $4,129,000 as of December 31, 2004 and 2003, respectively, and is included in "Accrued interest payable and other liabilities". Accordingly, the plan had additional minimum liabilities of $1,940,000 as of December 31, 2004, and $0 as of December 31, 2003 and 2002. Due to these additional minimum liabilities, the plan also had accumulated other comprehensive expense before taxes of $1,940,000 as of December 31, 2004, and $0 as of December 31, 2003 and 2002. The measurement date at the plan is December 31.
The following table sets forth the unqualified supplemental retirement defined benefit plan's status at December 31:
(Dollars in thousands) 2004 2003 2002 ---------- ---------- --------- Change in projected benefit obligation Projected benefit obligation at beginning of year...... $ 3,962 $ 3,350 $ 2,399 Service cost........................................... 473 457 636 Interest cost.......................................... 386 198 153 Actuarial (gain)/loss.................................. 2,223 (43) 162 Special termination benefits........................... 765 -- -- Benefits paid.......................................... (64) -- -- ---------- ---------- --------- Projected benefit obligation at end of year............ $ 7,745 $ 3,962 $ 3,350 ========== ========== =========
(Dollars in thousands) 2004 2003 2002 ---------- ---------- --------- Change in Plan assets Fair value of Plan assets at beginning of year........ $ -- $ -- $ -- Actual return on assets............................ -- -- -- Employer contribution.............................. 64 -- -- Benefits paid...................................... (64) -- -- ---------- ---------- --------- Fair value of Plan assets at end of year.............. $ -- $ -- $ -- ========== ========== =========
Unfunded Status.......................................... $ (7,745) $ (3,962) $ (3,350) Unrecognized net actuarial (gain)/loss................... 1,940 (167) (125) ---------- ---------- --------- Net amount recognized.................................... $ (5,805) $ (4,129) $ (3,475) ========== ========== =========
Accrued benefit liability................................ $ (7,745) $ (3,962) $ (3,350) Accumulated other comprehensive expense.................. 1,940 -- -- ---------- ---------- --------- Net amount recognized.................................... $ (5,805) $ (3,962) $ (3,350) ========== ========== =========
Weighted-average assumptions as of December 31 Discount rate......................................... 5.60% 7.00% 7.00% Rate of compensation increase......................... N/A N/A N/A Expected return on Plan assets........................ N/A N/A N/A
The following benefit payments, which reflect anticipated future events, as appropriate, are expected to be paid over the following years:
Year Benefit Payments ------- --------------------- (Dollars in thousands) 2005 $ 64 2006 126 2007 164 2008 225 2009 241 2010 to 2014 2909
The elements of pension costs for the unqualified supplemental retirement defined benefit plan at December 31, 2004 were as follows:
(Dollars in thousands) 2004 2003 2002 ---------- ---------- --------- Components of net periodic benefits cost Service cost.......................................... $ 473 $ 457 $ 636 Interest cost......................................... 386 198 153 Amortization of (gain)/loss........................... 116 (23) 130 ---------- ---------- --------- Net periodic benefit cost............................. 975 632 919 Expense due to special termination benefits........... 765 -- -- ---------- ---------- --------- Total expense..........................................$ 1,740 $ 632 $ 919 ========== ========== =========
The net periodic pension cost was determined using the following assumptions:
2004 2003 2002 ---------- ---------- --------- Discount rate in determining expense..................... 6.25% 7.00% 7.00% Discount rate in determining benefit obligations at year en 5.60% 7.00% 7.00% Rate of increase in future compensation levels for determining expense................................. N/A N/A N/A Rate of increase in future compensation levels for determining benefit obligations at year end......... N/A N/A N/A Expected return on Plan assets........................... N/A N/A N/A
(12) DISCLOSURES OF FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair value amounts have been determined by using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented are not necessarily indicative of the amounts that could be realized in a current market exchange. The use of different market assumptions and/or estimation techniques may have a material effect on the estimated fair value amounts.
The carrying amounts and estimated fair values of the Company's financial instruments as of December 31, 2004 and 2003 were as follows:
2004 2003 ---------------------- -------------------- Estimated Estimated Carrying Fair Carrying Fair (Dollars in thousands) Amounts Value Amounts Value --------------------------------------------------------- ---------- ---------- --------- --------- Assets Cash and cash equivalents.............................. $ 57,746 $ 57,746 $ 114,217 $ 114,217 Securities............................................. 232,809 232,809 153,473 153,473 Loans, including loans held for sale, net.............. 750,212 748,139 683,275 682,120 Other investments, including company owned life insuran 30,998 30,998 27,777 27,777
Liabilities Time deposits.......................................... $ 162,876 $ 162,436 $ 145,841 $ 146,403 Other deposits......................................... 755,659 755,659 689,569 689,569 Other borrowings....................................... 47,800 43,800 43,600 44,843 Notes payable subsidiary grantor trusts................ 23,702 21,702 23,702 21,859
The following methods and assumptions were used to estimate the fair value in the table, above:
Cash and Cash Equivalents
The carrying amount approximates fair value because of the short maturities of these instruments.
Securities
The fair value of securities is estimated based on bid market prices. The fair value of certain municipal securities is not readily available through market sources other than dealer quotations, so fair value estimates are based on such dealer quotations.
Loans, net
Loans with similar financial characteristics are grouped together for purposes of estimating their fair value. Loans are segregated by type such as commercial, term real estate, residential construction, and consumer. Each loan category is further segmented into fixed and adjustable rate interest terms.
The fair value of performing, fixed rate loans is calculated by discounting scheduled future cash flows using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The fair value of variable rate loans is the carrying amount as these loans generally reprice within 90 days. The fair value calculations are adjusted by the allowance for possible loan losses.
Other Investments
Other investments consist of FRB and FHLB stock and the cash surrender value of the Company Owned Life Insurance policies. The carrying amount represents a reasonable estimate of fair value.
Deposits
The fair value of deposits with no stated maturity, such as non-interest bearing demand deposits, savings, and money market accounts, approximates the amount payable on demand. The fair value of the demand deposit intangible has not been included in the fair value estimate. The carrying amount approximates the fair value of time deposits with a remaining maturity of less than 90 days. The fair value of all other time deposits is calculated based on discounting the future cash flows using rates currently offered by the Bank for time deposits with similar remaining maturities.
Commitments to Fund Loans/Standby Letters of Credit
The fair values of commitments are estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. The amounts of and differences between the carrying value of commitments to fund loans or stand by letters of credit and their fair value is not significant and therefore is not included in the table above.
Other Borrowings
Other borrowings consist of FRB and FHLB short-term borrowings and other long-term borrowings. The fair value of the short-term borrowings was based on their carrying amount. The fair values of the other borrowings were determined based on the current market value for like kind instruments of a similar maturity and structure.
Notes Payable to Subsidiary Grantor Trusts
The fair value of the notes payable to subsidiary grantor trusts was determined based on the current market value for like kind instruments of a similar maturity and structure.
Limitations
Fair value estimates are made at a specific point in time, based on relevant market information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Bank's entire holdings of a particular financial instrument. Fair value estimates are based on judgments regarding future expected loss experience, 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 estimates.
(13) COMMITMENTS AND CONTINGENCIES
Financial Instruments with Off-Balance Sheet Risk
HBC is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its clients. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk, in excess of the amounts recognized in the balance sheets.
HBC's exposure to credit loss in the event of non-performance of the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. HBC uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Credit risk is the possibility that a loss may occur because a party to a transaction failed to perform according to the terms of the contract. HBC controls the credit risk of these transactions through credit approvals, limits, and monitoring procedures. Management does not anticipate any significant losses as a result of these transactions.
Commitments to extend credit as of December 31, were as follows:
(Dollars in thousands) 2004 2003 --------------------------------------------------------- ---------- ---------- Commitments to extend credit............................. $ 313,036 $ 269,504 Standby letters of credit................................ 5,256 4,449 ---------- ---------- $ 318,292 $ 273,953 ========== ==========
Commitments to extend credit are agreements to lend to a client as long as there is no violation of conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses. Since some of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. HBC evaluates each client's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by HBC upon the extension of credit, is based on management's credit evaluation of the borrower. Collateral held varies but may include cash, marketable securities, accounts receivable, inventory, property, plant and equipment, income-producing commercial properties, and/or residential properties. Fair value of these instruments is not material.
Standby letters of credit are written with conditional commitments issued by HBC to guaranty the performance of a client to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to clients. The Company has a deferred liability of $19,000 as of December 31, 2004, which represents the premiums received on outstanding financial standby letters of credit. The Company recognizes these premiums as income as the commitments are used or as they expire.
Claims
The Company is involved in certain legal actions arising from normal business activities. Management, based upon the advice of legal counsel, believes the ultimate resolution of all pending legal actions will not have a material effect on the financial statements of the Company.
(14) REGULATORY MATTERS
The Company and its subsidiary bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and HBC must meet specific capital guidelines that involve quantitative measures of the Company's and HBC's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company's and HBC's capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Company and HBC to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes that, as of December 31, 2004, the Company and HBC meet all capital adequacy guidelines to which it is subject.
The most recent notification from the FDIC for HBC as of December 31, 2004 categorized HBC as "well capitalized" under the regulatory framework for prompt corrective action. To be categorized as "well capitalized" HBC must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank's category.
The Company's actual capital amounts and ratios are presented in the following table.
Actual For Capital Adequacy Purposes -------------------- ------------------------------------------ (Dollars in thousands) Amount Ratio Amount Ratio ------------------------------ --------- --------- --------- ------------------------------- As of December 31, 2004 Total Capital................ $ 132,719 14.3% $ 74,248 (greater than or equal to) 8.0% (to risk-weighted assets) Tier 1 Capital............... $ 121,096 13.0% $ 37,260 (greater than or equal to) 4.0% (to risk-weighted assets) Tier 1 Capital............... $ 121,096 10.9% $ 44,439 (greater than or equal to) 4.0% (to average assets)
As of December 31, 2003 Total Capital................ $ 120,933 14.6% $ 66,265 (greater than or equal to) 8.0% (to risk-weighted assets) Tier 1 Capital............... $ 110,530 13.3% $ 33,242 (greater than or equal to) 4.0% (to risk-weighted assets) Tier 1 Capital............... $ 110,530 11.1% $ 39,831 (greater than or equal to) 4.0% (to average assets)
HBC's actual capital amounts and ratios are presented in the following table.
To Be Well-Capitalized Under Prompt Actual For Capital Adequacy Purposes Corrective Action Provisions -------------------- ------------------------------------------ ------------------------------------------ (Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio ------------------------------ --------- --------- --------- ------------------------------- --------- ------------------------------- As of December 31, 2004 Total Capital................ $ 127,474 13.7% $ 74,329 (greater than or equal to) 8.0% $ 92,911 (greater than or equal to) 10.0% (to risk-weighted assets) Tier 1 Capital............... $ 115,851 12.5% $ 37,162 (greater than or equal to) 4.0% $ 55,742 (greater than or equal to) 6.0% (to risk-weighted assets) Tier 1 Capital............... $ 115,851 10.4% $ 44,687 (greater than or equal to) 4.0% $ 55,859 (greater than or equal to) 5.0% (to average assets)
As of December 31, 2003 Total Capital................ $ 113,538 13.6% $ 66,787 (greater than or equal to) 8.0% $ 83,484 (greater than or equal to) 10.0% (to risk-weighted assets) Tier 1 Capital............... $ 103,135 12.4% $ 33,269 (greater than or equal to) 4.0% $ 49,904 (greater than or equal to) 6.0% (to risk-weighted assets) Tier 1 Capital............... $ 103,135 10.3% $ 40,052 (greater than or equal to) 4.0% $ 50,066 (greater than or equal to) 5.0% (to average assets)
The Company is required to maintain reserves with the Federal Reserve Bank of San Francisco. Reserve requirements are based on a percentage of certain deposits. As of December 31, 2004, the Company maintained reserves of $8,800,000 in the form of vault cash and balances at the Federal Reserve Bank of San Francisco, which satisfied the regulatory requirements.
Under California law, the holders of common stock are entitled to receive dividends when and as declared by the Board of Directors, out of funds legally available therefor. The California Banking Law provides that a state-licensed bank may not make a cash distribution to its shareholders in excess of the lesser of the following: (i) the bank's retained earnings, or (ii) the bank's net income for its last three fiscal years, less the amount of any distributions made by the bank to its shareholders during such period. However, a bank, with the prior approval of the Commissioner, may make a distribution to its shareholders of an amount not to exceed the greater of (i) a bank's retained earnings, (ii) its net income for its last fiscal year, or (iii) its net income for the current fiscal year. In the event that the Commissioner determines that the shareholders' equity of a bank is inadequate or that the making of a distribution by a bank would be unsafe or unsound, the Commissioner may order a bank to refrain from making such a proposed distribution. At December 31, 2004, the amount available for such dividend without prior written approval was approximately $27,885,000 for HBC. Similar restrictions apply to the amounts and sum of loan advances and other transfers of funds from HBC to the Company.
(15) PARENT COMPANY ONLY CONDENSED FINANCIAL INFORMATION
The condensed financial statements of Heritage Commerce Corp (parent company only) are as follows:
CONDENSED BALANCE SHEETS
December 31, December 31, (Dollars in thousands) 2004 2003 ----------------------------------------------------------------- ------------ ------------ Cash and cash equivalents........................................ $ 7,830 $ 8,880 Investment in and advancements to subsidiary..................... 115,044 104,104 (1) Other assets..................................................... 1,191 1,300 ------------ ------------ Total.................................................... $ 124,065 $ 114,284 ============ ============
Liabilities...................................................... $ 1,784 $ 1,097 Amounts due to subsidiaries...................................... 23,702 23,702 Shareholders' equity............................................. 98,579 89,485 (1) ------------ ------------ Total.................................................... $ 124,065 $ 114,284 ============ ============
(1) As restated, see Note 2.
CONDENSED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
For the Year Ended, ------------------------------------------ December 31, December 31, December 31, (Dollars in thousands) 2004 2003 2002 ----------------------------------------------------------------- ------------ ------------ ------------ Interest income.................................................. $ 97 $ 122 $ 95 Management and service fees...................................... -- -- 10,747 Interest expense................................................. -- (1,965) (1,920) Other expenses................................................... (3,124) (71) (11,176) ------------ ------------ ------------ Loss before equity in net income of subsidiary banks............. (3,027) (1,914) (2,254) Equity in undistributed net income of subsidiary................. 10,676 9,090 (1) 8,669 (1) Income tax benefit .............................................. 829 600 739 ------------ ------------ ------------ Net income ...................................................... 8,478 7,776 (1) 7,154 (1) Other comprehensive income (loss)................................ (1,809) (1,635) 693 ------------ ------------ ------------ Comprehensive income............................................. $ 6,669 $ 6,141 $ 7,847 ============ ============ ============
(1) As restated, see Note 2.
CONDENSED STATEMENTS OF CASH FLOWS
For the Year Ended, ------------------------------------------ December 31, December 31, December 31, (Dollars in thousands) 2004 2003 2002 ----------------------------------------------------------------- ------------ ------------ ------------ Cash flows from operating activities: Net Income....................................................... $ 8,478 $ 7,776 (1)$ 7,154 (1) Adjustments to reconcile net income to net cash used in operations: Provision for deferred income taxes........................... (829) (600) (739) Equity in undistributed income of subsidiary.................. (10,676) (9,090)(1) (8,669)(1) Net change in other assets.................................... 96 135 (416) Net change in other liabilities............................... 1,529 796 2,328 ------------ ------------ ------------ Net cash used in by operating activities (1,402) (983) (342)
Cash flows from investing activities: Cash distributed to Bank subsidiaries........................ -- -- -- Net cash used in investing activities ------------ ------------ ------------ -- -- --
Cash flows from financing activities: Proceeds from issuance of common stock........................ 4,316 1,173 421 Proceeds from issuance of long-term debt...................... -- -- 4,000 Payment to repurchase common stock............................ (4,214) -- -- Other, net.................................................... 250 (443) (693) ------------ ------------ ------------ Net cash provided by financing activities........................ 352 730 3,728 ------------ ------------ ------------ Net increase (decrease) in cash and cash equivalents............. (1,050) (253) 3,386 Cash and cash equivalents, beginning of year..................... 8,880 9,133 5,747 ------------ ------------ ------------ Cash and cash equivalents, end of year........................... $ 7,830 $ 8,880 $ 9,133 ============ ============ ============
(1) As restated, see Note 2.
EXHIBIT INDEX
* Management contract or compensatory plan or arrangement.